Investing in Global Currencies

The threat of a global fallout from the US credit crisis continues to loom over the region as investors witnessed repeated write-downs in the balance-sheets of banks with substantial exposure to the subprime debacle; prices of crude oil and other commodities continue to skyrocket; inflationary pressures continue to raise concerns and bond yields are facing upward pressures.

In some ways, this can be described as an unfavourable period to enter the market. Many are holding on to cash while waiting for the bottoming out of equity markets, but with inflation rates exceeding bank deposit rates, these investors will see the value of their cash holdings diminish as well.

Unlike many equity funds that are only able to take long positions in the market, currency funds are able to adopt both long and short positions in order to generate absolute positive returns. Short positions, or the sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value, allow traders to profit when the assets sold decrease in price, and result in losses when their prices increase. Some methods of adopting short positions include short selling an asset on the spot market, or buying short contracts in the futures market.

For example, a fund which borrows SGD and sells it on the open market for other currencies is said to have a short position in the SGD. The fund must eventually return the borrowed currency by buying it back from the open market. If the SGD falls in price, the fund buys it for less than it sold it, thus making a profit. In other words, such funds can take advantage of both upward and downward movements in the market, thus providing the fund managers with greater flexibility.

This begs the question: what opportunities are there in the currency markets? In an interview with Phoon Chiong Tuck, fund manager of the DWS Currency Fund as well as Managing Director and Chief Investment Officer (Asia ex-Japan) of Deutsche Asset Management (Asia) Ltd, he shares his outlook for various regional economies, and provides an insight into the issues surrounding the SGD and the Korean Won.

US Crisis-A Long Time Coming

By now, most, if not all, investors would have heard of the credit crisis that started in the US, which was triggered by the bursting of the housing bubble and the onslaught of the subprime mortgage crisis, and had spread to parts of Europe and even Asia. The USD Index, which measures the value of the USD against 6 major world currencies (the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc), shows that the USD has been on a steady decline since news of the subprime crisis broke, and hit historical-lows in March 2008.

Chart 1:

Source: Bloomberg

In Phoon's opinion, the current crisis is a long and anticipated unwinding of global imbalances. The US had been living in a state of unsustainable inequilibrium-large external deficit, its status as the world's biggest debtor, and overly high consumption compared to savings. Thus, this unwinding of imbalances will only reach an equilibrium when lower consumption, a higher savings rate and smaller current account deficits are achieved.

Phoon reveals that the interest of policymakers, or more specifically their desired currency levels, is one factor that he always considers. In this case, one strategy that policymakers in the US may employ in reducing the current account deficit is to have a weaker USD. Furthermore, as the US has its foreign debt denominated in USD and its foreign assets in non-USD currencies, a weaker USD will result in an appreciation of its foreign assets and a more favourable financial position. As such, the fund takes on a bearish view on the USD, which accounts for its largest short position in its currency overlays.

Euro Bearing Brunt of USD Decline

On the other hand, the Euro has been generally appreciating against the USD since late 2005. This implies that the adjustments of the weakening USD have largely been borne by the Euro. The DWS Currency Fund's factsheet as at 30 April 2008 predicts a weakening of the Euro due to deteriorating economic fundamentals, and its active currency allocation chart reveals a large short position in the Euro as well, second only behind the USD.

Chart 2:

Source: Bloomberg

Phoon feels that the Euro is currently overvalued, and the trend of its appreciation against the USD will probably cease before it hits a level of 1.65. Some factors he says support this view include the housing bust in the UK, and more generally the presence of different countries in the Eurozone with varying economical and political climates; while the Germans might favour a stronger Euro against the USD, the Italians and Spanish might beg to differ. Hence, the Euro will not be able to endure further stress without stirring up political tensions, and there will likely be interventions made to weaken the Euro.

"We think that the Euro has stretched things as far as it can go, and the authorities are already feeling the pinch at the current level. The exchange rate can move a bit higher, but will probably stop before it hits 1.65; if it hits 1.65, something has to give, and the Europeans may intervene to push the Euro down," he opined.

Positive Outlook on Asia and SGD

In contrast, Phoon has a much more bullish view on currencies in Asia. He points out that the economies of India and China have developed substantially over the last decade, and Asia's developing economies take up a larger share of the world's total GDP. This increase in production by Asian countries will likely lead to further readjustments in the world economy, part of which will be played out in the form of currency adjustments, as exchange rates can be thought of as reflections of the relative value of trade between countries.

However, investors interested in trading Asian currencies will have to delve into deeper analyses of different Asian countries, such as understanding the individual contexts of their currencies, as well as the flexibilities and desires of their policies. One current concern of many Asian countries, especially oil importers, is imported inflation. Policymakers may favour strong currencies in order to curb inflation, but before investors make their bets, they should also consider the financial means of these countries.

To illustrate, Phoon reveals the motivation behind his positive outlook on the SGD, which accounts for the fund's largest long position in the currency overlays. "We are very sure that we know what the MAS wants, and what is their immediate priority: inflation. They will keep the currency strong, and they have the wherewithal to make sure that the currency will not become weak. In comparison, some other countries do not have the same degree of flexibility," he explained.

Putting Volatility into Context

One of the common misconceptions about currency plays is that the currency market is a volatile market to enter into. This might have arisen due to its longer trading hours, and ticker movements generally occurring more frequently as compared to equity markets. However, investors should realise that while fluctuations of 20% in stock prices are commonplace, similar moves in a currency are likely to constitute a financial crisis. For example, according to Bloomberg data as at 2 June 2008, the DWS Currency Fund's 1-year volatility was 12.54%, compared to 16.16% for the MSCI World Index.

When quizzed on the topic of investors entering the gold market to hedge their portfolios against inflation, Phoon suggested that such investors may want to consider diversifying to the currency market.

He quipped, "Basically, gold as an investment play is very one-dimensional. You exchange your base currency for gold on the view that inflation may increase. However, there isn't a straight equation between gold and inflation. In the case of currencies, investors can choose whatever they wish to buy or sell; hence it is multidimensional, and that is why I think that in terms of generating returns, this fund is superior to a straight investment in gold."

Chart 3:

Source: DWS Investments (as at 30 April 2008)

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