Carry and Consequence

In this note, we explore the main factors contributing to the high levels of currency co-movement experienced globally. This will be explored in two parts. First, by focusing on emerging market (EM) currencies, we utilize dimension reduction techniques that enable us to gauge the extent to which global factors underpin movements in these currency spot returns. We find, unsurprisingly, that since 2000 there has been a clear and consistent increase in the aggregate co-movement of currency pairs versus the US Dollar (as has been reported for most asset classes during this period as well). The homogeneity peaked during the large scale US quantitative easing programs, but have since the start of 2016 continued trending upward. We also use the representative global components so identified and study its association to various macroeconomic and financial indices. This is done in an attempt to gauge what the key drivers of EM spot return co-movement are during different periods.

Thereafter we focus on the rand, and apply statistical models to gauge the extent to which its movements can be explained by various global and local factors. We conclude from this analysis that the majority of movement in the rand tend to be explained, firstly, by global factors (in particular related to risk), and also factors influencing its attractiveness as a carry instrument. We deduce from this that the rand’s unexpected resilience since 2016 could, despite controversial political decisions, speculation of state-capture, general economic malaise and a looming recession, largely be explained by factors outside of our own borders. While this might not be a surprising finding in and of itself, it is striking for two reasons. First, the amount of weekly spot return variation explained by a few key global components are unexpectedly high, to which we provide statistical evidence. Second, many currency analysts and economists overstate the impact that local political developments and economic indicators would have on the value of the rand.

Our conclusion is that the rand has been kept afloat largely as a result of this higher risk appetite from within yield depressed developed markets (DMs), combined with the rand’s relative attractiveness as a carry instrument. This latter feature of the local unit possibly comes at the cost of forward stability if its attractiveness should wane in coming months. Our note should thus serve as both an explanation for the recent unexpected resilience of the rand, as well as a caution to future rand stability following from the source of said resilience. Our suggestion to portfolio managers are thus to look past the hull of the ship, or the short term local political and economic noise, which explain at most a small part of shorter frequency spot movements. Instead, they should focus on the proverbial horizon, or the factors affecting global capital movements, in order to assess the likely direction of our local currency.