How To Invest in Foreign Currencies

A client inquired about my rather large allocation to foreign currency denominated bonds. (The allocation is larger than what other advisors recommend, but not too large in my opinion). My reasoning is that the theoretical weighting should be 52% Emerging Market currency, so the client could be underweighted, not overweighted.

This is because it is a bit unusual for an investment advisor to recommend so much in EM FX but based on the world economy and blindly assuming that the market is always efficient and that one must simply diversify in proportion to the word’s economy then people should have half of their assets in EM denominated investments in either bonds or stocks or real estate, etc. However, I don’t believe that the markets are efficient, which is why I recommend a very large bond allocation.

Why Foreign Bonds Are Going Down

Regarding why Emerging Market bond investments had a bad day on Monday, July 11 I think that ultimately bonds are the “shadow owner or contingent owner” of equities and real estate, so if equities and real estate go down (this Monday morning July 11 stocks crashed in Hong Kong by 3%) then that makes bonds in those regions look less reliable than before stocks crashed.

There are two conflicting theories:

  1. The traditional theory is that when the world economy crashes that America is the only safe haven
  2. A new paradigm (that I advocate) is that the U.S. is no longer that great of a safe haven and Asian developing countries have better solvency than developed countries. But no one can tell for sure.

The new fears

The new fear in recent days in the news media is that China is a bubble and if it crashes it will hurt other EM countries and when an economy is hurting then risk of default goes up and thus bond prices and EM currencies both go down. It is hard to tell if China is a bubble or if it crashes will its closed system with no foreign debt somehow keep the Yuan stable. Their debt to GDP as discovered by the news media keeps rising with the latest estimate at 90%, but about half of that is offset by foreign exchange holdings, making them still very solvent compared to developed countries. Further their restrictions on export of cash and refusal to allow foreigners (with few exceptions) to own their bonds helps to insulate them from a world crisis. But if they had a hard landing then the neighboring countries could become weaker. But the Asian countries did a great job of installing good financial ratios after the 1997 crash. I spend a lot of time reading about China and thinking about this.

The theory that there has been a paradigm shift from the old pattern of the U.S. as safe haven is a new and untested theory, so one is justified in being apprehensive about my theory. The recommended investments were picked based on being some of the least risky of their asset class; rhetorically speaking, the alternative might be to “give up” on my paradigm and meekly sit tight in dollars and let the dollars get depreciated. Remember how badly the British pound behaved from 1945 to 1992.

Further reading

Some people ask what to read to understand foreign exchange movements. Regarding what I read, my self-education has been primarily periodicals including web published articles from things like CFA Journal or Financial Times rather than books. What I read is on my website at http://www.mayflowercapital.com/educate. I don’t know of a list of a few key books that someone could read to get up to speed on this matter. The news articles I read often contain synopsis of academic finance books.

Trying to predict foreign currency movements is very difficult because it suffers more heavily from capricious government intervention than do other investments, reminding me of Churchill's statement about a "a riddle wrapped in a mystery wrapped inside a Sphinx".

About the author

Don Martin, CFP®

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