by Christoph Schon, CFA, CIPM
Despite ongoing central-bank claims that the current spike in inflation is “transitory,” the recent surge in oil prices to 7-year highs, combined with ongoing supply shortages across many industries, suggests otherwise. At the same time, the increasingly frequent selloffs of both stocks and bonds severely limit diversification opportunities for investors. That said, not all is doom and gloom. Quite the contrary, we found that ‘commodity’ currencies, such as the Norwegian krone and Australian dollar, are likely to benefit from higher prices for energy and raw materials.
Since the last FOMC meeting on September 21-22, the 10-year US Treasury yield has climbed 0.25%, almost all of which could be attributed to a rise in the corresponding breakeven inflation rate. Over the same period, the STOXX® USA 900 trended mostly sideways. As we noted in our recent blog post and whitepaper, a further increase in inflation expectations is likely intensify any co-movement of stocks and bonds, eliminating much of the traditional diversification benefits from holding the two asset classes together. Investors might, therefore, want to consider options for hedging against a further rise in consumer prices.
Given that many of the recent price increases were driven by higher energy and industrial-input costs, one potential strategy would be to invest in so-called ‘commodity’ currencies, whose value is closely linked to the prices of specific raw materials. Due to their heavy reliance on oil and gas exports, the exchange rates of the Norwegian krone and the Canadian dollar, for example, are strongly driven by the level of crude prices. Australia, meanwhile, is the world’s third largest exporter of gold, which means that its currency often moves with the value of the precious metal.
To validate our thesis, we performed a scenario analysis in which we applied a 50-basis point upward shock to the 10-year US Treasury breakeven inflation rate from its current level of around 2.5% to 3%. The impact on various exchange rates against the US dollar was estimated using a transitive stress test in Axioma Risk™, Qontigo’s multi-asset class analytics platform. The covariances and betas between the breakeven and FX rates were calibrated using daily returns over four six-month periods. The dates in the graphs below denote the respective end dates.
The first calibration period, ending March 6, 2020, covers the five months before the onset of the coronavirus pandemic, as well as the initial stock-market selloff. This environment was mostly characterized by optimism about an impending trade deal between China and the United States, which led to a positive correlation between share prices and the dollar. The second scenario represents the recovery ahead of the announcement of the first COVID vaccine in early November 2020, during which the dollar mostly weakened against a broad range of competitors. The third period to the end of April 2021 encompasses the inflation concerns earlier this year, while the fourth period represents the current correlation regime.
The first chart below shows the expected returns for four commodity currencies: the Canadian dollar, Norwegian krone, Australian dollar, and New Zealand dollar. The results confirm the notion that these can provide protection against rising raw-material prices. The second scenario displayed the highest expected returns, as the underlying calibration period (May to November 2020) was dominated by a steady depreciation of the US dollar. The Norwegian krone exhibited the biggest gains, as its value is most closely linked to the price of crude oil.
Simulated FX returns for a 0.5% rise in inflation expectations – commodity currencies
The picture is less clear-cut for other countries and regions, however. The chart below shows the projected performances of the four most actively traded currencies: the US dollar, euro, Japanese yen, and British pound. The returns of EUR, JPY, and GBP are against the USD, whereas the latter is represented by the so-called Dollar Index—a measure of its average value against a basket of major trading partners.
Simulated FX returns for a 0.5% rise in inflation expectations – G4 currencies
The pound appears to be most likely to benefit from higher inflation. So far, rising consumer prices have been mostly good news for the British currency, the main argument being that it could prompt the Bank of England to raise interest rates sooner, which, in turn, would make the currency more attractive to foreign investors. Recent market movements seem to confirm this notion. Since the beginning of October, the probability of a BoE rate hike before the end of the year—implied by short-term interest-rate markets—has risen from virtually zero to almost 70%, while GBP/USD strengthened more than 2%. The British stock market also has significant exposure to the energy and mining sectors, which make up more than 16% of the STOXX® UK 180 blue-chip index. This could be another argument for a stronger pound, especially if prices for raw materials rise further.
The dollar meanwhile has been predominantly negatively correlated with inflation expectations, particularly as it weakened through most of 2020, when breakeven rates rebounded alongside recovering stock markets from their respective lows after the initial COVID panic. The only period in which the predicted return for the Dollar Index was positive was before the pandemic, when rising inflation was seen as a sign of a healthy and recovering American economy, which was positive for the US stock market and currency alike. It is also interesting to note that the calibration period ending April 30, 2021, shows a much smaller loss. This was due to the temporary strengthening of the greenback during the first quarter, when the likelihood of a Fed rate hike in the first half of 2022 was still considered to be less than one in five. Since the last FOMC meeting on September 21-22, the probability implied by futures markets has risen to more than 50%.
The yen is usually negatively correlated with stock markets in other parts of the world, as Japanese investors tend to be highly risk averse and likely to withdraw their capital in times of turmoil, causing their home currency to strengthen. As breakeven rates have also been mostly moving with share prices, it is not surprising that the expected returns for JPY are negative in three out of the four scenarios. The relationship was once again strongest in the first, pre-crisis environment, while the zero return in the second calibration period reflects the yen’s sideways movement against the dollar during most of 2020.
