How currencies can help fixed income investors
Exactly 150 years ago on this day, August 10 1866, the Times newspaper in London published the exchange rate between pound sterling and the US dollar. What made this particular publication unique was that, for the first time, the exchange rate had been transmitted via a cable laid across the Atlantic Ocean.
There had been more striking examples of how the cable could speed up communication: in 1856, Queen Victoria had sent the first message via the cable to James Buchanan, the president of the United States, but communications soon broke down and it took nearly a decade until a reliable connection could be made.
In the history of finance, though, the transmission of the exchange rate via the cable marked a giant technological leap forward and made “cable” a byword for the pound/dollar exchange rate. Interestingly, the first financial news whizzing between New York and London in a matter of minutes was about currencies – not equity, bond, or commodity prices. Even then, as today, currencies were (arguably) the most important piece of financial information.
Despite their huge significance, currencies are sometimes considered a hindrance rather than an opportunity. Not all fixed-income investors, for instance, appreciate that currencies can offer an additional source of diversification and returns in today’s environment of ultra-low and negative interest rates.
So what is the attraction of fast-changing foreign-exchange rates to the fixed-income world? One possibility for bond investors is to look at currencies as the “new duration”. In recent years, currencies have become increasingly sensitive to changes in interest-rate expectations. As the chart below shows, a change of 100 basis points in expected interest-rate differentials can cause significant moves in the affected currencies. In fact, since the adoption of aggressive accommodative monetary policies by central banks, these moves have been amplified. Anticipating such changes can therefore prove beneficial.
Currency move associated with a 100bps increase in expected interest-rate differential
This is just one example of the value an active currency approach can add in a fixed-income strategy. Further benefits can include reduced long-term risk, increased flexibility and a diminished overall volatility in bond portfolios. For these reasons, we believe currencies deserve to be considered as a separate asset class, rather than just a risk to be hedged. In the coming weeks we will delve deeper into this asset class from a fixed-income perspective and the rationale for implementing currency strategies in bond portfolios – provided of course that the cables are working.
Ludovic Colin is senior portfolio manager at Vontobel Asset Management