May 11, 2010

Don't Let The Euro Madness Scare You Out Of The Currency Market

After the €750bn loan package has been put together by EU leaders and the IMF in support of the Eurozone countries, its flagship, the Euro, has found some support in the currency markets.  However, there are still many who question the ongoing viability of the Euro and recent positions in currency futures markets reflect that fear of uncertainty quite clearly.  The chart below shows the commitment of traders (COT) below the futures prices of the Euro.  It indicates a widening gap between commercial hedgers (green line) and large traders i.e. the speculators (red line) which started about 6 months ago coinciding with the rapid decline of the Euro since then.  At present, there is no sign that the speculators believe in a positive outcome of the European debt crisis, something which may or may not change in coming weeks. 

Euro_fut_weekly

Given this narrative, one might get the impression that currency markets have been and continue to be incredibly volatile.  They are in a way but in terms of comparing price volatility and market risk with other markets, I beg to differ.

For instance, oil futures dropped almost $12 or about 13% last week, which in view of the unresolved Oil leak in the Gulf of Mexico and the possibility of an end to further off-shore oil drilling on America’s coastlines, still leaves me slightly confused.  In the absence of other economic factors, these types of events would typically boost oil prices.  The fact that it didn’t means that a lot more price volatility, possibly in either direction, is on the horizon.

Oil-2010-05807

Stock markets around the world fell over 6% last week, notable exceptions were Hong Kong (-5.6%) and India (-4.5%).  As of Friday last week, the major US Indices have been slightly in negative territory for the year – who would have thought...

SPX-Dow-2010-0507

But the US is holding up better than the rest of the world thus far.  European stocks have been hammered since the Greek crisis.

Europestocks

And emerging markets have not been spared either.  Last week, China’s Shanghai Composite Index was leading the pack with a 17.6% drop for the year.

EmergingStocks

How does that compare to currency movements?

The Euro clearly took a beating this year having lost about 11% against the US  Dollar until Friday.  Other currencies however did not fare too badly versus the US Dollar and also held up well compared with the returns of the S&P500.

FXcompare1

Examining a measure of risk as expressed in daily volatility, the major currencies (including the Euro) have generally been far less volatile than the broad stock market index S&P500 during almost every period in the past few years (our comparative data go back to 2007 only). 

2009   2008
FXcompare2009   FXcompare2008
     
2007   2007 – May 7th 2010
FXcompare2007   FXcompare2007-2010
     

I do not suggest that investing in currencies would be more profitable than investing in stocks.  But given the same amount of leverage, for instance by using the standard ETFs for the various markets, the major currencies provided a far less bumpy ride than the US stock market in terms of the average daily returns. Given the high correlation of most international stock markets in recent years, the notion of diversification to mitigate risk should be carefully re-assessed.  As Douglas Short of www.dshort.com puts it:

Diversification works – Until it doesn’t!

diversification-failure

In the above chart and in many asset allocation models, currencies are typically not included.  They are somewhat implied with international equity and bond exposure. I believe however, given appropriate balancing, currencies should be considered a separate asset class and be part of every investor’s portfolio if an inclination to some international diversification is present.  Done correctly, currencies can help mitigate overall risk and generate some balance for your returns.  The sample portfolio below is just one basic example to give you an idea how a simple allocation could be structured.  In the same time frame as above, a basic 40% Bond, 20% Currency and 40% Equity allocation not only provides better returns than the S&P500 but it also results in less than half the volatility and substantially lower risk. 

sample-portfolio

(Please note that the chart above is just one example of a hypothetical portfolio allocation.  We do not suggest that you should use these exact percentage allocations or any other allocation for that matter.  If you would like more information on how to include currencies within your portfolio, please email: info@fxistrategies.com for a more comprehensive assessment of your specific investment objectives.)

Good luck and good investing!

Disclaimer
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