Joseph Wong    Rich Blake, Brindha Gunasingham, PhD, CFA
30 Jul 2018
Category: Currency

Country or region: Asia Pacific (Overall)

Based on the paper “Business Cycles and the Cross-Section of Currency Returns” by Steven J. Riddiough and Lucio Sarno, available at

This paper was recently recognized as the CFA Institute Asia-Pacific Research Exchange Best Paper at the 7th Annual Financial Research Network (FIRN) Conference. FIRN is a network of finance researchers and PhD students across Australia and New Zealand.

Originally published in the spring of 2017 and recently updated, “Business Cycles and the Cross-Section of Currency Returns,” by co-authors Steven J. Riddiough (University of Melbourne) and Lucio Sarno (Cass Business School and CEPR), makes a case for a genuine connection between currency returns and the waxing and waning of countries’ business cycles worldwide. According to Riddiough and Sarno, excess returns can be gleaned—and quantified in a risk-compensation context—by buying and selling a crosssection of currencies relative to the strengths or weaknesses of their country’s economic cycles, a finding that flouts decades of research suggesting the absence of a link between
macroeconomic variables and currency fluctuations.

Among the drivers of such a strategy is the use of the spot exchange rate, demonstrably more 
predictable than interest rate moves. Also crucial to understanding the source of returns is the observation that the most robust currency appreciations occur when cross-border business cycles are diverging. Although buying the currencies of strong economies and selling the currencies of weaker ones might seem intuitive, there is no shortage of real or theoretical headwinds facing anyone who might attempt it. The spot market is notoriously and exceptionally volatile, and the nature of forecasting business cycles represents its own deeply explored yet only partially understood pursuit. Empirically, Riddiough and Sarno have tilled new ground.

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.


Summarized by Rich Blake. Rich is a veteran financial journalist who has written for numerous media outlets, including Reuters, ABC News and Institutional Investor. The views expressed herein reflect those of the authors and do not represent the official views of CFA Institute or the authors’ employers.

This article qualifies for 1 CE under the guidelines of the CFA Institute Continuing Education Program. 
We encourage CFA Institute members to login to the CE tracking tool to self-document these credits.


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