Foreign exchange markets have taken centre stage again in recent weeks. President Trump’s apparent indifference to the relatively steep dollar depreciation trend of late has raised a few eyebrows and added fuel to the dollar fire. Treasury Secretary Scott Bessent sought to swing markets back into dollar strength mode by reassuring everyone that a strong dollar is still part of US policy, to little avail. There were also rumours that Japan and the US might conduct a coordinated currency intervention as the yen reached uncomfortable levels, although these were later denied. In Europe, Martin Kocher of the Austrian Central Bank commented on the possibility of the ECB having to act by reducing rates should the euro continue to appreciate. The cherry on the cake was the confirmation of Kevin Warsh as the new Fed chair which has translated into a stronger dollar and a large hiccup in the debasement trades as he is perceived as both a hawk and a credible economist.
First, when assessing whether an asset is going to increase or reduce a portfolio’s volatility, it is important to consider not only correlations with existing holdings, but also the asset’s own standalone volatility. An asset that has a low correlation with the portfolios underlying assets can still increase total volatility if the standalone volatility of the new asset is very high. Cryptocurrencies are a good example of this. While they may not be highly correlated with traditional portfolios, that doesn’t mean they would reduce volatility. Volatility measures would depend amongst other things on the time horizons used for the calculations, but as a broad comment, we find currency volatility to be more akin to that of equities than fixed income.
Second, correlations themselves are not stable, which means that any reduction in volatility due to low correlations is not stable either. Correlation estimates depend heavily on what the time horizon is and what’s the frequency of the returns used (daily, monthly, yearly would all yield different correlation numbers). For example, the six-month correlation using daily returns between the dollar index (DXY) and the S&P 500 has been negative more often than positive in the last 15 years. However, there have been periods, of well over 12 months, where correlations have been positive. At present, short correlations are very volatile indeed as a result of the myriads of headlines discussed earlier, swinging from positive to negative unexpectedly.
Given this backdrop, and in the context of fixed income, we believe it’s an opportune time to double check that fixed income investments are FX hedged. While we are not currency traders, given the very high volatility and the growing risk of diversification away from the US dollar we do think that those investors that want to run, or have to run currency risk, might benefit from diversification across G7 currencies, rather than having all their eggs in the US dollar basket.
