Q: Can you briefly discuss the recent focus of both central banks and governments on global currency movements? Has something fundamental changed?
Bhansali: Currency's historic function has been to facilitate trade, and governments were able to agree in 1944 on a global currency system, known as Bretton Woods, which did exactly that.
But now the world is divided into two blocks with conflicting views on how currencies should fluctuate. As a consequence, currency is becoming more integrated with government and central-bank policies on economic growth and inflation. Today, currency is a policy tool; yesterday, it simply facilitated trade.
The two blocks, of course, are the developed and emerging nations. Developed countries, such as the U.S., are suffering elevated unemployment and fear deflation; and, as a result, they are pursuing expansionary policies that potentially put downward pressure on their currencies. Emerging nations, meanwhile, want to maintain their robust economic expansion, and so have only very reluctantly allowed any currency appreciation.
Q: As central banks around the globe pursue further unconventional measures, what are potential consequences to currency markets?
Clarida: It's one of our core beliefs that over a secular horizon (three to five years) currencies will act as a shock absorber in the global economy. Quantitative easing by the Federal Reserve, for example, will tend to weaken the dollar: But the question is, against whom?
Japan, for example, has intervened to offset upward pressure on the yen, and Brazil is using tax policy to dampen capital flows. But notwithstanding such headlines, we believe the trend going forward is for a weaker dollar, and that is one way to implement our secular macro view.
There is another way to view quantitative easing and, more broadly, monetary policy today: Just three or four years ago, basically the only tool used by central banks was the short-term interest rate. Back then, monetary policy was basically a number: What's the federal funds rate or the overnight rate? Now, of course, there is a whole range of policy possibilities, especially with short-term interest rates near zero, and that enhances the role that currencies must play in international adjustment.
Q: Have the dynamics of foreign currency investing changed since the financial crisis? And considering recent tensions over currencies of export-driven economies, why invest in currency markets now?
Clarida: An essential change for currency investors to note is the rise in market volatility, which in the years leading up to the crisis, was historically low. Indeed, at the tail end of what we now know was the great credit bubble of the last decade, volatility in all markets "“ equities, fixed income, and currencies "“ was historically low.
Certainly, volatility going forward is likely to be higher than it was in 2005, 2006, and early 2007. But it will likely be lower than it was in the fall of 2008, when it looked as if the global financial system was collapsing. Our best estimate is that currency volatility is probably going to return to where it was in the mid to early part of the last decade: oscillating in the neighborhood of 10%. Currency volatility, interestingly enough, has historically been less than equity market volatility but somewhat greater than bond market volatility. And we expect these relative relationships to continue.
Bhansali: Greater volatility "“ as well as political factors I mentioned earlier involving conflicting geographic blocks "“ creates risk, certainly, but also creates a lot of opportunity, and that means now is a potentially attractive time to invest in currencies.
Q: How does PIMCO approach currency investing?
Bhansali: Let me start by answering another question: Why is PIMCO emphasizing currencies? It's useful to take a step back and understand the world is undergoing a slow motion economic rebalancing, what pessimists might call a slow motion train wreck. It seems to have started with the Japanese bubble bursting, and more recently, the subprime bubble bursting, stock market swings, and the sovereign-debt crisis in Europe.
As we see it, global currency markets are potentially significantly dislodged from fair valuations. Our approach, therefore, seeks to generate returns by exploiting structural inefficiencies and valuation misalignments in these markets, while simultaneously managing downside tail risk. We believe we can accomplish these goals with a focus on liquid currencies of developed economies and some exposure to major emerging economies, such as Brazil and Mexico.
Clarida: I would add to that the importance of a top-down macro view, which we see as essential to currency investing. At PIMCO, a top-down macro view is part of our investment process, and the macro factors that we study and monitor in relation to currencies are duration, curve and spread. We also monitor closely a small set of other factors, especially volatility. We continuously monitor implied volatilities, because they give us useful information about the way to structure our portfolios, as well as the way to scale the overall risk of a portfolio.
Q: Does PIMCO employ other currency strategies that seek to capitalize on the carry trade or momentum, as other asset managers do?
Clarida: As one would expect, we do seek carry, which in the currency world is simply an overweight investment in the front end of the yield curve in a country with a high interest rate matched by an underweight position in the front end of the yield curve of a country with a low interest rate.
But we are looking for intelligent carry, which we define as carry that we can understand from a macro basis. An example I like to give goes back to the summer of 1992, when Italy offered very high carry, about 11% or 12% annualized. But that carry was not indicative of an attractive investment; it was indicative of a chance that Italy would leave the European monetary system and devalue its currency, as indeed, it did in September 1992.
And, as well, we do monitor momentum and valuation. Momentum, we think, is a particularly important variable when it lines up with other macro developments, such as positive momentum for a currency that coincides with aggressive rate hikes. And we carefully monitor valuation, taking into account the terms of trade and productivity differences.
Q: How might an investor utilize PIMCO's strategy? Does PIMCO see currency as an asset class?
Bhansali: We think investors should think in terms of the diversification benefits of currency strategies in the context of their overall portfolios. Depending on what the rest of their portfolio looks like, a currency allocation may increase the portfolio's potential return without increasing much of its risk exposure.
Currency can be considered an asset class, but we like to think in terms of risk factors. As Rich pointed out in a March paper, Norway's Finance Ministry commissioned a study that found that returns on currency portfolios are one of a small set of tradable global risk factors that explain most of the realized returns on global asset allocation strategies (other risk factors included slope of the yield curve, credit spreads and equity returns).
Clarida: I should add that at PIMCO, we recognize in our bones that historical correlations can and do break down. But as Vineer said, currencies are a tradable risk factor "“ $4 trillion a day trades in the currency markets. Numerous studies show that a return on currencies would be difficult to reproduce using other assets. So yes, we do think of currencies as both an asset class and a risk factor.
Thank you, Vineer and Richard.
There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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