Long term currency risk

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Topic Author
konik
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Joined: Mon Aug 17, 2020 2:44 pm

Long term currency risk

Post by konik »

Hi all!

I have a question about currency risk in the long term perspective. Is it correct that in the long run your savings (most probably) will do similar in any currency? What other factors can influence currency performance? Are there any difference between developed countries and developing world currencies? I see that EUR/USD just bounce back and forth, but many developing markets currencies almost always weaken relative to USD.
glorat
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Re: Long term currency risk

Post by glorat »

If we are talking strictly long term (i.e. ignoring all the speculative froth), the theoeretical (and market actual) answer is based on relative long term interest rates between the two currencies. A currency with a higher interest rate set by that government will, all else being equal, have a currency that relatively strengthens over the long term.

After risk relative free interest rate differences, the next theoretical factor is "currency basis" which, if I recall correctly, encompasses things like the credit worthiness and "trust/stability" in the government setting the currency. This tends in living history to favour a strong USD and weaker for emerging markets. [Edit: as subsequent posts have pointed out, I should have added "inflation" as a major component to currency basis]
Last edited by glorat on Tue Sep 01, 2020 1:40 am, edited 1 time in total.
Valuethinker
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Re: Long term currency risk

Post by Valuethinker »

konik wrote: Sat Aug 29, 2020 4:57 am Hi all!

I have a question about currency risk in the long term perspective. Is it correct that in the long run your savings (most probably) will do similar in any currency? What other factors can influence currency performance? Are there any difference between developed countries and developing world currencies? I see that EUR/USD just bounce back and forth, but many developing markets currencies almost always weaken relative to USD.
Glorat has a good answer.

Purchasing Power Parity or the Law of One Price says in the long run currencies adjust for relative inflation. If British inflation is twice as high as American then the pound will depreciate by half.

Empirically that is never true although I think the academic consensus now it it is true enough to be a long term guide.

So for the purposes of Yen Euro Pound Dollar and maybe a few currencies like Swedish Kronor or Canadian Dollar it is probably true in long run. Beware though because you can have 10 yeear+ periods when a currency does not obey this principle.

You are correct about EM currencies because in the long run they tend to have higher inflation. So they depreciate against USD and Euro. When Itsly had its own currency it used to depreciate against the DM. Everybody depreciated against CHF ;-).

Complicating the picture is many EMs have foreign exchange controls and the Renimbi in particular has an official ex change rate and string restrictions in dealing. This can lead to large deviations from where markets would put the currency and sometimes explosive devaluations or revaluations.
YRT70
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Re: Long term currency risk

Post by YRT70 »

glorat wrote: Sat Aug 29, 2020 10:10 am If we are talking strictly long term (i.e. ignoring all the speculative froth), the theoeretical (and market actual) answer is based on relative long term interest rates between the two currencies. A currency with a higher interest rate set by that government will, all else being equal, have a currency that relatively strengthens over the long term.
I'm trying to understand this better. Afaik US offers higher interest rates than Europe. Would this mean USD will relatively strengthen over the Euro?

Or are there other factors at play?
typical.investor
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Re: Long term currency risk

Post by typical.investor »

YRT70 wrote: Sun Aug 30, 2020 2:32 am
glorat wrote: Sat Aug 29, 2020 10:10 am If we are talking strictly long term (i.e. ignoring all the speculative froth), the theoeretical (and market actual) answer is based on relative long term interest rates between the two currencies. A currency with a higher interest rate set by that government will, all else being equal, have a currency that relatively strengthens over the long term.
I'm trying to understand this better. Afaik US offers higher interest rates than Europe. Would this mean USD will relatively strengthen over the Euro?
Um, actually isn't that backwards? Higher inflation will eventually mean a weaker currency.

At the current time, lower rates for Europe means there is an additional hedge yield on EU bonds that are hedged to the USD. The reason is that the EUR is expected to strengthen so owning a 0.070% German bond and hedging it to the USD earns you more than 0.070% in USD. This is because three months from now (or whatever hedge term they are using), the EUR bond will return it's yield and both the yield and value of the underlying bond are expected to be worth more in USD. So the hedge contract returns that.

If the higher paying USD were expected to strengthen, you would get less than 0.070%.

But that is long term. Short or medium term, people might flock to the higher yields of the USD especially if they expect the USD to strengthen for other (economic/political) reasons. And more people buying USD will strengthen it and raise expectations of it strengthening and ... who really knows when it will weaken. The hedge contracts though will still be priced as if it's expected to weaken, and that's because it is ... at some point.
YRT70
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Re: Long term currency risk

Post by YRT70 »

typical.investor wrote: Sun Aug 30, 2020 2:48 am
YRT70 wrote: Sun Aug 30, 2020 2:32 am
glorat wrote: Sat Aug 29, 2020 10:10 am If we are talking strictly long term (i.e. ignoring all the speculative froth), the theoeretical (and market actual) answer is based on relative long term interest rates between the two currencies. A currency with a higher interest rate set by that government will, all else being equal, have a currency that relatively strengthens over the long term.
I'm trying to understand this better. Afaik US offers higher interest rates than Europe. Would this mean USD will relatively strengthen over the Euro?
Um, actually isn't that backwards?
That's what I thought too but I'm far from an expert.
typical.investor
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Re: Long term currency risk

Post by typical.investor »

YRT70 wrote: Sun Aug 30, 2020 5:34 am
typical.investor wrote: Sun Aug 30, 2020 2:48 am
YRT70 wrote: Sun Aug 30, 2020 2:32 am
glorat wrote: Sat Aug 29, 2020 10:10 am If we are talking strictly long term (i.e. ignoring all the speculative froth), the theoeretical (and market actual) answer is based on relative long term interest rates between the two currencies. A currency with a higher interest rate set by that government will, all else being equal, have a currency that relatively strengthens over the long term.
I'm trying to understand this better. Afaik US offers higher interest rates than Europe. Would this mean USD will relatively strengthen over the Euro?
Um, actually isn't that backwards?
That's what I thought too but I'm far from an expert.
Well just think about it ... if the higher yielding currency is expected to appreciate, why would anyone ever not choose the higher yielding currency?

The reason we don’t flock to EM currencies which yield more is that we fear devaluation.
YRT70
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Re: Long term currency risk

Post by YRT70 »

typical.investor wrote: Sun Aug 30, 2020 5:48 am
YRT70 wrote: Sun Aug 30, 2020 5:34 am
typical.investor wrote: Sun Aug 30, 2020 2:48 am
YRT70 wrote: Sun Aug 30, 2020 2:32 am
glorat wrote: Sat Aug 29, 2020 10:10 am If we are talking strictly long term (i.e. ignoring all the speculative froth), the theoeretical (and market actual) answer is based on relative long term interest rates between the two currencies. A currency with a higher interest rate set by that government will, all else being equal, have a currency that relatively strengthens over the long term.
I'm trying to understand this better. Afaik US offers higher interest rates than Europe. Would this mean USD will relatively strengthen over the Euro?
Um, actually isn't that backwards?
That's what I thought too but I'm far from an expert.
Well just think about it ... if the higher yielding currency is expected to appreciate, why would anyone ever not choose the higher yielding currency?

The reason we don’t flock to EM currencies which yield more is that we fear devaluation.
Oh I totally agree with your reasoning, this is why I didn't understand what glorat was saying.
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Robert T
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Re: Long term currency risk

Post by Robert T »

.
I recall this article (written 20 years ago) by Hussman on Valuing Foreign Currencies that provided a simple explanation https://www.hussmanfunds.com/html/euro.htm

May be helpful
.
Anon9001
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Re: Long term currency risk

Post by Anon9001 »

Long Term is very vague term but even after 10 years your CAGR can be lowered by -1.78% compared to local currency investor or on the flip-side if you are lucky it can be raised by 1.78%. This is not minimal. This risk should be avoided but if the costs to avoiding it are too high lets say hedging EM currencies if you are living in Europe or USA or Japan than it is best to split 50-50 between hedged and un-hedged.
Topic Author
konik
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Re: Long term currency risk

Post by konik »

Thank you all for replies!

Honestly I didn't fully understand the idea. So EM currencies decline relative to DM currencies due to government issues - ok. But on the other hand usually EM have higher interest rates, which make their currencies stronger?

My practical question is how to better preserve my emergency fund held in cash. I'm now living in Russia. I hold some part of it in roubles for immediate needs, but the major part is split equally between USD and rouble, which is quite volatile.
Fortune Seeker
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Re: Long term currency risk

Post by Fortune Seeker »

Both EUR and USD are fine for that. If you feel particularly uneasy about currency risks of those 2, there should be no problem just splitting your savings 50/50 and using both.

What @glorat probably meant was if you adjust 2 currencies by their inflation rates and for their credit rating (country default spread or CDS), a currency with higher rates should eventually appreciate.
anoop
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Re: Long term currency risk

Post by anoop »

Check out dollar milkshake theory. His thesis is that the dollar is by design going to kill all the other currencies. This has not been true for some currencies like the Yen and the Swiss Franc, but otherwise seems to be happening even for the Euro and Pound.
https://www.youtube.com/watch?v=2qTOWuL7Zco
Valuethinker
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Re: Long term currency risk

Post by Valuethinker »

konik wrote: Mon Aug 31, 2020 2:40 pm Thank you all for replies!

Honestly I didn't fully understand the idea. So EM currencies decline relative to DM currencies due to government issues - ok. But on the other hand usually EM have higher interest rates, which make their currencies stronger?

My practical question is how to better preserve my emergency fund held in cash. I'm now living in Russia. I hold some part of it in roubles for immediate needs, but the major part is split equally between USD and rouble, which is quite volatile.
I would be something like USD, EUR & Rouble. Rouble only for say 12 months expenses. If I was being ultra-safe I would put 20% into the (doubtless over valued) CHF/ Swiss Franc.

EM currencies decline against USD in particular because of higher inflation. EUR has its own problems - sits on the edge of deflation, and perpetual weakness in the Italian fiscal-economic system, as well as other countries with poor growth prospects.

EM countries therefore have higher interest rates, to attract foreign funds. Setting aside China, which has a controlled currency and a huge economy, and has its own special macroeconomics.

What that means is most of the time if you invest in EM currency, the higher interest rate is not punished by as much currency devaluation, thus you make money doing this relative to sitting in safe USD assets.

BUT every so often this goes horribly wrong. There is a fiscal crisis - Turkey is having one now, Iceland had one in 2008, Russia has had its ups and downs. This may have something to do with political situation in a country or it just may be straight economics. If you ever saw the cartoon "Bugs Bunny Road Runner" there is always a scene where Wil-E-Coyote chases Roadrunner (there is actually such a bird in the American desert) off a cliff, keeps going and then looks down and realises there is nothing under him. In international currencies we have these "Wil-E-Coyote" moments. Something that was not possible (a country can borrow infinitely from the rest of the world) had been ignored for so long, and finally the market realised it was impossible and violently overcorrected. Russia nearly had a rouble crisis (in 2014 I think), but its Central Bank governor (a woman) was very good and had the support of the leadership, and there was stabilisation (Russia in 1998 had a bad one which led to the failure of the world's largest hedge fund Long Term Capital Management -- I don't believe that will ever happen again with Russia*). Normally what drives the Rouble, I think, is the price of oil- as it is the world's 2nd or 3rd largest producer and exporter.**

What happens is countries "emerge" and become developed markets. Israel has done it, South Korea has done it, Taiwan has more or less done it. They become stable nations whose currencies fluctuate, but no one thinks they will collapse economically in a crisis. However countries also go the other way - Greece has.

I would generally choose safety over higher returns. Invest in a global bond fund that hedges into USD and to diversify another that hedges into EUR. Right now EUR bank accounts pay higher interest than EUR govt bonds -- the bank accounts pay 0%, the safe government bonds actually have negative yields, a guarantee an investor will get back less than they put in.

* for reasons of politics/ prestige, but we are not allowed to discuss politics here (and it would be pointless).

** It occurs to me as I type this that one could argue a Russian resident should aim away from USD. When the oil price is strong the Rouble tends to be strong and the USD tends to be stronger than other countries- the US, alone among developed economies (if we count Canada as part of the US economy), is self sufficient in oil.

Thus when the oil price is low & rouble is weak currencies like the Yen and the EUR should be stronger, relatively.

I think, though, that this is an overly sophisticated argument which should not be taken too far - correlation in the past does not mean certainty of prediction in the future. There are reasons why the rouble might be strong even with a lower oil price, and vice versa. And the EUR has its own set of political issues and potential crises - Italy always teeters on the edge of an economic & political crisis, and in terms of Eurozone govt bond funds, Italian govt bonds are the largest single component (about 40-45% of total). That's why I always encourage people to hold Global bond funds, hedged into EUR - the returns of the fund will be similar (because of the foreign currency hedging) but the credit diversification is much wider- the US & Japan are the largest borrowers.
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