Currencies – the year behind and the year ahead

As trading gets under way in 2014, it's worth taking a moment to review 2013 to see what worked in the FX market and compare it to what's expected for this year.

There are major differences between last year's market and what investors anticipate will happen this year. By looking at these differences, we can perhaps discern what the market's assumptions are and decide whether we agree. That should help to shape our investment strategy for the year.

Table #1 shows the total return for G10 currencies in 2013. The first column shows the return just from the change in the price of the currency, with the DKK and the EUR effectively tied for first place and the JPY in last, while the second column shows the interest earned on the currency.

Table #1

While interest rate differentials don't matter much for short-term trades, in normal times they can make a difference for longer-term trades. I say "in normal times" because interest rates among the G10 are so low and the differences in interest return between currencies is so small that for the G10 currencies this isn't a big factor.

So, for example, the AUD had the highest interest rate but was the second worst-performing currency overall. On the other hand, the DKK was the second best performing currency and the CHF the third best on a total-return basis even though interest rates for those currencies are actually negative!

I should probably turn that statement around: those currencies aren't strong despite negative interest rates, but rather the interest rates in those countries are negative because the currencies are so strong. That's why the central banks instituted such radical policies: to discourage investors from buying these currencies and pushing them up further.

The relationship between interest rates and total return is easier to see on graph #1, which shows the total return for the year on the X-axis, against the interest return on the Y-axis. There are two main groups of currencies: the high-interest currencies that depreciated – the AUD, NOK and CAD; and the low-interest currencies that appreciated – the EUR, DKK and CHF.

Graph #1

Note this is what makes carry trades dangerous sometimes. If you had put on a G10 carry trade at the beginning of the year, buying the three highest-yielding currencies and selling the three lowest-yielding ones, you would have lost about 5.7 percent.

There were two major anomalies last year: the JPY and the NZD. The JPY was a low-interest currency, yet it depreciated. On the other hand, the NZD was the second-highest interest currency and it appreciated.

What does the market expect for the year ahead?

So, what's going to happen this year? According to Bloomberg's market consensus forecasts, shown in table #2, this is what investors are anticipating. The spot return column shows that the market expects all the G10 currencies to fall in price against the dollar, or conversely, the dollar is forecast to rise against all its G10 counterparts. With interest rate differentials so low, most of the return will be price return.

Table #2

The right-hand column shows that only in the case of the AUD and NZD is the interest return enough to offset the loss from the expected price decline and turn the expected loss into a profit. Otherwise, the total return on the currencies is expected to be almost the same as the price return and the ranking of the two columns is almost exactly the same, with the exception of NZD and CAD.

It's not possible to tell what's driving each individual forecast, but graph #2 shows that neither mean reversion nor momentum is driving them. Graph #2 shows the actual return in 2013 against the forecast return in 2014.

Graph #2

Sometimes it's the case that the currencies that do particularly well one year do badly the next year as the factors that boosted them before fade, i.e. mean reversion. On the other hand sometimes the currencies that do well one year continue to do well the next year as the factors that boost them continue, i.e. momentum.

In this case I can't discern any pattern. Some of the currencies that did well last year are expected to do badly this year (CHF, DKK, EUR), but at the same time, some of the currencies that did badly last year are expected to do badly again this year, too (JPY, NOK, CAD).

However, if we look at the same data we've been looking at a different way, a relationship does become clear.

Graph #3 shows the expected return for 2014 on the Y axis, but in this case, the X axis is the interest return from 2013. Now there's a very strong relationship – the R-squared is 0.76, meaning that the interest return explains 76 percent of the variation in the forecast 2014 return. Currencies with higher interest return are expected to do better this year and the currencies with lower interest rates are expected to do badly.

Graph #3

Why is this when, as we saw, there was an inverse relationship between interest return and currency performance in 2013? It's probably because the market is expecting continued normalization in the global economy.

Putting the pieces together

One reason why low interest-rate currencies gained so much in 2013 was investors were looking for safe havens. Denmark, with a current account surplus of around 6 percent of gross domestic product (GDP) and only a small budget deficit of 1.7 percent of GDP, seems pretty safe. Switzerland, with a current account surplus of 12.7 percent of GDP and a balanced budget, seems even safer.

But apparently people have become more confident about the global economy and are now less concerned about safety. This is probably because so many things we've worried about haven't come to pass. The Eurozone hasn't collapsed yet, the U.S. government didn't default, quantitative easing didn't cause hyperinflation, the Federal Reserve's exit from quantitative easing didn't cause the emerging markets to implode…many of the major problems that were facing the markets at the beginning of 2013 seem to be under control now.

In that case, people are going to start looking for some return on their money. They're likely to put on carry trades funded with the low-yielding currencies of countries whose central banks are unlikely to change monetary policy any time soon and invest in higher-yielding countries where the central banks are at least going to keep rates stable and may raise them at some point.

Now, I'm not saying that I agree with all these forecasts. On the contrary, I disagree with many of them. But that's where the opportunities lie for a fundamental analyst. We have to examine where our forecasts differ from other people's forecasts and ask two questions: What possibilities might we be missing and what might the market be missing? And secondly, do we have enough confidence in our view to back it with money? That's the way fundamental investors work.

The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.