Should investors hedge their foreign currency exposure?Contributor Dr. David Kelly
1. Hedging in normal conditions
In “normal” market conditions, does it make sense for an investor to hedge currency exposure in fixed income and international equity markets? The right way to think of this is to consider the currency position in an international investment as an investment in its own right with a cost, an expected return and a contribution to overall portfolio volatility. If we assume that interest rates are the same in the domestic and international market then the cost of hedging is essentially zero; so this boils down to a question of expected return and impact on portfolio volatility. If we further assume that it is impossible to forecast which way the currency might move, then taking a foreign currency position is likely just adding to overall portfolio volatility while not providing any additional expected return. For this reason, many portfolio managers of developed country, high-quality bond portfolios prefer to hedge.
2. Hedging in a world of over-active central banks
Today, however, many investors believe there is a way to forecast currencies by recognizing the implications of further rounds of quantitative easing (QE) from Europe and Japan even as U.S. QE has come to an end. I believe that, while QE has succeeded in depressing long-term interest rates around the developed world, it has not stimulated economic growth.
In the case of Japan in 2013 and, more recently, in Europe, the prospect of QE has led to a welcome slide in their currencies. This can not only stave off concerns of deflation, but can also promote stronger export growth. Conversely, the U.S. central bank is being pushed by a tightening labor market into raising interest rates, likely starting in the middle of this year. This is also widely expected to put further downward pressure on currencies of many emerging markets. If these central banks stick to their playbooks, it is possible that the prospect of a further flood of euros and yen into the global market could push the U.S. dollar up further in 2015. If this was truly a very likely scenario, then investors might well want to not only hedge their currency exposure to international investments, but perhaps even over-hedge, allowing their portfolio to benefit from a rise in the dollar from these levels.
3. The long-term case for a balanced currency view
For long-term investors, however, it is not necessarily a great idea to avoid all foreign currency exposure in favor of the dollar. First, the dollar has already risen a great deal (see chart). The real effective exchange rate of the U.S. dollar, as calculated by the Federal Reserve, has risen 15% from its low of July 2011, and global measures of purchasing power suggest that it is now expensive relative to the yen and the euro.