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By Charlie Henneman, CFA

In the long term, economic fundamentals hold sway over currency markets. But what about the short term? At the inaugural CFA Institute Asia Pacific Investment Conference in Hong Kong, Avinash Persaud, chairman of Intelligence Capital Ltd., laid out his “seven rules of foreign exchange” that can help market practitioners manage their exchange rate exposures “over periods that matter” and clarify the future direction of currency markets, which he said are often misunderstood even by sophisticated investment professionals.

Building on remarks that he delivered at last year’s Second Annual CFA Institute Middle East Investment Conference in Abu Dhabi, Persaud argued that investors should think of currencies like bonds, not stocks, whose long-run prices are driven by inflation rates. After all, countries with the strongest currencies (the Swiss franc, for example) do not have the most rapidly growing economies, he pointed out.

After a year of relative calm in the currency markets, Persaud warned that investors should brace for a return of currency volatility — and its impact on investment returns.

He also predicted that the Chinese renminbi will supplant the U.S. dollar over the next ten to twenty years as the world’s reserve currency, even though such a move will be resisted by American policymakers. “Having the reserve currency is heaven and losing it will be hell,” said Persaud, in reference to the United States. “This will be the history of the 21st century.” Still, Persaud acknowledged that “you can lose a lot of money in the short term betting on a long-term trend.”

Asked about the likelihood of a return to a gold standard during the Q&A portion of his talk, Persaud was skeptical. “We’ve tried gold,” he noted. “It has many attributes but its supply is random, dependent upon new discoveries, and liquidity injections are therefore unrelated to economic and financial conditions.” If a gold standard does return in some form as a response to currency debasement, he predicted, “it will not last.”

Persaud’s seven rules of foreign exchange are as follows:

Rule Number 1 – Currencies will trend towards the point which provokes a policy response, and turning points are usually marked by a policy intervention, not a change in economic fundamentals. If central bankers proclaim that they are not concerned about a movement in their currency, it will likely continue to move until they are.

Rule Number 2 – Don’t try bursting currency bubbles on your own. Traders who believe a currency is overvalued based on economic fundamentals are often tempted to bet on a currency decline. But in the short term, the forces of economics are weak in the currency markets. Paraphrasing John Maynard Keynes, Persaud pointed out that currency markets “can stay irrational longer than investors can remain solvent.”

Rule Number 3 – In the short term, currencies are driven less by local economic fundamentals than by investors’ appetite for risk. Currencies with similar risk profiles will trade similarly, regardless of the economic fundamentals of their home country.

Rule Number 4 – In a crisis, investors are not searching for value, they are “running home.” When markets are turbulent, investors do not sell what they do not have, and they don’t usually increase exposures to existing long positions. Rather, they sell what they can sell and bring their money home. For these reasons, the most liquid currencies get hit the hardest during times of financial crisis.

Rule Number 5 – Small, open economies try to manage their exchange rates, while large closed economies don’t care. This puts smaller countries at a disadvantage, and explains their interest in establishing fixed exchange rates.

Rule Number 6 – If central bankers say something for which they could have said the opposite, this is a significant statement that carries information value. If the statement cannot be inverted, it is meaningless and has no value. For example, if a central banker says “we believe the currency is undervalued,” this is worth listening to because the inverse — that the currency is overvalued — could possibly have been true. Conversely, the statement that “we will manage the currency based on its fundamentals” has no plausible inverse, and is therefore merely noise.

Rule Number 7 – Currencies go up and down because investors have instruments to use, and it is useful to ask what instruments investors would have to buy to impact a currency. For example, if bond yields are extremely low, investors might avoid buying bonds, even if their macro view might favor the currency.

Source: Avinash Persaud: Investors Should Brace For A Return Of Currency Volatility