Why Currency Risk Matters (to everyone)

The fascinating thing about the currency market is that it is an expression of the monetary system itself. Whereas other asset classes like bonds, equities, or commodities are merely measured in money, the FX market is quite literally made of money.

This makes the currency market interesting for a couple of reasons. First, it impacts every investor (in fact, every human being!) irrespective of investment strategy or specialization. No investor can ignore the currency market, as the returns of every investor will be measured in one currency or another. While this impact is most noticeable when investments are made in different currencies, currency is relevant even for a purely domestic investor, as the price and supply of money (loosely proxied via interest rates and inflation) will always impact real returns and investment performance. In other words, while ‘FX risk’ may be dependent on making investments, or doing business, in other currencies, ‘currency risk’ is an ever-present factor in investment performance.

Second, currency risk can be seen as systemic, in the broadest sense of the word. Bubbles and crashes in other asset classes may result in a degree of contagion of course, but usually in an indirect (and often psychological) sense. As the currency market (and, more specifically, the US dollar) represents the ‘atomic’ level of the global financial system, any emergent risks will almost certainly impact every asset class.

As we know from physics, the splitting of an atom can result in a nuclear explosion. Similarly, excess pressure on currency markets could result in dramatic and explosive effects in both financial markets and the real economy. As the post-Bretton Woods dollar-centric global monetary system nears the end of its fifth decade, such pressures are building. Interest rates have been anchored at or near the zero bound for over a decade, leading to a proliferation of public and private sector debt, which is a deadweight on the economy and increases the likelihood of economic contractions and financial volatility.

Central banks are attempting to address this issue through the currency markets, by directly or indirectly monetizing debt, which also weakens pricing signals which are normally a function of market supply and demand. Governments are exploiting this deterioration in market discipline by increasing fiscal largesse, further exacerbating unsustainable debt loads, and creating a vicious circle which further undermines trust in the monetary system. This weakening public trust is manifested in the emergence of phenomena such as cryptocurrencies and the increase of speculative assets such as so-called ‘meme’ stocks, SPACs, and heightened volatility in certain commodity markets.

Our fiat currency system, and by extension all financial markets denominated in fiat currency, is based on trust. Ultimately the guardians of this trust are central banks whose main duty has traditionally been seen as preserving the purchasing power of the currency, whilst maintaining the stability of the financial system.

Current global debt levels and rising inflation ensure that these two objectives are increasingly coming into conflict with each other. The battlefield for this conflict will ultimately be the currency market, which represents the purest expression of investor’s relative trust in individual currencies. The ability to understand and manage FX risk will become an increasingly important skillset for investment managers as the global monetary system is tested to its limits.

It might seem strange to be highlighting the importance of currency risk when FX volatility is sitting near multi-decade lows. In fact, this is exactly the right time to be prioritizing these risks. As Nassim Taleb wrote in a 2011 article entitled ‘The Black Swan of Cairo’:

‘Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks…These artificially constrained systems become prone to “Black Swans” – that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm…such environments eventually experience a massive blow-up, catching everyone off-guard and undoing years of stability…’.

Currencies, the building blocks of the complex system that is the global financial marketplace, are particularly exposed to the building pressures of years of volatility suppression from central banks, and the consequences for investors across all asset classes will be significant, if not symmetrical.