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What Bond & Currency Allocation To Consider If Recession Fears Are Justified?


Should we expect a recession?

Current fixed income market conditions & allocation.

Today's currency market & currency allocation.

What if I'm wrong?

Synthesis of the allocation.

Should we expect a recession?

Being a firm believer in market cycles, I am not concerned about whether recessions will happen in the future, as I consider that they are natural components of economic cycles.

Therefore, do I forecast the next recession for February 2020, September 2021, or maybe June 2022? Neither of that, I do not forecast.

What I can do, however, as recession probabilities increase, is to put the odds on my side by changing the composition of my portfolio to make it more resilient, or even "antifragile". Thus, allowing it to be less affected by, or even to benefit from, a recession.

Having understood that, you could legitimately ask what makes me think that recession risks have increased. Here are key elements that make a recession probable, despite not certain, at short or mid-term:

  • Yield curves have inverted. Despite the existence of false signals in history, every of the last three recessions was preceded by an inverted yield curve 12 to 18 months before its beginning.
  • We are late in one of the longest economic cycles we have ever experienced.
  • Manufacturing PMIs are plunging and services PMIs show signs of weakness.

Current fixed income market conditions

As market participants have been risk-seekers since the recovery from the Great Financial Crisis, riskier assets (that provided significant risk premiums during the crisis) have now seen their risk premiums decrease substantially. As a consequence of this spread tightening, riskier assets appreciated considerably more than safe-haven ones.

Indeed, as we can observe below, the spread between the poorest quality of investment-grade bonds and government bonds substantially decreased, confirming that those poor quality investment-grade bonds have appreciated far more than the best quality bonds since 2009.

Sources: FRED, NBER, JR

Moreover, as spreads have now reached low levels (from a historical perspective), the potential for overperforming government bonds with corporate bonds is becoming thinner and thinner, while the risk induced by a potential spread widening is increasing along with recession fears.

Therefore, the additional risk taken with riskier bonds relative to government bonds is not adequately compensated anymore by the additional return they provide.

Fixed income allocation

Therefore, my bond exposure will ideally be made of:

  • Government bonds, as they might benefit from a "flight to safety", and because corporate bonds do not currently offer a good risk/return tradeoff.
  • Low duration, as the potential for a significant rate decrease is low (many government bond yields being close to, or below, zero).
  • The only government bonds for which I would target a medium duration (from 3 to 5) would be US Treasuries, as rates are still positive and offer some potential for a decrease.

Today's currency market

The move from safe-haven assets (in high demand during the crisis) toward riskier ones has not only been observed across different bond categories, but also within the currency market itself.

This new risk appetite has been illustrated by a growing interest in currencies deemed to be riskier - but offering more attractive yields - than safe-haven currencies. As a consequence, since the recovery from the Great Financial Crisis, this market behavior pushed the prices of some safe-haven currencies below their fair values (as measured by the Purchasing Power Parity).

This situation offers an excellent opportunity to acquire, for less than their fair values, currencies having significant probabilities of appreciation if a recession occurs. Therefore, adding exposure to such currencies might allow an investor to strengthen his portfolio in case a downturn occurs, or even to benefit from it, depending on the weight that would be given to this allocation in his portfolio.

Currency allocation

Since trying to predict what will precisely happen to a given currency would be a very efficient way to be wrong, I will not try to forecast that a given currency will be up by X% next year, as it exists an infinity of possible scenarios.

However, I could instead create a relatively diversified currency basket having good probabilities of appreciating in a 3 to 4-year time, given the characteristics of each currency included in this basket and where we stand in the current market cycle.

Having said that, what currencies would I include in my portfolio if my investment horizon is not less than 3 years?

1. Japanese Yen

The Japanese Yen would be given the highest weight in my currency basket (35%) as it offers a high potential of appreciation due to:

  • Its historical tendency to appreciate when a recession occurs,
  • Its current undervaluation (as shown below).

Undervaluation of the Yen relative to the US Dollar (based on Purchasing Power Parity)

Sources: OECD, JR

It seems that the trend of the Yen is already bullish, as it can be seen below (nb: a decrease in this graph means that the Yen is appreciating, as we need less and less Yen to buy one Euro).


Source: TradingView, JR

2. Swedish Krona

The Swedish Krona (SEK) has historically performed well when a recession occurs while the currency is undervalued.

Therefore, as the SEK is nowadays undervalued, it offers a strong upside potential in case a recession occurs, which is why it will represent 25% of my currency basket.

Undervaluation of the Swedish Krona relative to the US Dollar (based on Purchasing Power Parity)

Sources: OECD, JR

However, the SEK seems not to be entered in a bull market as of today, despite its current undervaluation. Nevertheless, as this currency is already cheap, an investor might still begin to gradually add Swedish Krona to its portfolio (what I do).

3. Swiss Franc

Then, I will also add 20% of Swiss Franc to my basket because:

  • Based on Purchasing Power Parity, this currency seems to be undervalued against the US Dollar.
  • Moreover, as with the other currencies we already discussed, it might be qualified as "antifragile", therefore has a strong probability to benefit from bad times (a recession or a bear market, for example).
  • The Swiss National Bank has intervened for years to slow down the appreciation of its currency, in order to preserve the country's competitiveness. However, despite this intervention, long-term currency appreciation hasn't been stopped. In fact, the Swiss Franc only appreciated slower than it would have done without this intervention, still making CHF holders richer. Furthermore, the Swiss National Bank declared that its balance sheet couldn't be expended indefinitely, which implies that its interventions to slow down a too strong appreciation of the CHF might be limited in the future, which would potentially help the CHF appreciate more freely.

Relative valuation of the CHF against the USD

Sources: OECD, JR

It seems that the CHF is now in a bullish trend against the EUR (as shown below), while it has no clear tendency yet against the US Dollar.


Sources: TradingView, JR

4. US Dollar

Finally, 20% of my basket will be composed of US Dollars, for the following reasons:

  • The US Dollar is percieved as a safe-heaven compared to many currencies.
  • There is currently a risk of Dollar shortage, which might push its market value higher.
  • The US government debt doesn't trade at negative yields as of today. Therefore, it attracts investors looking for returns, and other ones buying such debt expecting rates to decrease (in order to realize a capital gain on the bonds they hold).
  • The Dollar seems to be currently appreciating against the Euro (which is relevant if you are a Eurozone investor or have Euros in your portfolio).


Sources: TradingView, JR

What if I'm wrong?

While I can't be certain that each of those currencies will appreciate, I consider that this currency basket, as a whole, offers a good potential of appreciation against the majority of other currencies if a recession occurs (including against the Euro).

Thus, if I'm right, my portfolio will be more protected and might even benefit from a recession, depending on the weight that will be given to this foreign currency bonds basket within my portfolio.

If I'm wrong, however, having the majority of my basket composed of undervalued currencies (thus already trading at low prices), I may reasonably expect that the downside potential would be now quite limited.

Therefore, being wrong in that case would probably not put my wealth at risk while being right might be very beneficial to my portfolio. This seems to be a promising risk/return trade-off.

Synthesis of the allocation

For the sake of simplicity, here is a synthesis of the allocation I have detailed above.

Source: JR

Finally, living in France, it would be relevant for me to compare this basket to my local currency, the Euro. Therefore, this is what I did below to be able to assess my future returns, keeping in mind that I expect this investment to pay off within a few years, not weeks.

Of course, the same exercise could be done with any currency.

Value of the currency basket as of 17 October 2019.

Weights Exchange rates against the Euro
JPY 35% 120,85
SEK 25% 10,80390
CHF 20% 1,09907
USD 20% 1,11244

Source: TradingView, JR


Disclosure: I am/we are long USD, CHF, SEK.

Additional disclosure: I currently have positions in government bond funds in USD, CHF, and SEK.
I plan to add JPY government bond funds to my portfolio in 5 to 7 days.