Increasingly volatile currency moves are becoming a headache for largely-unhedged equity investors and corporates as markets prepare themselves for central banks to wind down super loose money conditions.
The dollar hit a 13-month low against major currencies this week as risk-hungry investors dumped low-yielding assets, while sterling fell to its lowest in 6 months versus the euro after Bank of England Governor Mervyn King said a weaker currency was helping to rebalance the nation's economy.
The timing of the "exit", or scaling back of emergency economic support, is key for investors of all asset classes as interest rates, which are near zero in many developed economies, will have to rise eventually to ease inflationary pressures.
And policymakers may have already begun to take a step towards the exit. Major world central banks announced on Thursday they planned to wind down facilities allowing them to inject emergency tranches of U.S. dollars into their banks.
Events next week are set to bring more clues on exit policy as finance chiefs move from Pittsburgh to Istanbul to attend the IMF/World Bank meeting. The monthly U.S. employment report will update on the state of the U.S. economy.
As the third quarter draws to an end, the MSCI world equity index have risen more than 16 percent since the start of July, gaining more than 25 percent — recouping more than half of last year's losses.
But on Friday the MSCI index hit a 1-1/2 week low. While some say this is a natural correction after a big rally, others warn investors are already getting prepared for an eventual rise in borrowing costs or growing nervous about currency moves.
"(Stable currency markets) had been quite helpful for risk appetites. People just felt a little bit more comfortable. That disappeared," said Michael Dicks, head of research and investment strategy at Barclays Wealth.
"Wobbles in currencies and a lot of second-order issues associated with them got people worrying. There's real uncertainty coming into the policy setting. And this is making it harder work for the rally to be sustained."
Dicks said U.S. and UK real estate markets enjoy high correlation but sharp currency moves could generate a shift in performance, a factor which could postpone investment decisions.
According to Thomson Reuters data, the S&P 500 index has risen 16.3 percent in dollar terms, compared with less than 10 percent in euro terms.
PERFORMANCE DIFFERENTIATOR
Standard & Poor's says the strength of emerging market currencies against the dollar is providing U.S. investors a positive performance differentiator.
According to the firm, U.S. investors found a 12.2 percent year-to-date currency tailwind from emerging market stocks. This compares with only an 8.3 percent FX benefit from developed foreign stocks.
This is because many key emerging currencies like the Brazilian real and the South African rand have risen far more against the dollar than the euro or sterling.
And some investors and businesses may not be ready for such huge currency moves.
According to a survey by Lloyds TSB Corporate Markets, 80 percent of UK businesses have no hedging strategy in place against financial market risks.
The survey, which questioned 2,579 UK businesses, also shows that 28 percent of companies are more concerned than six months ago about FX movements, 18 percent about the impact of interest rate volatility and 34 percent about commodity prices.
Only 10 percent of companies are prepared to have a hedging strategy in place to face risks from FX volatility.
EXIT ON HORIZON
Apart from FX market uncertainty, changes in central bank monetary policy are under way as the economy recovers, which influences interest rates in the longer term.
"Emergency policy have to be withdrawn at some point. There's a risk of leaving stimulus for a long time. We have to be prepared for this. It will mean higher interest rates at some point," said Chris Iggo, chief investment officer of fixed income at AXA Investment Managers.
"Big policy events out there on the horizon are very important for financial markets. There is an expectation of normalisation for interest rates in the next 2-3 years, which is negative for government bonds."
Iggo prefers inflation-linked debt to play the exit policy theme in the fixed income markets.
"Inflation is not an issue at the moment. But index-linked bonds are attractive and they are a cheap insurance," he said.
