To understand this, the most important thing to recognize is that what is driving the dollar is the interest rate differential between U.S. rates and other developed foreign rates; this provides a long dollar position with positive carry. The level of the interest rate differential, of course, is being driven by economic policy and politics. While U.S. yields have risen sharply since the election, other major markets (Europe, Japan etc.) are mostly pegged with very low or even negative interest rates. Repeating one of our original theses published in this forum a few months ago – it is as if the U.S. bond market has become an investment market again (positive yields with potential of price gain), whereas Europe and Japan bond markets are still very much “insurance” markets with negative yields. The U.S. vs. Europe differential over the next five years is almost 2.5% per year (and is the highest since the inception of the Euro). So the simple math is that if you can move your investments from Europe to the U.S., and you can take the currency risk, you can possibly make 10% cumulative extra return over the five year horizon. To take the other side of this trade, you need very good reasons why paying the negative carry is a good idea (while still taking currency risk). On the other hand, the trend is towards yields continuing to rise from all-time lows, so it might be premature to invest in longer duration bonds, where the yield advantage can quickly be overwhelmed by price losses if the rising yield trend continues. So we look for shorter duration relative value opportunities.
As an example of relative value across regions for shorter duration investments consider the impact of interest rates on exchange rates. If the spot currency exchange rate is 1.07 dollars to the Euro, due to the interest rate differential the forward exchange rate out five years is almost at 1.20 dollars to the Euro. So the interest rate differential implies that we can buy the dollar at a 13 cent discount to its current exchange rate for delivery in five years. The reason is that the foreign exchange markets price the forward exchange rate taking into account the interest rate differential due to interest rate parity. The second part of structural portfolio construction is the trend. While the dollar has already strengthened almost 25% over the last five years, the trend is still strong, and there is still plenty of room for it to get even stronger. The promised fiscal stimulus, talk of border taxes and the potential for a rapid and aggressive tightening path by the Fed are likely to create conditions for this trend to persist. Finally, implied volatility in currency markets is extremely low, which allows one to build enough protection in a dollar overweight portfolio in case there is a sharp and unpredictable reversal in the dollar as new news comes out.
No discussion would be complete without a mention about the equity markets. While from a pure valuation point of view, equities in the U.S. are on the richer side of what has been historically considered fair, as investors know very well from past events when animal spirits awaken, markets can overshoot (e.g. the massive rally in 2000 before the dotcom bubble burst). In the short run equity markets in the U.S. should be supported by the massive fiscal promises of the new administration, and even if a small portion of the money flowing into dollars goes into risky assets, current valuation levels could be well justified. But given the extremely low levels of implied volatility and the price of protection, modest dividend yield and positive momentum, it would be hard to argue against a long equity bias protected on the downside, just in case something unforecastable occurs.
To be sure, there are many political events on the horizon over the next few months, especially elections in many European countries, which are going to be hard to forecast. And even if we can get the political results right, we might not know with a high degree of confidence what the market might do and how quickly. For example, if the tail event of the European Union disintegration turns into reality, will the Euro weaken or strengthen? While the Euro weakening case is clear, one can make the case that the Euro will be the currency of the “core” countries like Germany, which may make it stronger. We can make equally probable cases for both. We are again faced with a conundrum of having to invest when we have really very little forecasting ability about politics, the market reaction to the politics, and about the speed of markets getting from one point to another. But we can be sure of one thing, that despite our lack of confidence in forecasting, if we can build structurally sound portfolios, we are likely to be able to weather and maybe even benefit from the lack of information. Investing in dollar assets, to wit short term bonds and downside protected equities is one such strategy for the day.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.