Currency trading and business cycle dispersion - Buy strong growth and sell low growth in cross-sectional portfolio

 

Currency markets performance is much easier to explain when analyzed cross-sectionally rather than as a single pair. Positive portfolio gains can be achieved by building long/short portfolios based on momentum, carry, or value. For example, long high rates and short low rates, or long positive (short negative) momentum. 

In essence, investors are taking advantage of  dispersion across specific factors. A more primal relationship with currencies could be the dispersion in economic conditions, like growth. An exchange rate is a relative price so currency changes should be related to the relative behavior of macro fundamentals. A new paper shows that this is an exploitable relationship between the output gap of a country relative to the US and spot exchange rate changes. See  "Business cycles and Currency Returns" by Colacito, Riddiough, and Sarno. 

The intuition for this cross-section macro-fundamental idea is simple. Stronger relative growth should translate into greater demand for the exchange rate. This is consistent with signs associated with growth differences in fundamental exchange rate models. The authors use a unique approach of exploiting output gaps through deviations from growth trends. Measuring the output gap through any number of simple methods finds there is an increasing excess return function based on sorting from weak to strong economy currencies. Buy economic growth (positive output gap) and sell economic weakness. Cross-sectional analysis changes the emphasis of business cycle and macro fundamentals away from bilateral forecasting; however, this business cycle relationship also applies for time series analysis.  

What is most interesting about this simple result is that it is independent of interest rate differentials (carry) models. There is significant variation in output gaps even relative to interest rate differentials which suggest that sorting on business cycles generate unique risks.

The cumulative returns are positive, but there has been a change in behavior in the post-GFC period. Of course, the spread in output gaps were diminished in this period and there was a flight to dollar safety. Clearly, the QE period did not show the same annualized gains based on output gap sorting; however, if there is a normalization of different economic growth paths, that is, more dispersion, the business cycle may again be a source of cross-sectional and times series returns.