Seeking cash gains from currency management

Though the goal is still the same, investors playing by the same rules as a year ago are now taking on more risk, while the payoff for staying in the game is shrinking. When it comes to seeking out returns, though, there is not enough appreciation of how useful active currency positions can be in diversifying risk and generating outperformance.

With the Federal Reserve’s quantitative easing programme ending, volatility – which had been subdued – has spiked upward again. Yet the difference in yields between corporate bonds and US Treasuries remains very low.

The reason is that even with monthly asset purchases gradually falling away to nothing, Fed chairman Janet Yellen has been keen to assure investors that the extremely low Fed funds rate remains appropriate.

This has allowed investors to remain comfortable with minimal Treasury yields, while low volatility and improving economic data have generated heightened demand for riskier bond assets. A similar story can be found in the UK, where the low interest rate environment has pushed gilt yields to historic lows, and investors have moved up the risk spectrum to capture more attractive returns.

The danger is that in the face of falling unemployment and resurgent GDP growth, both the Fed and the Bank of England are under increasing pressure to prevent their economies overheating.

This would involve increases in base rates, which is bad news for bond valuations. Benign inflation readings in both economies have allowed some breathing space in the short term, but this is reaching a low for the economic cycle.

But investors still have options. One way in which returns can still be generated is via active currency management.

Treasuries and certain US corporate bonds look increasingly vulnerable as the US economy grows and rates rise. The US dollar itself, on the other hand, is likely to benefit from any such move. Its relative strength against less structurally sound currencies, such as the Canadian dollar or the Australian dollar, can generate attractive returns when rates begin to rise. Further gains can be made from emerging currencies with close ties to the US, such as the Mexican peso.

The euro offers yet more opportunities. Since its strength in recent quarters has been a major factor in the region’s economic fragility, the European Central Bank (ECB) has announced a combination of rate cuts and, more recently, a programme of asset purchases of its own. The euro has fallen by more than 7 per cent against the US dollar in 2014, but we can be fairly certain that the ECB’s policy accommodation will not go away any time soon and that further falls can be expected.

Weakening the euro is an integral part of allowing the eurozone to recover, and active fixed income investors can take advantage of this. The US dollar’s strength and the euro’s weakness can be generators of outperformance where broader bond markets are struggling.

The fact that bond markets have made such broad-based progress in 2014 has taken many investors by surprise. Now that the environment that has catalysed such strong gains is coming to an end, it will be more challenging to make real returns in fixed income. Active currency management offers a viable and valuable strategy for meeting these challenges head on.

Gareth Isaac is manager of the Schroder Strategic Bond fund