A Hedge against Market Uncertainty
As we have seen recently, foreign currency risk is undesirable in certain market environments. During periods of economic stress, investors flock toward stable, liquid assets when attempting to reduce their exposure to the markets. Given the U.S. dollar’s current role as the world’s reserve currency, it tends to appreciate during periods of increasing global uncertainty. When an investor buys a currency such as the dollar, he is implicitly selling short a foreign currency to gain this exposure. Given the simple laws of supply and demand, this trade has the effect of driving up the price of the dollar against the foreign currency that was sold.
Portfolio Diversification through Negative Correlation
Historically, currency returns generally have a positive correlation with local asset prices. When U.S. investors buy foreign assets such as stocks and bonds, they must convert their dollars to the local currency and purchase locally denominated assets. This causes an increase in demand for the local currency as well as a rise in asset prices. The dollar, by comparison, is seen as a “safe haven” currency in the current market environment. Therefore, as risky assets decline in value, the value of the dollar may tend to increase. This perhaps overlooked current market dynamic has the impact of creating a negative correlation for most foreign currency positions against the S&P 500.
Weekly Correlations, October 31, 2008 – October 31, 2013
Conclusion
Investments in the U.S. dollar against foreign currencies can be used in a variety of ways in an investor’s portfolio. Given the low opportunity costs associated with long positions in the U.S. dollar against many developed market currencies, the current role the U.S. dollar plays in the global financial system and the potential for diversification from a negatively correlated asset to traditional asset classes, we believe that certain market environments may create opportunities to benefit from a strengthening U.S. dollar.
Important Risks Related to this Article
Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Diversification does not eliminate the risk of experiencing investment losses.