Whatever Happened to FX?
This is a three-part series exploring the underperformance of currency markets and strategies since the great financial crisis. This week, we take stock of the problem and whether FX underperformance has created a hidden opportunity.
At $6.6 trillion in daily volume, the foreign exchange market is the largest financial market in the world. Yet, despite its size, the currency market has not been a profitable one for investors over the last decade. In fact, from the end of 2010 to today, macro currency hedge funds in aggregate have generated zero profits.
Figure 1: HFRI Macro Currency Index (2010–Present)
Source: HFR Research,Verdad
This zero-return environment has led to an exodus of currency hedge funds. After peaking at around 145 in 2008, the count of funds focused on currencies is now down below 50.
What’s happened to currency markets and currency strategies that’s rendered the market so barren of opportunities and profitable strategies? The short answer is a sharp decline in the volatility of both exchange and interest rates since the financial crisis.
Currency returns are driven by two variables: changes in the spot rate (i.e., how many rupees you can buy with a dollar) and changes in the spread between countries’ interest rates (i.e., how much interest rupees earn versus how much interest dollars earn in interest-bearing accounts).
The past decade has seen a convergence of global interest rates. The below chart shows the average spread between the 20 most traded foreign currencies and the US Dollar since 1982. This has bounded the opportunity set for those trying to arbitrage interest rate differentials.
Figure 2: Average Depository Rate Spread to USD since 1999
Source: Thomson Reuters Datastream, Verdad
Changes in spot rates have also become less volatile. The 1990s saw numerous crises and dramatic exchange rate fluctuations. From the Peso Crisis to the Asian Financial Crisis, foreign exchange market participants witnessed precipitous declines. Since these events, however, volatility has been declining. Figure 3 shows the average standard deviation in monthly changes in nominal exchange rates for 20 countries against the USD since 1987, together with the standard deviation. The data show that average volatility rose through the 1990s but has declined in recent years.
Figure 3: Average Standard Deviation of Exchange Rates since 1987
Source: Datastream, Verdad
Falling interest rate differentials and declining volatility have made currency markets a difficult place to make money. Yet we tend to think that the less interesting a market has been, the fewer smart participants, and the greater the bearishness, the better the potential opportunity. So we have set to studying common currency trading strategies to understand the basics of how these markets work and what we can learn about the potential value of foreign currency strategies as part of broader investor portfolios.
We analyzed the distinct currency pairs of the 21 countries listed in Figure 4, including both emerging markets and developed countries.
Figure 4: Currency Panel and Classifications
Source: Verdad
Using Thomson Reuters Datastream, we pulled monthly historical nominal exchange rate data for the 21 currency pairs and the associated three-month depository rates for the period 12/31/1982 – 2/29/2021.
We used this panel of currencies to test three of the most common systematic FX strategies: carry, momentum, and value, which we will explore next week. By analyzing the return characteristics of these strategies and studying crashes that have affected various currencies over the decades, we have uncovered an opportunity for equity investors to diversify their portfolios with a hedging strategy that selectively shorts the riskiest currencies. We’ll explore that in detail two weeks from now.