Currency cyclicality and valuations

Takeaways:

• Currency pro- and countercyclicality examined using stocks and bonds;
• Pro- and countercyclical FX v global stocks and bonds: chiefly JPY, and commodity orientation and EMs, respectively;
• Under- and overvaluations in addition to FX cyclicality: more granular FX long/short strategies

Identifying pro- and countercyclical currencies and their valuations can help manage FX exposure in investment portfolios.

• Currency pro- and countercyclicality examined using stocks and bonds

Inspecting currency cyclicality can be done by considering stock and bond returns over economic upturns and downturns. This is because global stocks and bonds are positively and negatively related to the global manufacturing PMI, as depicted in Figure 1. The charts show the correlation over time (LHS) and percentile ranges (RHS) and imply the procyclicality and countercyclicality of stocks and bonds, respectively.

In addition, it’s interesting to note the unusual correlation between bonds and the economic cycle lately. The recent correlation between global bonds and the PMI, although remaining negative, became an outlier, rising above the 95th percentile (also see ‘Bonds struggle during high inflation’).

• Pro- and countercyclical FX v global stocks and bonds: chiefly JPY, and commodity orientation and EMs, respectively

Being more exposed to (or less hedged against) countercyclical currencies but less exposed to (or more hedged against) procyclical currencies could help smooth out the volatilities of and correlations among underlying foreign currency-denominated assets. Consequently, downside risks in overall investment portfolios can be managed better, especially in times of distress where diversification benefits are needed. These implications are for FX managers who take a pessimistic stance on economic and investment outlooks.

Meanwhile, being more exposed to procyclical currencies but less to countercyclical currencies would leverage tactical positioning if overall economic and investment outlooks are perceived as optimistic rather than pessimistic.

To study FX pro- and countercyclicality, the correlation of currencies with global stocks and bonds was computed on a 5-year-rolling basis, as illustrated in Figure 2, using NEER (upper pane) and REER (lower pane) indices.

On the one hand, countercyclical currencies that are negatively associated with stocks and positively with bonds are JPY, CHF, and EUR, while the USD is not always the case, given its REER’s inverse relationship with global bonds (bottom-right chart). On the other hand, procyclical currencies positively associated with stocks and negatively with bonds are mainly commodity-oriented (AUD, CAD, NOK, etc.) and EM (KRW, INR, MXN, etc.).

• Under- and overvaluations in addition to FX cyclicality: more granular FX long/short strategies

Furthermore, FX valuations are among the assessment tools that supplement FX cyclicality considerations.

To diversify FX risks, portfolio managers can raise exposure to undervalued countercyclical currencies or reduce that to overvalued procyclical currencies.

On the contrary, investors that favor an economic recovery or expansion or a soft or no landing might increase positions in undervalued procyclical currencies or decrease those in overvalued countercyclical currencies. These would help augment efficiency pertaining to mean-reverting opportunities.

As seen in Figure 3, standardized measures, namely z-scores and percentile ranks, are computed by deploying NEERs and REERs in addition to FX cyclicality (correlations with global equities rather than bonds taken into account due to monetary contractionary policies being more intense than typical these years). REERs to a certain extent also capture the conception of purchasing power parity (PPP) since REERs around long-run levels probably indicate PPP validity; thus, deviations could point to PPP-based under- and overvaluations.

Recently, by diversifying FX risks, the calculated z-scores and percentile ranks (considering both NEERs and REERs), coupled with FX cyclicality, suggest going long in (or becoming less hedged against) undervalued countercyclical JPY or going short in (or becoming more hedged against) procyclical overvalued GBP and MXN. Conversely, economic optimists may go long in undervalued procyclical CAD, SEK, NOK, KRW, ZAR, etc., or go short in overvalued countercyclical USD, EUR, and CHF.

All in all, FX cyclicality alongside valuations applied to FX management can be summarized and exhibited in Figure 4, where other methodologies are also applicable to further improve and provide alternatives to the analysis above.

Thanks to Macrobond Financial's efficient platform (datasets, analytics, visualizations)

The views expressed in this writing are solely those of the author and do not reflect those of the author’s affiliation, Macrobond Financial.

Bibliography

Tazé-Bernard, E., Franceries, K., & Crosnier, L. (2023). Currency hedging policy for institutions. Amundi Asset Management.