December 2023


Currency demand drivers, rebalancing and liquidity

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Investors demand foreign exchange (FX) for different reasons and with varying urgency, including to support international asset transactions and hedge currency risk of international asset positions and speculative currency demand. According to State Street research, when predicting currency returns, practitioners can benefit from considering investor behavior across these disaggregated components of FX demand.

Data from State Street Global Markets indicates demand for FX driven by investors’ desire to hedge risks associated with currency fluctuations has displayed a greater impact on exchange rate pricing than FX demand to buy overseas assets, while cross-border asset flows have displayed greater persistence than FX hedging flows. “The maintenance of hedging has been a bigger demand driver for equity investors and a bigger consumer of liquidity in the context of this correlation,” said Neill Clark, head of State Street Associates EMEA.

“When it comes to forecasting flows… when trying to forecast forward-looking cross-border equity and cross-border fixed income flows, we find both price-based features and behavioral features to be important predictors,” said Clark. “But we find the behavioral features – looking at things like flow momentum, positioning, hedge ratios, and the underlying demand for hedging by equity and fixed income investors – to be more important than price-based features like short-term reversal and price momentum.”

The data analysis also showed growing demand for FX hedging from equity investors over the past decade, bringing it closer to that of fixed income investors, although fixed income hedge ratios remained higher than equity. Clark described the pace of this change as “surprising.” “Equity investors are certainly showing much stronger evidence of rebalancing and hedging to target hedge ratios,” he said.

Clark also said that “when it comes to predicting returns” there was a “difference in expectation between FX correlations and underlying asset correlations.” “For example, if we think about the fact that equity returns and FX returns are typically positively correlated and investors are targeting hedging of that FX exposure, if the equity market rallies, they have a bigger position. They'll have a bigger FX exposure to hedge, which means they need to sell the currency. But they're selling a currency that's rising in price,” he added. “So from an equity standpoint, we would reasonably expect to see, once short-term reversal effects have passed, a negative correlation between the FX hedging flow and the FX return.”

This research provides evidence that investors can enhance currency return predictions by considering these disaggregated components of investor FX demand by equity and fixed income investors, and that behavioral features have been of greater relative importance than return features.

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