Analyzing Currencies in a Pandemic

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This is Richard Lawrence. I’m a senior vice president on the global fixed income team at Brandywine Global Investment Management in Philadelphia.

Let’s talk about currencies. Obviously we’ve had a significant impact on the currency complex as a result of the COVID-19 pandemic. Actually, we started the year in a fairly quiet fashion in the currency complex; just modest appreciation in the U.S. dollar in January and February, up about 3.5%. It was really in March where all hell broke loose and there was about a two-week period in the middle of March where if you didn’t own the U.S. dollar, whatever you did own went down and went down fast — in particular emerging market currencies. And also commodity-influenced currencies, in particular oil-influenced currencies such as Colombian peso and the Russian ruble. And in particular, the Norwegian krone got hard hit. A lot of this was due to diminish liquidity in dollars. So what we observed in some of the technical factors that we follow in the currency markets was there was just simply too much demand for the U.S. dollar and not enough supply.

And what we saw was the Federal Reserve aggressively responding to that dollar liquidity problem. They expanded the number of central banks that they engage in foreign exchange swap line activity with. They’ve always done those swap lines with central banks in Canada, England, Europe, Switzerland and Japan. They extended that program to include even emerging market central banks in Korea, in Brazil, in Mexico, [and] also in New Zealand, Australia, the Scandinavian countries. The other thing the Fed did was demonstrate a willingness to allow central banks to repo whatever Treasury securities they have on deposit at the Fed and gain dollar liquidity that way. So what we saw was an incredibly sharp sell-off in the currency complex. Overall, it was pretty indiscriminate. No currency was really spared from that, but since the Fed stepped in to provide these incremental liquidity measures, we have seen things definitely calm down in the currency markets.

And as we’re now coming out the other side of that liquidity squeeze, we’re seeing very strong performance in particular by some of those oil underperforming currencies from markets such as the Norwegian krone and the Colombian peso, but also some cyclical currencies like the Australian dollar and the emerging market currencies have enjoyed a bounceback.

The one real laggard right now in the currency complex is a Brazilian real. And I think what’s going on here is we’ve got a little bit of a political crisis unfolding in Brazil that I think has created some idiosyncratic risk there. But the rest of the EM currency complex has started to improve [and was] much better in April and May.

What’s been highly challenging when we think about currencies right now is we’d like to take a valuation-based approach to investing in currencies. The idea being that, over time, we think discounted currencies create economic change. So when a currency goes down, it makes the export side of a country’s economy more competitive. It brings more tourists to that economy. But of course in this COVID-19 influenced world, those economic feedback cycle mechanisms aren’t working right now. It doesn’t matter how cheap the Mexican peso gets right now, you’re not going to get U.S. tourists going to visit the beautiful beaches in Mexico. And you’re going to find that Mexican exports are really going to be constrained by the pace of the slowdown in the U.S. And that’s a story that’s playing out all over the world. So near-term, what we’re trying to do is think about currencies that often benefit from very high levels of tourism flow. A good example of that might be a currency like the Thai baht.

So when you look at the Thai baht, its current account, tourism is a significant component of its current account, in particular Chinese tourists. So when the COVID-19 crisis first hit in Northern Asia, in particular in China in the early part of this year, that’s a currency we actually put a short position on in a few of our portfolios because we anticipated that currency coming under a lot of pressure as a result of those diminished tourism flows.

So the challenge as we look ahead is starting to think about as economies start to recover, where are we going to start seeing some of that export activity pick up, with currencies as deeply discounted as they are. So we’ve started to focus a little bit more right now on export-oriented manufacturing economies. Think, for example, the Korean economy or the economies in Eastern Europe, such as Hungary and Czech and Poland that benefit from a pickup in economic activity around the world. And in the case of the Eastern European currencies, of course, a pickup in economic activity in the Eurozone.