FX: Good news and bad news – Deutsche Bank

George Saravelos, Strategist at Deutsche Bank, explains that even though volatility is low and uncertainty around key macro questions high there does not appear to be a structural decline in the excess returns available to FX investors.

Key Quotes

“Our Deutsche Bank currency index (dbCR) was launched more than a decade ago and captures the "beta" in FX market returns by following a simple carry, valuation and momentum strategy. Returns have been remarkably stable since the advent of free-floating exchange rates and very resilient to the global financial crisis. This year the dbCR is down 2% - mostly hurt by poor performance in G10 FX carry - but a rolling 2-year Sharpe ratio is well within historical ranges.”

“Now to the bad news. FX macro manager returns have typically tracked market "beta" well with modestly higher returns reflecting the presence of market "alpha". Something highly unusual has happened this year however: returns have collapsed to the lowest levels since the 1980s with the divergence between macro manager and beta returns at a record high.”

“What is driving this sharp deterioration in performance? It is hard to identify one factor but a primary candidate may be a breakdown in the traditional macro relationships that would be expected to prevail at this stage of the global cycle. The single biggest surprise this year has been a slowdown in US inflation despite a continued closing of the output gap, for instance. The upside of discretionary investing is that it is more forward-looking than cycle-agnostic "beta". The downside is that when the forward-looking view is wrong the cost can be greater. The most important take-away for optimists like us is that excess returns have not disappeared from the market. There appear to be fundamental shifts in global macro drivers and it is taking time until investors fully understand them.”