FX in Focus

Recently we’ve been thinking a great deal about FX.

Partly, of course, it’s the fact that the yen is playing such a central role in conversations just now, with the unwind of the carry trade driving a rally in a currency that has moved more or less exclusively in one direction since Covid. In his latest ‘Solid Ground’ newsletter, the great Russell Napier (who was a star turn at Man Group 's MAIS conference last year) wrote compellingly about the fact that markets are more complexly intertwined than most of us imagine. “The exceptionally high valuations accorded to US corporations is not solely a reflection of their exceptionalism,” he said, “but it is in part, a large part, a product of monetary policy decisions made in the east.” As always with Napier, the force of his argument doesn't leave a great deal of room for nuance (and there are plenty who would disagree with many aspects of this statement) but I feel like there’s truth at the heart of it.

The link between the decline of the Magnificent 7 and the unwind of the yen carry trade might not immediately be obvious, but we think that there are deep-lying reasons for associating the two: we are potentially witnessing a profound structural change in the global economy, one which will only likely accelerate should Trump win the election in November. To quote another market sage, Ronald McKinnon of Stanford (who, by-the-by, developed the theory of financial repression), “Economists have failed rather dismally to construct convincing theoretical models of why the seemingly endless U.S. current account deficits are sustained by the seemingly endless willingness by the rest of the world to acquire dollar assets.”

The devaluation of the dollar is a key element in the economic philosophy of JD Vance in particular. Trump and various influential think tanks (this interview with Oren Cass of American Compass is enlightening) have leapt upon devaluation as a policy tool that delivers an America that looks much more like the manufacturing powerhouse of their (American) dreams. It may be they have a point – the chart below (from BCA Research ) shows that (albeit prior to the recent moves) the yen is more than 50% undervalued relative to the dollar in purchasing power parity terms. What’s more, our Japan analysts have picked up signs of pricing pressure in Japan that may mean the BOJ has to move faster and further than currently anticipated.

There are also shorter-term explanations linking what’s going on in the US equity markets with the yen unwind: there’s a lot of swift-moving money in both trades. Just as a reminder, the yen carry trade involved borrowing in yen – perennially low-yielding – and investing in higher-yielding currencies (most often and liquidly, the US$). Driving the unwind of this trade was the confluence of a BOJ seeking to normalize interest rate policy (and wind down yield curve controls) and an increasingly dovish US Fed. As hedge funds rushed to cover their yen borrowings, they liquidated profitable positions in US tech. The chart below shows the relationship between yen (in blue) and the Magnificent 7 (orange) over the past year.

It's not just the yen that is moving. The AUD saw its biggest fall in almost a year last week and has continued to trend lower. It’s perhaps unsurprising – AUD is usually viewed as a risk-on currency, highly-correlated to equity and, particularly, commodity markets. And yet – along with other risk-on currencies such as NZD and NOK – the currency has traded rangebound in the past 18 months notwithstanding the significant run up in stocks (as the 5-year chart below, showing AUD in blue and the S&P500 in orange, illustrates). We’ve been thinking about this decoupling in the light of the post-COVID regime shift: is this another factor that simply isn’t the same in an era of higher inflation and higher interest rates?

It’s striking that some of Australia’s fundamentals relative to the rest of the world are now indicative of a more risk-off region.? Notably the current account surplus (relative to an average historic deficit of around 4%), the budget balance at -1% of GDP relative to -6% for US, and an improvement in labor force participation rates. It may be that we have marked AUD in our collective minds as risk-on, without recognizing that these things are not fixed in stone.

There’s one clear insight here: for a decade or more, interest rates were low across the globe and, given that interest rate differentials were largely absent, we looked for other drivers of FX moves – with market sentiment key among them. Many market participants have never known a world of higher and differentiated interest rates and so there is an element of discovery going on here.

As always, perspective is a powerful tool. We have been working on a long research project that seeks to identify whether we can attach more specific risk premia to given currency pairs in the period since the end of Bretton Woods in 1971, working as ever with álvaro Cartea and his colleagues at the Oxford-Man Institute of Quantitative Finance, University of Oxford and with our long-time collaborator Professor Campbell Harvey at Duke. It’s still a work in progress, but we believe that FX rates are profoundly influenced by shifts in the macro regime and that it’s possible to identify specific signals that drive moves in key FX relationships. It’s one of a number of such long-term empirical studies we have carried out, always cognizant of the fact that the long view brings insight that is invisible in the shorter term.

We speak often to our global institutional client base about the hedging of their currency exposures. Many of them are denominated in what we would have traditionally thought of as risk-on currencies and have seen historical bases and costs shift dramatically in the past few years. What is clear is that the approach to hedging FX that worked in the period of near-zero interest rates that held for much of the 2010s needs to be reconsidered in this new era of greater volatility and dispersion in rates. We have worked closely with clients to help them develop models that contemplate the new regime and the costs and dynamics involved.

FX tends to be thought of as a problem to be dealt with rather than a source of alpha; a low-margin, generic product rather than one at the center of global financial markets. The new regime requires new ways of thinking about asset classes and how we access them. At Man Group we have always drawn insight and inspiration from our engagement with academics and the deep research we carry out in collaboration with Oxford University. FX is just the latest example of an asset class we understand better and with greater perspective because of this meeting of theory and practice.