Our systematic FX Protected Carry strategy provides for a screening of the currency universe using quantitative methods at the beginning of each calendar year. We have used this procedure to identify the five most attractive high-yield currencies which come from four continents this year – Asia, South America, Africa and Europe – and thus offer broad geographical diversification. Quantitative methods are also used to determine signal strength. Currently, sentiment is positive across the board with high positionings in the five selected high-yield countries.
The positions are financed either in US dollars or euros. The decision is made using models on a rule-bound basis. The models currently point to a persistently weak US dollar and are positioned accordingly.
Metzler Currency Management reacts promptly to changes in the market environment and quantitative models are recalculated daily. The aim is for the models to provide predominantly positive signals when risk appetite on the capital markets is high. On the other hand, the strategy is also intended to provide protection when sentiment is clouded and a risk-averse scenario prevails. This was often the case in 2022. The US Federal Reserve created more headwind on the markets with its aggressive interest rate policy in 2022, and this was reflected in the models’ strategies which were more defensive on average. High-yield currencies were chosen only selectively and assigned a low weighting for the portfolio. The models favored the US dollar in 2022, thus making it the most significant long position against the euro. The basic idea behind the strategy can be divided into four quadrants as shown below.
Currency development in 2022 is best illustrated by quadrant 1. Risk aversion was a major theme on the financial markets, and the US dollar appreciated significantly against most currencies while emerging market currencies weakened against the US dollar. Losses were made on the equity and bond markets. Normally, globally falling market prices are accompanied by a strong US dollar. Including this component in the investment strategy can neutralize the traditional correlation between carry strategies and equity markets. 2023 started off with a weak US dollar, robust emerging markets, and rising equity prices as described in quadrant 4.
The strategy can be adapted to fulfil specific client requirements and implemented individually. In 2017, we started implementing the strategy in the form of a UCITS fund (ISIN: DE000A2DHUFO), which makes it possible for institutional clients to invest as little as 50,000 euros. The strategy is implemented via derivatives which means that the money in the fund must be invested in securities. Euro bonds with good credit ratings and short maturities were acquired to serve this purpose. Until 2021, these bonds bore interest at negative yields, but 2022 brought a turnaround. Now the securities are generating clearly positive yields again, which boosts expectations for higher returns in the future. Only securities with good credit ratings and short maturities will continue to be selected for new investments.
The strategy is implemented via derivatives rather than via short-dated bonds in the respective countries because the advantages outweigh the disadvantages. Investments are made via forward exchange contracts or non-deliverable forwards. These offer attractive interest rates with high market liquidity and low transaction costs. Foreign exchange transactions are concluded with major international banks and secured by mutual collateral. The most important advantage for us is market liquidity with low transaction costs. In a risk-averse environment, our dynamic investment approach requires rapid position smoothing. While foreign currencies can still be traded at low transaction costs in such an environment, the local bond market in high-yield countries often freezes. The bid-ask spread widens considerably. Such a dynamic strategy is therefore not feasible with fixed income securities either. However, the risk characteristics of the derivative option correspond to implementation via local bonds and results in a portfolio of select foreign currency bonds in attractive high-yield countries – with protection against devaluation of the foreign currency and the option to switch to US dollars in a risk-averse environment.
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