Forex ripples from the centre
The FT's currencies correspondent Roger Blitz and Bill Street, head of EMEA investment at State Street, discuss how shifts in monetary policy by central banks like the Fed and ECB are generating substantial volatility in the FX market
Produced by Alessia Giustiniano. Filmed by Rod Fitzgerald.
It's not just the Federal Reserve, but other central banks who are now shifting monetary policy. Now that means much more volatility in the foreign exchange market. With me to discuss this and where the dollar, in particular, is heading is Bill Street of State Street Global Advisors.
Bill, now why does volatility in FX move so much in these kind of shifts in monetary policy?
Yeah. I think we're coming out of a period post-financial crisis where there's been a lot of coordination of Central Bank activity. And this has dampened a lot of volatility and a lot of asset classes. However, when we are seeing the monetary policy becoming less coordinated, that's where the relative value play between the currency basis becomes much more volatile.
And what we're seeing now is the Fed have beginning to move, become much more hawkish. And if the markets believe that it's a coordinated hawkish tone, the market will probably remain relatively sanguine and volatility be contained. But when you have a disparity of that sort of monetary policy or monetary expectation, that's when volatility will really pick up.
So to hedge currencies or not to hedge currencies? Give us an idea through your charts over what those kinds of strategies would have done to your return.
Yes. So now the first chart we have here is the chart of the MSCI world as a UK sterling based investor. And what we're seeing here is that if you look at your absolute returns, approximately 50% to your returns are coming from the currency return of your unhedged exposure. And that is very significant.
So as you're mapping through what your asset classes are actually doing in a global basis when your base is at a currency such as sterling, one needs to be very cognizant of not only the returns, but the volatility of those returns which are contributing to your absolute outcome.
So OK. But that's the last four years. It's not always the case.
No, it's not at all. So if we go back-- so the chart previously was sort of post-financial crisis. And there's a lot of discussion about the coordination of policy, which has led to these positive outcomes.
But pre-financial crisis, you can see that the 10 years previous to that, very much currency has been detracted from these absolute returns, and has been dragging down to a negative point some of those cumulative returns.
So currency risk in the portfolio-- is that getting more and more acute for investors?
Yeah. If we look at a basket of volatility across the asset classes, we do a lot of work on looking at bond volatility, equity volatility, and looking at things like the VIX and the MOVE indexes. When you look at currency volatility as an asset class vis a vis the others, by far the highest contribution of risk in your return--
Let's have a look at that third chart to explain that.
So this is a chart showing how currency risk of portfolios is trending high. So this is the contribution of volatility into your portfolio. Now, this is going back over 17 years. And we can see that broadly speaking, over that period your contribution of volatility has gone from a baseline of say 25% up to heading towards 50% of volatility in your portfolio is currency volatility. And that's really important.
Now, part of that is symptomatic of the fact that other asset classes have got extremely low periods of volatility at the moment apart from currencies. So it's dominating the volatility in your portfolios.
OK. So this higher currency volatility is a difficult one to try and assess what happens to the dollar. What's State Street's view?
So I think when you're looking at-- say, let's call it G10 currencies-- it's always a beauty parade. And it's always a relative value judgement between different currencies. But I think where we are with the dollar at the moment, again, against a broad basket, is we're looking for the dollar to very much trend sideways. We feel that although we may be at the top end of valuations of the dollar, we don't think this is a declining top.
So we're very much looking for the next 12 to 24 months of sideways trend. Now there are going to be disparities in that where you've got something like cable, sterling dollar very undervalued at the moment against the dollar. So you may have some whipsawing. But broadly speaking against the basket, we're seeing a sideways move on the dollar.
OK. Bill street, thank you very much indeed.
No problem. Thank you.