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Currency markets:
Navigating shifting global economies
Max Pears
Investment Analyst
Global markets have experienced significant volatility in 2024, with the VIX—Wall Street’s "fear gauge"—surging to its highest level since 2020 following a sharp market sell-off in August.
This turbulence has rippled through currency markets, driven by shifting monetary policies and geopolitical tensions. Reviewing portfolio exposure to currency risks has become increasingly important to mitigate potential negative impacts.
Economic case for currency hedging
Currency hedging in an investment portfolio is used to mitigate the risks associated with fluctuations in exchange rates. When investors hold assets denominated in foreign currencies, changes in currency values can significantly impact the portfolio's returns when converted back to the investor's home currency. By employing hedging strategies, investors aim to reduce potential losses from adverse currency movements and strip the added volatility from currency risk.
However, the extent to which institutional investors should manage currency risk is contentious. Economic theories like Purchasing Power Parity (PPP) suggest that over the long term, exchange rates adjust to reflect inflation differentials between countries; in other words, if one country experiences higher inflation than another, its currency should depreciate to maintain the same real cost of identical goods and services. Anything else is just noise around long-term equilibria. However, while PPP suggests that real exchange rates tend to mean-revert over time, in practice deviations can persist for extended periods.
The Normal Effective Exchange Rate (REER) data illustrates this dynamic, showing how currencies like the dollar, yen and yuan show trends in their movements – not just noise around an equilibrium.
Source: BIS Data Portal
It is not all just explained by differences in inflation. The dollar’s status as the world’s primary reserve currency has been bolstered by investor confidence around the continued strength of the US economy. In contrast, the yen has been declining consistently through Japan’s battle with deflation. With the Japanese economy heavily dependent on exports, there’s a clear incentive for policymakers to devalue the currency to maintain competitiveness and perhaps some price stability. Meanwhile, the Chinese yuan has generally appreciated over the past two decades, reflecting China's growing global economic influence.
Sustained deviations from equilibrium exchange rates can lead to substantial currency risk, impacting portfolio returns. Time horizon plays a key factor in weathering volatility as exchange rates tend towards parity; however, empirical data shows that, even over the longer term, currency hedging can reduce unsystematic risk.
Currency hedging – what level is “optimal” for investors?
Our data suggests that, particularly for riskier asset classes like equities, a hedging level of about 50% (or slightly below) strikes a balance between reducing volatility and maintaining resilience during drawdowns. For fixed-income assets, the approach to currency hedging differs. Bonds are typically held for their stable cash flows, and unhedged foreign-denominated bonds can introduce avoidable volatility.
A carry trade takes advantage of low interest rates in one country to invest in higher-return assets abroad; the strategy relies on the difference, or "carry," between the low-cost borrowing rate and the higher-yielding investments.
Currency hedging: navigating volatility with a strategic approach
While intuition might be to fully hedge currency risk, evidence shows that unhedged exposure, particularly in riskier asset classes like equities, can help reduce long-term portfolio volatility for sterling-based investors. The graph below illustrates that during major market drawdowns, unhedged equity portfolios have historically outperformed hedged ones. The pound tends to weaken against safe-haven currencies, such as the US dollar, during periods of market stress, providing a natural hedge.
Total returns for the unhedged versus hedged MSCI ACWI during major market drawdowns
Source: Bloomberg.
The table below ranks different levels of currency hedging by volatility, with 1 being the most volatile and 11 the least. Although there may be years when partial hedging minimises volatility, a 100% hedging level has, on average, resulted in lower long-term volatility.
Source: Bloomberg. Volatility of different levels of currency hedging for investment grade corporate bonds: 1 is the most volatile, 11 the least. Chart based on the Barclays Global Aggregate Corporate Total Return Index over the 20 years to 31 December 2023.
Conclusion
Investors should align their currency hedging strategies with their broader objectives, asset allocation, and risk tolerance:
- For equities, a partial hedge of around 50% (or slightly below) balances the need to reduce volatility with maintaining resilience during market drawdowns.
- For fixed income, full hedging is often optimal, ensuring better alignment with predictable cashflows while avoiding unnecessary volatility.
Your LCP consultant is available to assess your current currency exposure and recommend adjustments to optimise outcomes in today’s dynamic markets. Get in touch with us - we can assess your currency exposure and recommend any adjustments to better suit your objectives in today’s dynamic markets.
