Investment returns from all global portfolios in any financial asset class, be it bonds or equities, have been influenced to a greater or lesser extent by movements on the currency exchanges. Over the past two calendar years, this ‘influence’ has been rather less than benign for many global bond investors, as the euro defied consensus expectations and weakened dramatically over the first two years of its existence.
“I would start by stressing that volatility of exchange rates is certainly not a new thing,” agrees San Paolo IMI’s head of fixed income Roberto Plaja, “and currency returns have been a large component of bond returns going far back into history. But, yes, it is fair to say that the past two years have had a harsh effect.”
Some investors opt to “ignore” the exchange rate fluctuations, perhaps because the choice of asset is already implying a currency view, such as looking to pick stocks of exporters on the expectation of a weakening currency. Alternatively, investors can choose to take a much more pro-active approach and look to add value from expected currency moves.
Most international fixed income investors would now describe themselves as active currency managers, whether or not they run dedicated ‘managed currency’ funds. Investors everywhere are seeking to add value from their currency forecasts, as opposed to only avoiding depreciating currencies, and view currencies as being in a distinct asset class.
“We are very active in our approach to currencies and will always take some sort of a view, whether that is overweight, underweight or neutral to our benchmarks,” says Asoka Woehrmann at DWS in Germany. “Our approach to currency allocation is very similar to the way we construct our bond portfolios. Initially we set three scenarios and then assign probabilities to each of them assessing the possible risks. We can then create our most likely scenario and forecast a strategic six-month view. Our aim is to add extra value.”
That currency management is nearly always run within the domain of the fixed income departments of asset management houses has more than a little to do with the fact that currency and interest rate forecasting use very similar ingredients.
Says Peter Geike-Cobb at Merrill Lynch Investment Management (MLIM) in London, “Essentially global bond managers are using similar disciplines such as break-even analysis, technical analysis and of course macro-economic and political research to set their interest rate and currency targets. That said, however, we always make separate decisions for either asset – often we like a bond market but not its currency so we would overweight that bond market and hedge out the currency exposure.”
Paul Cavalier, head of fixed income at Lombard Odier, agrees that currency forecasting should be viewed as another asset class providing another investment opportunity, but suggests that too simplistic a comparison of currency analysis with interest rate forecasting could dangerous. He points out that, though there are undoubtedly many common determining elements, that the currency markets do have some very different factors influencing them. He explains, “Currency markets tend to be much more dynamic. Consider the size of transactions traded throughout the world on a minute-by-minute basis. There is unlimited liquidity! With bonds and equities there is a finite supply, but in a world with no significant currency controls, volumes can be enormous.”
Cavalier goes on to argue that often currencies are not led by pure fundamentals, and short-term market traders can and do greatly affect currency markets for reasonable periods of time. He points out that technical analysis is a tool much suited to the shorter term horizons of many market participants. “We have to incorporate these ‘other factors’ into our views and basically try to make sure that our currency risk, in terms of tracking error, is less than our bond risk even if we have similar strengths of views on currencies or bonds at the time.”
At MLIM there is less emphasis on weighting the risks in this way. Geike-Cobb explains, “Bearing in mind that every client has specific and often differing needs, we consider the riskiness of the overall portfolio and aim to target that. Obviously each time we ask, ‘Where can we add value?’ – a duration play, sector weighting, yield curve position, credit, or currency – there has to be an implicit risk/reward addendum. We attach confidence levels to each available source of potential added value. Our investment style is multi-strategy, and in the end we don’t mind where that value comes from.”
Geike-Cobb argues that currency influences should not be viewed as more important than others. He explains, for example, that MLIM did not take big bets on the euro during 2000, because it did not have strong convictions, and consequently currency management per se added little extra value that year.
At JP Morgan Investment Management, the currency question has been answered by the creation of a distinct currency management team. Harriett Richmond heads up this team in London and describes its history. “Until the early 1970s, US investors had predominantly been keeping their money at home. 1974 marked the start of the move into international markets. JP Morgan has always treated currency decision in any international portfolio as separate. During the 1980s a lot of work was done in analysing what was driving foreign exchange markets, and on building up separate investment process.” In 1989 JP Morgan Currency Management won its first currency-only mandate.
Richmond stresses that, just because the currency decision has been isolateed, this does not mean the process itself has become that complex. She adds, “What we do is not rocket science, but uses plain common sense. There really is nothing complicated, and our success is built on the basis of a transparent and comprehensive process. We constantly review our analyses and check our structural models, as the world changes around us.”

Not everyone agrees that currency management should be a process completely independent from the underlying assets. “We are keeping currency management with our bonds,” says Geike-Cobb, adding, “It involves the same decision-making process, involving just a handful of issues, and it makes sense that the same decision-makers are involved.”
Cavalier remains sceptical that currency analysis using quantitative models is a recipe for success. “Personally, I believe that currency correlations are too fluid to be boxed into a model. We look at our whole portfolios and control risk accordingly, and we are constantly analysing correlation trends. I am not saying that specialised managed currency funds are invalid and that forecasting currencies is impossible. You have to be forecasting changing correlations and I think it is too difficult to separate that out and stick to a constant quant approach.”
At DWS there is a team which co-ordinates currency views across the group, but does not impose them rigidly. Woehrmann comments, “We do not have completely separate market specialists in this field, bond managers are responsible for their currency allocations too. Individual managers are allowed to deviate from our house view if they are able to defend their views at the monthly strategy meetings. We know that currency movements can be really important for performance and that is why we have this team of foreign exchange co-ordination managers to communicate our FX views to our managers across the world.”

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