Exchange rate risk declines as euro, stocks and bonds all rise

Week of July 21

In the first three weeks of July, we saw short-horizon risk for the EUR/USD exchange rate decline by 0.20%, from around 7.15% at the end of June to 6.95% as of last Friday. Over the same period, the single currency gained more than 2% versus the greenback. Most of the increase occurred in the last week, when the dollar lost almost 1% against both EUR and JPY on Tuesday followed by another 1% surge in the euro on Thursday. The latter came when European Central Bank President Mario Draghi tried to reassure markets that he was not too concerned about the currency’s recent appreciation, while the former was a reaction to the renewed failure of the Trump administration to push through its planned healthcare reform.

In the second week of the month, stock and bond prices both rose in an unusual co-movement. The phenomenon was most pronounced on Wednesday, July 12, 2017, when US stock indices gained 0.7%, while the benchmark 10-year US Treasury yield dropped 4 basis points, prompting bond markets to rise, too. Normally, fixed income assets tend to decline in value when investors shift money to riskier assets such as equities, but the uncommon move was triggered by Janet Yellen’s testimony to Congress on that day. In her speech, the Federal Reserve chair was mostly bullish about the US economy’s performance, but at the same time added a note of caution with regards to consumer price inflation, which put into question the projected path of future rate hikes.

Over the same three-week period, short-term risk in Axioma’s global multi-asset class model portfolio rose sharply by 2.27% to 5.78%. The increase was mostly driven by a significant reduction in the diversification effect due to considerable changes in risk factor correlations.

The most notable impact came once again from a positive relationship between equity and FX factor movements, namely global stock markets reaching record highs while most major currencies appreciated versus the USD. This meant that stock market returns across the globe seemed to be even more correlated than usual, which in turn increased the risk contributions from all of them.

The other major contributing factor was the flipping in sign of the relationship between equity and interest rate returns. As mentioned above, stock and bond prices usually move in opposite directions, but a mixture of robust economic data and only moderate inflation in the US have led to a more positive relationship between those two. This removed an important source of risk reduction from the portfolio.

Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.