When Currencies Matter In A Portfolio

by: Ben Emons

Summary

In recent years, currencies have reacted increasingly aggressive to central bank announcements. When currency appreciation or depreciation gets too excessive, central banks verbally intervene.

There are three consequences and three effects that will matter for markets: No Limit to Negative Rates, Credit Easing, Helicopter Money and Cash Hoarding, Bond Shortage and Debt Substitution.

Based on the three consequences and effects outlined, a model type portfolio could look like this: 25% cash and cash equivalents, 35% Investment Grade, 15% Government bonds with maximum 8-years of duration 25% combined.

In recent years, currencies have reacted increasingly aggressive to central bank announcements. When currency appreciation or depreciation gets too excessive, central banks verbally intervene. Recently, the euro, the yen, Swiss franc, Swedish krona and Australian dollar have appreciated notably to the U.S. dollar. And so (excessive) appreciation was noted by central banks.

For example, Bank of Japan's Kuroda said in a recent interview with the Wall Street Journal that not just actual inflation but even trend inflation can be affected. Swiss Central Bank Governor Jordan emphasized the Swiss franc remains "significantly overvalued." Sweden's central bank - the Riksbank - cited the Swedish krona could not appreciate "too fast or too early." Reserve Bank of Australia Minutes said an appreciating exchange rate could complicate progress in economic activity. Last month's Yellen speech and FOMC meeting suggested dollar strength impacted employment in energy and manufacturing sectors negatively.

Currency valuation therefore matters to central banks. As such, there are three consequences and three effects that will matter for markets going forward:

Consequences

1. No Limit to Negative Rates

In the Wall Street Journal interview Kuroda said the BoJ could cut rates as negative as -0.4%. SNB's Jordan said exemption of negative rate thresholds for banks could be changed, and Riksbank Governor Ingves said rates could be cut further. ECB's Draghi defended negative rates to maintain policy independence and Nowotny said negative rates are a necessity to avoid deflation. In other words, central banks see no floor on interest rates.

2. Credit Easing and Removal of Financial Repression

As a next step in the evolution of central bank easing, negative interest rates are applied to the lending channel and used to dis-incentivize institutions to hold government bonds. Japanese officials hinted that next week's BoJ meeting could apply the -10bps deposit rate to the BoJ's lending facilities, a similar measure deployed in the ECB's new lending program (TLTRO2). During the ECB press conference, Draghi and Constancio both expressed support for a non-zero risk weighting and exposure limits on government bonds held by European banks. In Japan, the largest pension fund (GPIF) announced it will no longer re-invest maturing Japanese Government Bonds (NYSEARCA:JGBS) because of negative rates. These examples show that slowly the process of unwinding financial repression has begun.

3. Helicopter Money

"Helicopter money" is not on the table for discussion but central banks are considering such measures by way of mentioning them. For example, Draghi dismissed on Thursday helicopter money was a discussion point, but he said it was an "interesting" measure. ECB's Peter Praet said in principle there was no barrier for central banks to deploy forms of helicopter money. FOMC Minutes of October 2013 revealed an elaborate discussion to establish a facility to purchase unlimited amounts of short-term bills to inject money directly into the economy (as suggested by Bernanke in his 2002 deflation speech).

Effects

1. Cash Hoarding

The more negative interest rates and bond yields, the more pressure on banks, pension funds and asset managers. As a result, these entities move into cash which becomes more valuable as it offers zero rather than negative interest. Negative interest is also an advantage to debtors, and as such debtors will choose to deleverage faster. As a result, deleveraging leads to cash hoarding because deleveraging causes uncertainty. Statistics by the CIA Fact book shows globally, corporations, banks and households are awash in cash by more than 20 trillion dollars, about 25 percent of global broad money.

2. Bond Shortage

Combined, central banks hold close to 30 percent of global GDP in government bonds, according to the Bank of International Settlements. Coupled with a low inflation environment, prices on long maturity government bonds have reached in some cases the $200 mark. On a percentage basis, high premium bonds (those trading at a price higher than $150) present now 15 percent of the global bond universe, up from 1 percent a year ago. The more negative rates, the higher premium, and the scarcer bonds become in terms of price.

3. Debt Substitution

Global total financial and non-financial debt has continued to expand, and stands now near 59 trillion dollars according to the latest McKinsey research. The expansion is a result of debt substitution. Pre crisis about $3 trillion was issued in securitized debt. When the crisis hit, this securitized debt was substituted for $6 trillion in government debt to prevent banks, hedge funds and companies from collapsing. When QE began in 2009, fiscal austerity took effect and the dollar weakened, investors substituted developed market government debt for emerging market sovereign and corporate dollar debt to the tune of $4 trillion. When the taper tantrum of 2013 accelerated capital flows out of emerging markets, investors flocked to US and European investment grade bonds. As a result of this demand, corporations issued a cumulative of $3.5 trillion to date. And the recent ECB's announcement to buy corporate bonds has helped spur euro and dollar High Yield issuance recently. This issuance is a result of demand, anticipating the prospect of more negative yielding corporate bonds. Those negative yielding corporate bonds now present 13% of the corporate bond universe.

Investment Strategy

To construct the "optimal" portfolio to navigate an increasingly complex market, the investment strategy should be focused on a level of risk tolerance that is backed by liquid, positive yielding government bonds and cash. Because currency matters to central banks, investors will continue to face the need to substitute assets to avoid ending up with a negative yielding portfolio. Cash has therefore become a valuable asset because it has no volatility and no negative interest. Hence cash is now a welcome "diversifier" to higher risk assets in the portfolio. Cash and the portfolio as a whole should be held in a base currency. Because central banks continue to "target" currencies, a FX overlay and carry strategies are prone to increasingly higher drawdowns. Lastly, duration and credit risk should be sized relatively because of ongoing changes in debt issuance and rising premium bond prices. Based on the three consequences and effects outlined, a model type portfolio could look like this:

25% cash and cash equivalents

35% Investment Grade

15% Government bonds with maximum 8-years of duration

25% combined equity, high yield and energy exposure

Although the "optimal" portfolio doesn't exist, investors have continuously optimized their weightings in the landscape of negative rates, credit easing, shortages, positive correlations and greater need for cash as an diversifying asset.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.