Megan Czasonis: Great. Thank you, Michael. Okay, so today, Dave and I are going to discuss how to build more durable currency factors. And in particular, we are going to focus on two factors that are all about differentials. So interest rate differentials, which many of you will recognize as the quintessential Carrie factor and the challenge with Carrie and why it needs a bit of a redesign is that its performance has become a little bit lackluster over the past decade. But as we'll show, Carrie does continue to perform well within certain currencies. The trick, of course, is to know which ones those are. The second factor which Dave is going to cover is all about equity differentials. And the challenge here is that the dynamic between currencies and equities is actually pretty complicated. But as Dave will show, if we can understand the drivers behind their relationship, we can build a profitable strategy. So with that, let's start with the Carrie factor, which I think many of you are probably familiar with. But just as a quick refresher. Carrie is a strategy that takes a long forward positions in currencies with relatively high interest rates and short forward positions in those with relatively low interest rates. And despite the fact that interest rate parity tells us that this strategy should have a zero return because high yield currencies should depreciate by the extent of their yield advantage, historical experience has shown us that this strategy can be quite profitable. So let's start by looking at how we build a baseline Carrie strategy.
Megan Czasonis: And our goal in building this Carrie portfolio is to build it in such a way that it could apply to any investor globally. And that's actually a little bit tricky because with currencies we have a base currency and depending on how we design our strategy, that base currency can have a really significant impact on the performance of our portfolio. So for example, one common approach is to rank currencies based on their interest rate differentials versus the US dollar and then go long the top three currencies and short the bottom three currencies. And if we follow that sort of rule, we get a portfolio with currency weights that looks like the top panel that you see here. So this would be if we're considering a universe of G10 currencies. So what you'll see is that for this portfolio, the way that we've constructed this strategy, because the US dollar is its base, there's actually no US dollar exposure in this particular portfolio. So that means that another investor from a euro base, a yen base, any other currency base is going to get a different set of portfolio weights and a different carry experience. Now an alternative that would give you exposure to the US dollar would be to simply take positions in currencies based on the sign of their differentials. But there you would actually have basically an opposite challenge, which is that now you could have a very extreme and large residual exposure to the US dollar. So the approach that we take is to build a carry portfolio that is based currency agnostic.
Megan Czasonis: So to do that, we consider all 45 possible cross rates between our G10 currencies, our ten currencies. We align each of those pairs so that they correspond to a positive interest rate differential. And then we take positions in a subset of the pairs with the largest magnitude differentials. And when we do that, and when we net those pairwise positions at the currency level, we get a portfolio that looks like the bottom panel. So you'll see now that this portfolio can take positions and have exposure to any of the currencies. And in fact these positions would be the same whether you are again, a euro investor or a yen investor, regardless of your base currency. And you'll also notice that the portfolio is a bit more diversified and the positions themselves are a bit more nuanced. So this is our baseline carry and this is how this particular portfolio would have performed historically over the last 30 years or so. And you'll notice that there's really two defining features to Carrie's performance. So one, it clearly generates a positive return over time. So that's evidence of what's called the forward rate bias. But it often or not often it occasionally experiences these very and often dramatic crash episodes. So Carrie's known for this boom and kind of crash type dynamic. You may also notice that following its recovery or. Since its recovery following the financial crisis, that its performance has been a little bit lackluster. So it's had a positive return, but not quite as strong as we've seen historically.
Megan Czasonis: And it's had some drawdowns, but not really the dramatic crashes that we've come to expect from Kerry. So there's been a bit of a deterioration of sorts in terms of how Kerry's performed in the last 15 years. We first noticed this back in 2018, and at the time we explored four drivers of Kerry performance, which you see here. And we were curious if we could identify what explains this breakdown in performance. And what we found is that valuations and volatility were particularly important drivers of this. So starting with valuations, this is all about the spot side of Kerry's returns. So just quick step back. Kerry's total return consists of two components an interest rate differential and a spot return. By construction, our interest rate differential will always contribute positively, but that spot component is uncertain. So if our high yield currencies depreciate by more than their yield advantage, Kerry is going to have a loss. If they appreciate, then that's even better and we're going to have a more positive return. So that begs the question, well, what drives spot returns? And one answer to that is that currencies may tend towards some notion of fair value over time. So with that in mind, this is a look at the mis valuation of the Kerry portfolio that I just showed you. And the way that we construct this is we first determine the fair value of each currency pair in our portfolio. And we do that according to Pope purchasing power parity.
Megan Czasonis: So we're looking at relative price levels for each currency. We then determine its mis valuation by comparing its fair value to its spot rate, a spot price at each point in time. And then we aggregate these mis valuations across all the pairs in our portfolio and we get what you see here. And what you can see is this pretty striking pattern where in the first part of the sample where Kerry is performing, well, the Kerry currencies were actually generally undervalued, at least according to this PGP measure. But that trend reversed in the second part of the sample. So over the last 15 years or so, Kerry, currencies have tended to be overvalued. And this creates a bit of a of a headwind. And so if we then actually overlay Kerry's performance on top of its Mis valuations, you will see in fact, that it is the case that historically when Kerry currencies have been particularly undervalued, that's where we see a lot of very strong performance in Kerry, because again, Kerry is kind of doubly attractive in these environments. You get the yield advantage. There's reason to believe the spots might appreciate. And in case in this case, it appears that is the case. But when valuations are unfavorable, you tend to see underperformance. So this is part of what explains this kind of lackluster performance in recent years. And so this also is just kind of the first key takeaway, which is that valuations are very important determinant of Kerry's return.
Megan Czasonis: And I think this is interesting because I think a lot of investors think of valuations and Kerry as these kind of two distinct and uncorrelated factors, but in reality they're quite inter intertwined and it's important to understand their dynamic. So that's our first key takeaway. Now that we know that we're facing some challenging valuation headwinds, how can we improve Kerry's performance? And that brings us to our second key takeaway, which is that Kerry is most reliable in a subset of the most volatile currencies. So what you see here is the performance of two Kerry portfolios to construct these. We each month we sort our 45 pairs based on their trailing volatility. Then we form a Kerry portfolio from the pairs within the top half, another from the pairs within the bottom half. And you'll see this extremely kind of striking separation in their performance following the financial crisis. So despite the challenging valuations, we see that high volatility Kerry has performed or continued to perform extremely strongly. And it's that low volatility. It's the carrying the low volatility pairs where we've really seen that deterioration. I've also noted here that we first documented this result again back in 2018, and it's remained quite robust in the out-of-sample period first since. So how do we interpret this result? Well, one way to interpret this is that this aligns with the potential explanation for Kerry, which is that Kerry may, in fact be a risk premium. So with that in mind, this table shows you some characteristics of these two portfolios that I think lend perhaps some additional support to that, that explanation.
Megan Czasonis: So you'll notice that compared to low volatility, Kerry, high volatility, Kerry tends to be riskier in several ways. It has more volatile spot returns. It has a greater deviations from fair value on average. It also has more systematic risk. And it also appears that this risk is compensated. It's compensated by more favorable valuations on average by higher interest rate. Higher interest rate yields marginally, but still slightly higher yields. And also just the overall return to Kerry is just more positive. So again, some evidence that perhaps Kerry is a risk premium. And that's why we see a stronger relationship in these high volatility pairs. Here is another, I guess, interesting comparison of these two portfolios. This shows the Mis valuations of our low and high volatility, Kerry, And you'll see that the patterns over time between these two series are quite different. So low volatility. Kerry never really experienced those really favorable valuations that we saw in the beginning of the sample, the high volatility Kerry does, and in the most recent period where we've really seen that separation in their performance, it's the case that low volatility, Kerry occurrences have been really overvalued. They've been hitting historical highs, whereas the mis valuation or overvaluation of high volatility, Kerry is less extreme. Here's a look at the the net weights, currency weights of these two portfolios through time. I think there's two observations to make here. The first is that the compositions of these two portfolios look quite different, which might not be too surprising given that they have that performance differential.
Megan Czasonis: And another interesting thing which might be less obvious given the chart, but this the composition of high volatility, Kerry is actually more stable through time. So there's actually greater turnover in the low volatility Kerry currencies. And if you're curious, these are the net weights for the high volatility portfolio. This is as of the end of July, a little bit concentrated on the short side, but a pretty diverse on the on the long side. And again, this would depend to how many currency pairs you choose and whatnot would affect how concentrated it is. So next, I guess if you're still not convinced about high volatility, Kerry, or if you're wondering if this is just a developed market phenomenon, we recently applied this to a universe of 15 emerging market currencies, and we were really pleased to see a similar separation here as well. So I think again, just really nice out-of-sample evidence that high volatility, Carey is particularly robust and this now is just a look at the composition of those two portfolios. Again, they can look quite different. And then here are the the weights as of July. So I think I'll just conclude my portion by saying that if you're looking to build a more robust or reliable Carey portfolio, it's really important to think about valuations as well as the volatility and risk of the currencies themselves. And with that, I'm going to turn it over to Dave to discuss the equity differential.
David Turkington: All right. Now we shift focus to the equity differential factor in currencies. This is actually a factor and a relationship that we discovered a few years ago. And since then, we've been studying it intently and understanding it in more depth. The mechanics of how this works are almost identical to the interest rate differential. ngton: For the interest rate differential factor, we're going to go long one currency and short another if it has higher interest rates. For the equity differential factor, we're going to go long one currency and short another. If the trailing 12 month performance of the equity market in that country exceeded the other country. And it's important that we measure the equity performance in the local currency unit. So, for example, Japanese equities in yen minus Swiss equities in francs, because we don't want to confound the currency translation effect in this equity demand signal. Now the intuition for this is that equity demand pushes currencies around. For example, if you want to buy Australian equities or if foreign investors in general are massively interested in Australian equities, they're going to have to buy the Australian dollar to do it. Moreover, investors in equities globally tend not to hedge the currency very much. So we should expect to see this net positive demand for hot equity markets. To test this effect, we're going to build a portfolio across the 45 G10 pairs and exactly the same fashion as we did for the interest rate differential.
David Turkington: Now, over the past 30 years or so, this equity differential factor, equities predicting currencies, we're only investing in currencies here in this top line. It's had remarkable performance. The return to risk ratio, if you estimate it on monthly data, is about the same as that high volatility carry strategy that Meg showed. But also you can see here that the performance of this equity differential factor in currencies is very stable across regimes. If we were to calculate the return to risk on ten year outcomes, it actually has twice the return to risk ratio of that high vol carry factor, which is the second best factor that we have in effects. Now what's also interesting, if you look at the bottom line is that although equities can predict currencies really well here, they do so much better than currencies can even predict themselves. That bottom line is a 12 month momentum trade across these same 45 pairs. It doesn't work at all. Now it turns out that this factor is completely distinct from other known anomalies in the currency market. One way to look at this would just be to look at the zero or near zero correlations among these factors. But another interesting view is to run a panel regression across in this case, about 18,000 return outcomes per month across all the months in our sample and the 45 different pairs. And the chart here is showing t statistics of forward return predictability for all those currencies and all those months.
David Turkington: Now you have to correct these t statistics for the fact that there is overlap in these different pairs and so forth. But what we're looking at here are robust T statistics that account for that. Now you'll notice that the two best known factors in currencies, interest rate differentials and valuations are coming in with t stats of two and they are powerful, but the equity differential is completely distinct from that. It survives with even a higher T statistic. 2.1. This is highly significant. It's also economically significant. And we see that in the lower line, which is the same one from earlier. Diversifying across 45 pairs. This has a return on par with other known currency factors. If we were to only take the top pair at each point in time with the biggest trailing local equity return differential, we would have seen 150% cumulative return over this period. Now, I mentioned at the start that the most obvious story to explain this effect is that the whims of equity investing across borders are pushing currencies and taking them along for the ride. And that makes sense. But there is another alternative hypothesis, which is maybe the equity performance in these countries is a proxy for the overall economic health. And if the equity markets in these countries perceive either current or prospective strong growth, then that economy should thrive in its currency may appreciate accordingly.
David Turkington: We'd like to disaggregate these two effects and try to understand which one is truly at play here, which channel is operative. And the way we do it is that because our goal is to just explain this, we can benefit from hindsight. We can look and say, following the equity momentum signals, what was the actual equity differential return in the next month and was it aligned with pro momentum if it was? And the strategy works well for the equity differential in currencies. That's a demand story because equity demand happened and the currency appreciated in turn. But if we look at the performance in the months where that didn't happen, it's less likely to be a demand story and it's more likely some kind of an economic longer term relationship. So what we're going to do is rerun that regression I just showed you, but disaggregate the equity momentum effect in currencies into two pieces, one where equity momentum is aligned and one where it's opposed. And the punch line is in this green bar here, it's very clear that this is a momentum demand story. Principally, you see a large, strong effect when equity momentum happened and is aligned, which is just a month to month thing, are the times when the currencies came along for the ride. Now the coefficient is still okay. It's not zero in the other times, so there might be something to an economic story, which is another way to bolster this idea.
David Turkington: Now you'll notice a dramatic, impressive negative correlation on the bottom here, a T statistic of negative five. And that's because we had to control for the contemporaneous relationship between these equity differentials and countries and the performance of the currency pair that represents them. And I've been talking now about how again currencies are coming along for the ride with equities. They're positively influenced. So what is this negative relationship? Well, it turns out that there's a lot of complicated things going on in terms of lead lag effects and different causal effects between currencies and equities. One way to get at this issue is instead for a minute, let's consider the performance of equities as our goal. So before everything was how are currencies going to perform now? It's how our equity is going to perform after different signals occur. The top line is just equity momentum itself. After cross border, local equity returns are strong in favor of a country. That country's equity market outperforms the next month. So this is momentum at work. But what's amazing is the bottom line here, how currencies predict equity spreads across countries. Remember, before we saw that currencies are not very good at predicting themselves, but they're great at predicting equity performance. It's in the negative direction, though, So when currencies appreciate it is bad for the domestic economy all else equal because it's making everything more expensive for foreigners and it's suppressing the demand for what they're doing.
David Turkington: There's a great anecdote here we can look at to show how this causation works. Some of you might recall the Swiss National Bank in 20 15th January, releasing the policy cap that they had on the Swiss franc versus the euro. And so the franc's price popped against the euro about 20% in, I think, one day. Now, meanwhile, what happened was the local Swiss equities denominated locally went down about 15% coincident with that. And the narrative is alive and well. We saw even two years after there were stories like this reinforcing that strong currencies are to blame for weak growth. This confounding set of interactions between equities and currencies is part of the reason why I think this equity differential factor that we're arguing for here has been hiding in plain sight for a while. There are a lot of confusing and opposite and different stories about what the relationship should be between stocks and currencies, But it's not so simple as answering with one number. There is a lot going on. Now, I want to make this point that there are two important things happening at the same time, and they have countervailing effects. And I want to show this in a completely contrived exhibit, just to give you a sense for how these factors can play with each other in this tug of war. Imagine that an equity market performs pretty well.
David Turkington: Well, because of this demand effect. It can wag the tail, which is currencies. And you might see some currency strength. Now, if the currency goes up too far, that might weigh on domestic growth and on domestic equities. And so you're going to see that that hurts the stock market. But then again, that might pull down the currencies as you get that weakness. So these multiple effects are extremely strong as we showed before, and they can occur at the same time and to differing extents. What this creates is a sort of cycle of momentum across currencies that we see driven by equities. And I think of it sort of as the currencies are riding these waves that are happening across the equity markets and it happens everywhere. It's going to be distributed across all sorts of different currencies over time. Lately. The yen is riding high on that wave. Interestingly, because it's the massive short carry position Meg showed earlier. This might give pause and uncertainty as to what's going to happen, but I'm sure you're all aware of the dramatic equity performance we've seen there recently. Swiss franc and Norway actually hanging out at the bottom of this list. So to summarize what we've shown here, we wanted to rethink the building blocks of currency factors. What can we use as a guide for the future, especially given that many of the traditional factors have not worked very well in the last decade or so? Currencies exist in some sense to facilitate transactions, and maybe it's no surprise that rates, markets and equity markets are going to be pretty important in determining what happens to those currencies.
David Turkington: So we're saying that the interest rate differential is quite important, but it's not as easy as it was in the good old days. It requires a bit more selectivity. It almost looks like a risk premium in the sense that the higher volatility currencies have carry alive and well. And valuations are a second order concern here in the sense that we think they're very good at moderating your view on what the interest rate differential will say. And second, equities truly do push currencies, but this has to be considered aside from lots of other important dynamics between the two markets. So doing something as simple as an equity momentum signal, but investing in currencies has been surprisingly robust. Now it turns out these two fundamental building blocks are almost exactly uncorrelated to each other. So they were going to work really well together. And in this chart here, we have the cumulative returns of overlaid equally weighted strategies between the two and the most optimistic piece being how well they have continued to perform, albeit slightly at a tilted line since the financial crisis, but still seem to be a useful guide to where currencies might go. So with that, I'm going to open up to questions.
Speaker3: See, I told you that. Shed some light on. That's a that's a very nice upward sloping line that you've ended up with there. That's great. So I've got a couple of questions on here, but as always, I'm happy to take from the audience. So we have one at the back. Thank you.
Speaker4: Yeah. Hello. So just curious, what is the correlation of those two factors?
David Turkington: Zero.
Speaker4: I see. Okay.
Speaker3: That's great.
David Turkington: This is one of these one of these times where you look at the correlation and it's actually exactly zero, so I don't even have to round it for you.
Speaker3: Incredible. Okay. Fantastic. Okay. So let me take let me take one from Slido now. So do you think it would make sense to mix d M and M currencies into one framework, either looking at carry and or equity differentials?
Megan Czasonis: Yeah. I was wondering if that question would come up. We have not looked at that, but I do think that would be an interesting thing to look at. So basically to look at global factors that incorporate both. I don't necessarily know what that would reveal, but I do think it's interesting. We haven't looked at that with carry. I don't think we've looked at that with equity differentials, but.
David Turkington: I think there will be important differences. And yeah, that's maybe we'll go there next. Yeah.
Speaker3: Okay. Any from the room? Yeah, just in the middle. Right here. Yeah. Oh, sorry. Can you just wait for the mic so we can hear it online?
Thank you. Thanks. Thank you.
Speaker5: In terms of prior to the formation of the euro, how did you factor that in both on both in the for and for equities as well? You know, given much, much high some of the some of them were much, much higher yielding currencies lira and say to some of the others and and and more volatile.
David Turkington: Yeah in those experiments we use the deutschmark exclusively as the backfilled proxy for euro. So hopefully that's somewhat indicative of of what would have dominated at the time. Okay.
Speaker3: Okay. Yeah. Let me let me let me take from here a question about factors. Have you looked at equity causation, direction from current account deficit versus surplus countries? Has that as a factor? Is that something you've explored?
David Turkington: Have not looked at that. I guess that could be an interesting factor to put in those regressions. And in that analysis, I do think that this equity, the dynamics between equities and currencies, there may be many other important variables we could put in there to better understand it and tease things out. And that might actually help moderate some of our positions and get a stronger signal on it. So I think that's a fantastic idea. Other things that whether valuations are supportive or not for the momentum and, you know, even how flows are tracking against that, so many other things that could be added. Right?
Speaker3: And then one back middle. Oh, sorry, sorry, sorry. Was the one there as well. Oh, sorry. That was first, I think. Oh, we'll come to you. We'll come to you. Sorry.
Speaker6: Yeah. Earlier you were talking about how the appreciation of the currency obviously can be a headwind, right, for equity markets. But as you start to condition this based on whether or not an economy is consumer based or export based, you tend to get different results, especially in the US. I mean, when the US dollar is strong, technically the markets are usually better. I'm just wondering if you've conditioned some of your results on on those, on those things.
David Turkington: Fantastic point. We have not done it. Part of the reason that we did not do that is because the raw simplicity of this strategy is part of what makes it compelling as an entry point to thinking about this. Again, there are a lot of papers out there. There's not that many, but there are some papers out there over the last couple of decades that attempt to link these two markets. And they all have competing hypotheses and they all find no evidence for much. And then sometimes you'll be convinced it's positive versus negative. Et cetera. Another problem, and this is why we stressed and stressed early on the importance of this pairwise construction is that if you do this entire analysis versus the US dollar, you will conclude something about the currency market that doesn't apply to anywhere else. And the same is true for others. So we're trying to get something as a baseline, as an empirical finding. I love your question because I think that this can be refined and improved upon, you know, to see where this relationship is stronger and weaker. In the paper we wrote on the topic, we found that there's, you know, pretty, pretty widespread support for this across lots of currency pairs. So it's not only one that's driving it. And you would have seen how diversified those portfolios are in the slide. So yeah, I think this can be refined in a lot of ways and maybe maybe the punchline is it just warrants more resource, more attention to sort of what's this equity currency dynamic and how do you make money off of it?
Speaker3: Okay. So the last question there.
Speaker7: I was really interested to see the research very, very insightful. The size of the yen short from the valuations looked looked to be a bit unbalancing. And I wondered if you had a comment on that. And maybe the role of currencies in interest rates seems to be the purview of central banks. And you know, is there an impact of central banks hiding in plain sight in the data as you look through it?
Megan Czasonis: Yeah. So I think part of why that might have looked so concentrated, concentrated in part is actually just from how we constructed the strategy. So we are focusing on we're focusing on 50% of the currency pairs and then we're focusing on a subset of those. So I think in part that might just be by construction. How we formulated it. So I don't know if we were to look at all of the currency pairs within the top or high volatility, whether or not it would look less concentrated. So that's just kind of more of a, I guess, technical explanation for why we might see that. I'm not sure about the whole central bank, the role of central banks and how that might be explaining it. I mean, the size of those positions is I mean, it's reflective of the interest rate differentials. And so if, you know, you're you're going to get these really concentrated positions, if you know, a particular currency is aligned in terms of its differential in the same direction versus all of the other currencies. So I don't know if there's a I don't know, one of the strategists might have a better macro view on that. But that's just one thought I.
Speaker3: Think we would just add, and we've been saying this all year, every single BOJ meeting is live and I suspect at some point they will care about yen weakness. But unfortunately, we're out of time. The one consistent thing we've had this morning, we've had excess questions, but I know that Megan Dave will be around for lunch. So you can you can follow up with them directly then. So thank you very much.
