The Importance of Currencies
Currencies are an important consideration in investments.
First, exchange rates directly affect the investment returns for all non-U.S. investments. Second, the currency markets can provide insights on risk appetite and portfolio flows. On the first point, when you invest in a foreign market, you are simultaneously taking a currency position, whether you want to or not.
For example, to buy a Chinese stock, you have to first convert U.S. dollars into China’s renminbi/yuan to complete the purchase. When you sell the foreign equity, you will also be selling the foreign currency, to convert your gains/losses back to U.S. cash.
The total return from your non-U.S. investments is the sum of the local price return (with dividends) plus the currency return (i.e., the change in the value of the exchange rate during your holding period).
Non-U.S. investments result in two primary sources of risk. Investments outside of the U.S. can be particularly attractive when both the price and currency move in your favor. On the other hand, it can be very costly during periods of dislocation when both risks move against you.
On the second point, some currency pairs serve as a risk appetite measure. One of my favorites is the ratio of the Australian Dollar to Japanese Yen.
The Aussie dollar is a pro-cyclical currency, due to (i) the importance of commodities to the Australian economy, and (ii) Australia’s close ties with China.
Japan, on the other hand, has a defensive (or counter-cyclical) currency; it often behaves like a safe haven asset.
The chart below shows the behavior of AUDJPY of time. This currency pair has withstood the test of time as a fairly reliable risk-on/off indicator, as you can see.
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The most important currency of all, of course, is the U.S. dollar. It is the reserve currency for the world and all commodity prices are denominated (bought and sold) in dollars.
The so-called big dollar -- to distinguish the U.S. dollar from the Euro dollar, Australian dollar, Canadian dollar and New Zealand dollar -- is often said to have an unfair advantage. When U.S. markets are outperforming, foreign investors flock to the U.S., driving up the strength of the dollar. When global markets are in dislocation, many U.S. and non-U.S. investors flock to U.S. assets for shelter, strengthening the value of the dollar.
Is a strong U.S. dollar good for the country? It’s a double-edged sword: on the one hand, a strong dollar makes imports cheaper…and we’re a consumer-based economy where many of our consumption goods are imported. On the other hand, a strong dollar makes our exports more expensive for foreign buyers. Our trade deficit would improve if the US$ were to significantly weaken.
Esoterica's statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. For full disclosures, click here.
