Wednesday, March 16, 2016

Price and economic momentum result in better currency returns

There is a long history of showing that tracking trends or sorting by momentum in currencies will lead to good return performance.  Trends are viewed as one of the three key drivers for explaining currency returns along with carry and fundamental value. Currency returns are tied closely with the short-term interest differential or carry, deviations from fair value as measured by some variation of purchasing power parity and past return performance. The view is that fundamental models have done poorly in these markets so using price-based systems is the best way to extract returns.

A new study shows that currency returns are tied to trends in economic fundamentals. Put simply, the trend in macro variables will lead to price trends. This makes perfect sense in the trend-follower's world, but they choose to focus on price and not worry about the fundamentals.

The choice of which economic variables to follow may be problematic. Instead, prices are viewed as primal to the process. What this study does is go beyond just saying that price trends are driven by economic trends and shows that following macro trends are a unique method for predicting currency returns. See "Economic Momentum and Currency Returns" Magnus Dahlquist Henrik Hasseltoft.

A trading strategy that goes long the currencies with strong economic momentum and short those that have weak economic momentum will have a Sharpe ratio close to 1. More importantly, it will add alpha even after controlling for carry, momentum, and fundamental value. 

Additionally, if you track the economic momentum across countries you will actual be following the alpha of carry trades. Carry trades may just represent the manifestation of differences in strong and weak economic growth. Interest differentials capture economic momentum, but if you weight or aggregate the underlying momentum in economics you may do better than following carry strategies. 

The authors find that investors' expectations of fundamentals may be extrapolative so that currency returns are a manifestation of these trending expectations. Past macro trends capture current expectations of future macro fundamentals. What the authors show is that a strategy of cross-sectional trends based on fundamentals in an effect strategy just like following prices.  

The numbers below show that adding a trend combination of macro fundamentals will improve prediction of currency returns. Now, the amount explained is not impressive but considering that most models have poor predictive power, this provides enough evidence for further study.

The following table looks at the weights for mean-variance efficient portfolios. The first four columns show the Sharpe ratio for following each individual strategy. The best is the trend combo. When the three traditional strategies of carry, momentum, and value are combined they will do slightly better than the trend combo; however, if you add the trend combo to the combination of strategies you will have a Sharp ratio above one. Notice that the weights show that you will place the most exposure on the trend combo and the least on carry. 

The evidence suggests that using fundamentals with price-base systems will do better than price alone. Trends in fundamentals predict currency returns and do better than some other well-established strategies. This paper provides good evidence that global macro trading in currency works and should be used by investors. 

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