Is it a Time for 'Change?'

07/01/2013 9:00 am EST

Focus: CURRENCY

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

As the bond market's volatility kicks up, investors may want to consider currencies as alternative investments, writes Axel Merk of Merk Investments.

Induced by "taper talk," volatility in the bond market has been surging of late. Is there a bond bubble? Is it bursting? And if so, what are investors to do, as complacency might be financially hazardous?

In our assessment, we don't need the Chinese to dump their Treasuries for there to be a rude awakening, but merely for historic levels of volatility to return to the Treasury markets. That's because bond prices can fall.

An investor in a bond fund is subject to interest rate risk, i.e. the risk of bond prices falling as higher interest rates are anticipated. A lot of yield chasers and other "weak hands" may be holding Treasuries that might flee this market, should heightened volatility persist.

The recent "taper talk" about the Fed reducing its Treasury purchases has provided a first taste of how increased volatility affects bond investors.

When bond prices are at risk and piling on equity exposure may not be desirable, alternative investments may become attractive. The challenge with alternatives is that they often depend on well-functioning markets.

In 2008, many alternative investment strategies broke down as managers were unable to execute when liquidity dried up, or regulators banned the shorting of certain securities. As such, let us highlight features of our home turf: the currency asset class:

Investors paring down interest rate and credit risk move closer to holding cash. However, cash is no longer risk-free, either, as negative real interest rates erode one's purchasing power.

We believe embracing currency risk may well be what the doctor has ordered, as it spreads the risk of any one currency. Currency risk is definitely risky on a nominal basis compared to holding cash, but investors may want to consider the potential benefits:

Currencies historically have low correlation to other asset classes. Compared to US bonds, currencies have a near-zero correlation or negative correlation (dependent on the index chosen).

Unlike their reputation, currencies are less volatile than either bonds or equities. When the euro moves a full cent, say from $1.32 to $1.33 versus the dollar, on a percentage basis it's a rather small move, even if it makes the headlines because it affects major economies.

Currencies are perceived to be volatile mostly because many speculators employ leverage. We don't think leverage is necessary to make money in the currency markets.

The currency space may be well suited for active management, as non-profit-maximizing participants, such as corporate hedgers; central banks, or travelers, can create market inefficiencies for professional investors to exploit. We group currency investing into two major camps:

  • Directional, as in taking a long-term bullish or bearish position on the greenback. For example, central banks have been diversifying to managed baskets of currencies. An investor can do the same in his or her portfolio.
  • Non-directional ("long/short"), which is taking a position, for example, on the Australian dollar versus the New Zealand dollar. Such a relative position may or may not be profitable, but the returns generated will almost certainly not be correlated to anything else in an investor's portfolio.

We believe we are in an environment where investors may be chasing the next perceived move of policymakers. The currency space may potentially lead to excess returns through superior insight and active management.

After all, we may not like what our policymakers are up to, but we think they are rather predictable. Said differently, investors take on a great deal of noise expressing policymaker moves in the equity market.

Read more from Merk Funds here...

Related Articles:

Position Sizing Strategies for Forex Traders

Investing for the Real Crash

Gold 1, Dollar 0