Anthony Rayner
One of the frustrations for many investors, especially the “fundamentalists”, is that markets have been so distorted by central bank actions over recent years that managing money has become a nigh on impossible task. Or, at least, an unrecognisably different job.
In reality of course, central banks have always decided short term interest rates. These, in turn, feed through to longer term interest rates, corporate bonds, equities, currencies, property and commodities, pretty much every financial asset, to some degree or another. So, we would argue that financial assets have always been manipulated in some way, though the more experimental monetary policy of latter years did take it to a new level.
How central bank action can feed through to bond markets and beyond can be seen very clearly in the graph below. It shows how the Japanese yen has weakened against the US dollar, as the interest rate differential between the 10 year US Treasury and the Japanese government bond has grown. Textbook stuff: as interest rate differentials grow, so the higher interest rate currency strengthens.
Higher US rates relative to Japan rates have driven the US dollar materially higher
Source: Bloomberg 13.09.2021 to 13.09.2022
Note also the scale of the move in the US dollar vs the Japanese yen: around 30% over the twelve months. This is a very graphic depiction of what happens when a hawkish Fed wants to get ahead of US inflation, during a time when the Bank of Japan is keen to maintain the 10 year rate at 0.25%.
So, central banks continue to drive markets but, importantly, in a very different way to the last 30 years. The wider picture is that economies globally are increasingly marching to their own drumbeat. As rates move higher, so a country’s imbalances become clearer. For example, higher rates bring into focus the degree of fiscal imbalance and, specifically, the higher cost of government borrowing. This is in stark contrast to the coordinated lower rates that characterised much of the globalisation years and which helped to soften the differences between economies and their financial markets.
Moreover, what has happened in currency markets isn’t just happening in a vacuum. If any major asset moves too quickly it can cause wider markets to dislocate. Arguably this hasn’t happened yet. However, as the US dollar strengthens, so it tightens liquidity globally and so a stronger US dollar is constraining markets that have been fuelled by excess central bank liquidity over recent decades. Of course, there will be a limit to US dollar strength: it might be parity (with sterling), and it might be driven by peak inflation, which the market keeps predicting (and keeps getting wrong).
From a portfolio construction perspective, we deal with currencies in quite a different way to other assets. On the basis that they are very speculative, i.e. difficult to value and often quick to move, we are reluctant to have too much portfolio risk in a single currency, or in non-sterling currencies generally. That said, we have less than usual in sterling at the moment, based on its negative momentum and the relatively poor economic position of the UK versus the US. Of course, one of the benefits of currencies is that they are very liquid and so positions can be changed quickly, if need be.
Thinking about asset classes more generally, as economies and their monetary and fiscal policy paths diverge, so the opportunities increase for active global multi asset managers, especially when diversifying portfolios.
