Practitioner's Brief: Cycle Spotting

In their paper, Riddiough and Sarno refer to academic research that supports the notion of a strange disconnect between macro fundamentals and currency exchange rate moves, particularly in short (one month) and intermediate (one year) time horizons. Why wouldn’t a country’s economic growth rate underpin—or indeed, help predict—the fluctuation of its currency, just as a company’s fundamentals would have an influence on share price? With this counterintuitive reasoning as a talisman, Riddiough and Sarno embark on a journey to resolve what others before them have found so puzzling. Employing that broadest measure of macro conditions—the business cycle—they examine how this basic concept gets measured in the first place, whether it even can be measured, and, if so, whether there is some way to harness it for alpha production.

Step one for Riddiough and Sarno was to determine how best to take the extensive data from a cross-section of 27 countries over three decades and come up with a measure of when each country’s business cycles started, when they halted, and how long they lasted. Even arriving at a commonly accepted measure for business cycles—the so-called “output gap,” which is a country’s percentage deviation from its long-term trend—proved challenging. Leaving aside the not-uncommon idea that cycles are too mercurial to pin down, there was the vexing conundrum of sifting through and amalgamating various output-gap measurement techniques (quadratic data-spanning filters versus linear counterparts). The authors needed to produce a drop cloth of macroeconomic conditions upon which to portray a currency trading strategy conducted in a long-term portfolio setting. By running numbers through the prism of a series of five simulated portfolios (set up in contrast, with degrees of weak and strong currencies), the authors were able to take into consideration such concepts as relative performance, risk compensation, and diversification benefits that could be associated with currency returns. In other words, this was no carry trade. The question then became, “If business cycles could predict currency returns in a portfolio setting, could an investor capitalize?”

Spot exchange rate predictability was evident in both a cross-section and a time series analysis of the countries’ business cycles. In summary, buying and selling based on business cycles not only generated high returns but the outperformance was not correlated with the most common currency strategies, such as long Australian dollar/short Japanese yen. According to the authors, “Currencies issued by strong economies (high output gaps) command higher expected returns, which compensates more risk-averse investors in weak economies.” The authors go on to say, “Our research suggests a strong predictive link from business cycles to currency returns, and raises questions as to why our results differ from those in the long-standing international macroeconomics literature.”

One reason may lie in the use of spot rate moves to extract excess return, and not via commonly used derivatives. In the aforementioned carry example, the trade would remain static; those long and short positions wouldn’t change over time even though business cycles or output gap differentials would.

“An output-gap investor would have taken long and short positions in both the Australian dollar and Japanese yen as their relative business cycles fluctuated,” the authors claim. Returns, they emphasize, mainly come from the divergence in business cycles. Using data and a rigorous process, investors can define cycles and exploit their turns.

Where once investors had only a few “risk factors” to choose from—growth, momentum, size, and value—now they have dozens and must add business cycles to the growing list. Because an output-gap strategy has such low correlation with other currency strategies, investors who once only considered currency exposure as something to be hedged might be open to using it as a source of alpha generation, particularly at a time when large segments of the stock and bond markets are reaching boiling points and perhaps pointing toward the start of a new set of intraglobal cycles to come.

At the heart of almost any model of currency returns is a tight link between the macroeconomy and exchange rate returns,” Riddiough explained recently in an email. “But it’s taken a long time to pin down this relationship empirically. In this paper, we’ve demonstrated that the link is real, spot returns are predictable, and the resulting investment strategy is unlike any we commonly employ in currency markets.

Riddiough and Sarno have found a relationship between macro fundamentals and exchange rates—a unique, underexploited source of returns. The analysis has been completed using data from markets around the world, including Australia, Japan, and New Zealand, demonstrating that this is not a phenomenon confined to the United States or even the Eurozone. Global and Asia Pacific investors, hungry for diversification, should take note.