Currency Investing: Carry, Momentum and Valuation

Recently, I have been trying to develop a strategy for intermediate to long term currency investing. I had looked into three of the most well known currency investing strategies that are known to produce positive returns: carry, momentum and valuation.

One common method for using these strategies is to select three currencies to buy and three to short from the G10 currencies. The currency carry strategy buys the currency with the highest yield and sells the currency with the lowest yield to earn the difference in interest rates. In addition, studies have found that currencies with high yields have historically outperformed those with low yields so in addition to the interest there is also appreciation potential. The momentum strategy is, as its name implies, long the currencies with the greatest momentum and is short those with the lowest. The last strategy, valuation, is based on a theory called purchasing power parity.

Purchasing Power Parity theory says that the price of an item in the U.S. should be the same as that in another country after accounting for exchange rates. The idea is, if the price of an identical item is cheaper in Canada than in the U.S., than the Canadian Dollar is undervalued and its value is likely to rise against the Dollar.

Based on Purchasing Power Parity, the valuation strategy is long the currencies that are the most undervalued and is short the currencies that are overvalued.

However, I did not just want to use just one of those strategies, and I did not want to use all three, I wanted to use all of them as one strategy which, I hoped, would outperform all three of the strategies individually. The reason I did not want to use just one strategy was because individual strategies often go through periods of underperformance and outperformance.

The db x-tracker currency ETFs offered to German investors is an example of why I did not want to use all three of the strategies at once. Of the four ETFs, one of the ETFs tracks all three of the strategies together while the others each track one of the strategies individually. The carry strategy was short the Swiss Franc, the Dollar, and the Yen while the momentum strategy was long those same three currencies. This would result in the ETF combining all three strategies, the currency returns strategy, being long and short those currencies at the same time.

Because in effect this is like using only part of a portfolio to earn money, there is some lost profit potential. Why should the Currency Returns ETF use signals from three strategies that sometimes send conflicting signals? It doesn't really make much sense. I was trying to avoid this when I was trying to come up with a currency strategy.

Then I remembered that for ranking stocks in some of my stock ranking systems I rank stocks according to subsystems and then combine the scores into one composite score. Why not do the same with currencies? Previously I had been trying to develop a more screen like strategy where a currency after passing one screen would either continue for more screening or would be dropped from continued consideration.

But now, with a ranking system, if a currency has a low score in one subsystem, it still continues for consideration whether or not it has a high score.

Using the currency ETFs that exist for the G10 currencies, here are the current rankings. There is no ETF for the Norwegian Krone, so I have just excluded it.

Subsystems Momentum

Currency ETF	Currency	Rank
BNZ	New Zealand Dollar	1
FXA	Australian Dollar	2
FXS	Swedish Krona	3
FXC	Canadian Dollar	4
FXF	Swiss Franc	5
FXE	Euro	6
FXY	Japanese Yen	7
FXB	British Pound	8
U.S.	Dollar	9

Carry

Currency	Interest Rate	Rank
Australian Dollar	3%	1
New Zealand Dollar	2.5%	2
Euro	1%	3
British Pound	0.5%	4
Canadian Dollar	0.25%	6.5
U.S. Dollar	0.25%	6.5
Swiss Franc	0.25%	6.5
Swedish Krona	0.25%	6.5
Japanese Yen	0.1%	9

Valuation

Currency	Rank
U.S. Dollar	1
New Zealand Dollar	2
British Pound	3
Canadian Dollar	4
Australian Dollar	5
Euro	6
Swedish Krona	7
Japanese Yen	8
Swiss Franc	9

Adding the rank from each subsystem creates the overall score. The lower the score for a currency the better its rank is.

Overall

Currency	Rank
New Zealand Dollar	1
Australian Dollar	2
Canadian Dollar	3
British Pound	4.5
Euro	4.5
U.S. Dollar	6.5
Swedish Krona	6.5
Swiss Franc	8
Japanese Yen	9

Since Purchasing Power Parity data is not easy to find, I will track this strategy in the monthly strategy update of my free investment newsletter.

Oh, and what does Purchasing Power Parity say about the dollar? Against most other developed market currencies, the dollar is undervalued. Combine that with negative sentiment, and we may be in for a dollar rally.

Disclosure: None

Comments

[NUCLEAR1929:]

nice piece

Sep 09 11:42 AM