The old saying goes something like this: “Don’t worry about protecting your foreign currency exposure: in the long term it’s all swings and roundabouts.” But after a six-month period in which the pound has been devalued against at least one mainstream foreign currency by more than 15 per cent, the ups and downs in exchange rates seem less akin to a children’s playground and more like Thorpe Park’s Nemesis Inferno. So is there any truth in this investment folklore or should long-term pension investors take exchange rate risk more seriously?
Foreign exchange (FX) is a market where many investors perceive trading gains are to be made because, unlike other markets – such as equities and bonds – it is full of unsophisticated buyers and sellers, people like you and me swapping our currencies to go on holiday, taking whatever rate we are given. This year, however, is a timely reminder that homespun observations such as this are frequently wide of the mark. The truth is that the FX markets are dominated by large corporates hedging their FX exposure and institutions speculating on future currency movements.
A favourite game played by the institutions is called the ‘carry trade’. The rules are simple. You borrow money in a country with a low interest rate – such as Japan, where interest rates have recently become negative. You take your yen, convert them to a currency which carries a higher interest rate (not many options currently, but at 0.5 per cent interest even the US dollar would work). You put your dollars in a bank or buy riskier dollar assets, earn your interest or returns and reconvert to yen to pay back your loan at the end of the term (say, one year later.)
The dollar interest rate you earned would have more than covered the yen interest you paid on the loan. According to trading logic, the currency of the higher-interest-rate country should also rise in value because it is more attractive to own dollars than yen. That will leave you with your interest covered, plus gains both in the FX rate and on the investment when you come to convert back to yen to pay off your loan.
The theory says no
This may sound sensible, but the plan is remarkably at odds with economic theory. The theory states that a low-interest-rate country should see its currency rise against a high-interest-rate country – not the other way around. Why? Imagine the scenario where the UK has interest rates of 10 per cent, the US has rates of zero, and the exchange rate is £1:$1.50. If you keep your pounds on deposit for a year, they will grow to £1.10. If you exchange your pounds for $1.50 at the beginning of the year and keep them on deposit, you will still have $1.50 at the end because US rates are zero. A year later, then, your £1.10 will be equivalent to $1.50, implying a new foreign exchange rate of £1:$1.36 – the pound buys fewer dollars and so is said to have devalued.
Another way of looking at this is to accept that a high interest rate implies high inflation (as is the case today in India and Brazil, for instance). If the UK is experiencing high inflation then one pound will be worth less in the future than it is today; in other words the pound is losing value.