Outlook on the Dollar, Currencies & Markets

Take a quick look at the chart to the right: When the stock market goes up almost in a straight line hitting record highs and volatility trends downward hitting record lows, it spells complacency. Complacency leads to asset bubbles. Asset bubbles, thus far, have never had a pretty ending.

Complacency: Mother of all Asset Bubbles

Investors have a tendency to ignore the hidden risks in their investments, even if those risks may be hiding in plain sight. You may recall the references to a “goldilocks” economy in the run-up to the 2008 credit crisis. Similarly, in the 1990s, what could possibly go wrong investing in tech stocks? What these episodes have in common is that the downside volatility of asset prices was unusually low. The pessimists warn of pending collapse, yet are ignored. 

As an optimist, I agree with the pessimists. Not because I think the world will come to an end, but because the path from euphoric to normal is a rough one. When low asset price volatility lulls investors into believing the markets have become safer than they really are, folks take risks that they are bound to regret. Those that pile into the equity markets on the backdrop of ever shorter corrections, of ever higher asset prices, of historically low volatility, may be running for the exit fast when they realize they had no business being over-exposed to the equity markets in the first place. 

Why Currencies?

We like the currency market for a few of reasons, including:

• Historically, exchange rates exhibit low correlation to equity markets; in fact, if one employs an absolute return (long/short) currency strategy, one can design a portfolio that should exhibit low correlation to equities over time. An example I like to cite is that taking a position in the New Zealand Dollar versus the Australian dollar will almost certainly generate returns that are not correlated to how equity prices behave.

• Low correlation can provide downside resilience. That may come handy should the quity markets reverse. If deployed without leverage, a long/short currency strategy has a risk profile that – in our assessment – makes it a good candidate to be used instead of a bond allocation.While there are bond strategies that have  historically had an even lower risk profile, few alternatives offer as compelling a risk profile as currencies. 

• The currency market provides unique profit opportunities as many market participants are not seeking to maximize their profits: from corporate hedgers to central banks, even tourists spending money abroad.

What follows is our currency outlook for the second half of the year. As all forward-looking statements, these opinions are subject to change as we continuously evaluate new information and adjust our outlook accordingly.

The Dollar - Leadership Anyone?

The U.S. dollar has not been acting as a safe haven currency. Part of it may be because of a lack of leadership. We are not referring to Mr. Obama, but Ms. Yellen. And it’s not personal. The Fed has, in our interpretation, communicated that monetary policy shall be increasingly ad hoc. In fact, the best indicator of where rates will go may be whether the convicted felons that the head of the Federal Reserve profiled in her first public speech have a job by now. I wish this were a joke, but I’m rather serious about it: Yellen has indicated she wants to keep rates low as long as necessary to boost employment as long as inflation does not cause too much of a problem. 

Curiously, when inflation numbers come out higher than expected, a currency often appreciates versus its peers, as investors anticipate the central bank will do “the right thing” and raise rates. It’s then, over time, that the currency reflects whether the central bank walks the talk. In the case of the Fed, we don’t think the Fed is likely to walk the talk. As such, we continue our overall negative view with regard to the dollar.