Can Investing in Currencies Bolster Portfolio Returns?

Investors are always looking for ways to enhance returns while reducing risks. The foreign exchange markets are among the largest in the world. They offer high liquidity at a low cost. However, how do you know which ones to buy, and when to buy them? The answer lies in determining what drives the value of a particular currency. The following is a list of the major factors that determine the value of a currency.

Inflation: Inflation represents the change in the price of goods and services over a period-of-time. If prices increase (decrease), it takes more (less) of a currency to purchase them, thus reducing (increasing) its value. Inflation has been relatively steady in the US, so its impact on the value of the dollar is negligible at this point.

Money Supply: Basic economics dictates the greater (less) supply of a currency, the lower (higher) the value. Over the past eight years, the US has been increasing the supply of dollars in the market through quantitative easing, the reducing the value of the dollar. The problem is, so has every other major currency in the world, so the impact on the value of the dollar is difficult to estimate.

Interest Rates: Interest rates have a positive correlation with a currency’s value. If interest rates increase, so will the value of the currency because of the greater demand for domestic debt securities. Naturally, investors want to earn a higher return. In the United States, interest rates have been close to zero for almost a decade. With an improving economy, interest rates look to increase over the next few years, thus increasing the value of the dollar.

Trade: Trade is one of the more difficult aspects to analyze. The Balance of Payments shows a country’s trade balance with another thru the current and financial accounts. If the US is a net importer (imports exceed exports) with Mexico, the value of the dollar will decrease because consumers must trade dollars for pesos. Mexican businesses prefer payment in pesos, not dollars, thus increasing the demand for pesos and reducing the demand for dollars. However, interest rates are usually higher in countries that are net importers, so Mexican investors will by dollar denominated investments in search for higher returns. In the end however, countries that are net importers will see their currencies depreciate.

Government Debt: Government debt has an inverse relationship with the value of a currency. High amounts of debt lead to inflation. Many countries around the world have large amounts of debt on their balance sheets. Countries must use funds earmarked for investment (which increases currency value) to make interest payments instead. This isn’t changing anytime soon.

Perhaps all of this seems confusing to you. Cross-currency arbitrage isn’t the easiest thing to comprehend. You basically need a degree in economics. In addition, globalization has led to increased competition and larger markets. Currency values are not only compared to themselves using different time-periods, but also to other currencies. Consider investing in a low-cost ETF instead.

For example, the following chart shows individual currency returns relative to the US Dollar for 2017 thus far:

Currencies are certainly worth adding to your portfolio. It’s a big market, and it has an effect on almost every other asset class. Consider investing 10% of your portfolio in alternative assets, which include currencies (including crypto), commodities, and hard assets (gold, silver, platinum).

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