October 2023


The evolution of FX factors

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Investors rely on factors like valuation, trend, carry and more to inform active currency views. David Turkington, head of State Street Associates, and Megan Czasonis, head of Portfolio Management Research at State Street Associates, explained how to form more reliable views from currency factors, both traditional and new, to build stronger portfolios, focusing on two key factors — interest rate differentials and equity differentials.

“For a new lens on how to build durable FX factors, we use differentials in both interest rates and equity performance as a foundation,” said Czasonis.

Carry factor performance has been lackluster over the past decade, according to Czasonis, adding that “carry does continue to perform well within certain currencies, and the trick is to know which ones those are.” Meanwhile, Turkington argued that understanding the complicated dynamic between currencies and equities is key to developing a profitable strategy.

Interest rate differential
Foreign exchange (FX) carry is a strategy that takes long positions in currencies with relatively high interest rates and short positions in those with relatively low interest rates. As described by Czasonis, “Our goal is to build this carry portfolio in such a way that it could apply to any investor globally. Depending on how we design our strategy, that base currency can have a really significant impact on the performance of our portfolio.”

Czasonis demonstrated a diversified carry strategy that considers all crosses within a developed market currency universe. This strategy, she said, has generated positive returns over the last 30 years due to the forward rate bias. However, it is also known for occasional dramatic crashes. Moreover, its performance has deteriorated since the global financial crisis. Czasonis identified valuations and volatility as the two key drivers of carry performance. Notably, she showed that carry performs most reliably within a subset of the most volatile currency pairs.

Equity differential
Turkington said equity differentials can predict currency movements by comparing the performance of equity markets in different countries. This strategy goes long currencies of countries with superior equity performance, and short currencies with weak equity performance. This equity differential factor, Turkington argued, is stable and outperforms many other currency factors.

Turkington stated that equity demand significantly impacts currency values. “Equity demand pushes currencies around. For example, if you want to buy Australian equities or foreign investors in general are massively interested in Australian equities, they are going to have to buy the Australian dollar to do it.”

Turkington and Czasonis underscored the need to consider valuation and volatility along with selective interest rate differential and equity performance. As their research illustrates, equity demand pushes currency values, and investors can profit from this effect. “Currencies exist in some sense to facilitate transactions, and rates and equity markets are important in determining what happens to those currencies,” Turkington concluded.

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