Side effects are unavoidable in the pharmaceutical industry. All drugs cause them, but sometimes they lead to great opportunities. Think Viagra, originally developed for angina.
So it is with central bank policy, where the law of unintended consequences is perhaps even starker than it is in drug development. In the last month or so, in an effort to stimulate growth, central bankers have begun a new round of creative experiments. This should lead to more market volatility and unexpected investment opportunities, particularly in currencies.
Take the yen, for example. The Bank of Japan (BoJ) recently announced a 2 percent inflation target and said it would pursue "open ended" asset purchases in a bid to reflate the economy. Currency traders have taken note. "Short yen" trades have surged in popularity, pushing the currency down around 15 percent against the US dollar since mid-November – the sharpest sell-off in almost two decades.
It remains to be seen if the BoJ will be successful in sparking inflation – the Japanese consumer price index (CPI) has exceeded 2 percent for only four months over the past decade.
But the BoJ is not the only central bank taking aggressive and unorthodox measures of late. In fact, as major economies grapple with high unemployment and sluggish growth due to ongoing deleveraging, central bankers continue to experiment.
The Fed has reversed a tradition started with Paul Volcker in the 1970s and set the reduction of unemployment, rather than suppressing inflation, as its primary goal. Meanwhile, Brazil is trying to control inflation and stimulate growth by manipulating its currency, the real, rather than by raising interest rates. And incoming Bank of England governor Mark Carney has expressed interest in exploring nominal GDP targeting.
In short, monetary policy is moving from black-and-white to something approaching technicolor, jolting currencies out of a long period of stasis.
In the black-and-white world, currency volatility was crushed. With near-identical interest rates, inflation expectations were well anchored, and central bank policies were very similar across the developed world, fluctuations in currencies were driven mostly by broad perceptions of risk.
The result -- for all the talk of currency wars -- was something of a stalemate. Currency selection offered limited opportunities for adding 'alpha', and mostly served only to add 'beta' to a portfolio. Trading the euro, or Australian dollar was similar to buying exposure to the equity market, while buying the yen or U.S. dollar was tantamount to 'going short' equities.
The euro has rallied alongside equities in twenty-two months since 2009; it only fell in months when equity markets rose on six occasions.
In our new technicolor world, currency volatility is on the rise again. As systemic risks such as a euro zone breakup and the U.S. "fiscal cliff" have receded, attention is returning to local, currency-specific risks.
As a result, currencies are no longer hooked to the whims of the equity market. The correlation of the U.S. dollar to equity markets averaged minus 74 percent between 2009 and 2012. Now, it is just minus 26 percent. Likewise, the Aussie dollar's correlation to equities has dropped from 75 percent to 34 percent.
In other words, currencies are no longer moving in lockstep with other asset prices. Furthermore, the performance of individual currencies is increasingly divergent; correlations across U.S. dollar currency pairs have collapsed to the lowest levels in five years. The result has been a return to currency picking; dedicated currency managers generated returns of 2 percent in January alone, equal to their average annual gain over the past decade.
Investors will see opportunities in different places, but two that deserve some consideration may be the British pound and emerging market currencies.
The pound has depreciated by almost 5 percent against the euro this year to date, partly on expectations that incoming central bank governor Carney would embark on nominal GDP targeting.
However, Carney's recent comment that "the bar for change is high" has reassured many investors that the central bank is unlikely to abandon its flexible inflation targeting framework. This should serve to push up short-term interest rates and support a rebound in the pound.
In a world where attention is returning to the fundamentals, emerging market currencies should also benefit. Emerging market currencies offer an attractive interest rate premium over developed currencies, and thanks to surprisingly low volatility and mostly steady appreciation, have been the most attractive asset class on a risk-adjusted basis over the past fifteen years.
As currencies are traded more on their own merits, rather than as risk-proxies, the lower debt levels and more positive growth outlook of the emerging world should prove clear tailwinds.
Risk-on, risk-off trading is beginning to subside and central bank policies are becoming more divergent. The ultimate outcome for economies remains unclear, but one thing is certain: currency trading is becoming interesting again.