This article first appeared in the April issue of
Hiram Johnson knew what he was talking about when he said "The
first casualty when war comes is the truth." After all, the
one-time California governor culminated his political career with a
stint in the U.S. Senate bookended by both World Wars.
Now in the 21st century, a bloodless war has been declared on
the currency front. Or so it seems to some pundits and market
observers. But is this true? Are central banks indeed engaged in a
race to the bottom of the currency bin? If so, what's the
implication for investors?
a currency war?
It's nothing more than a competition among nations eager to
stimulate their economies by lowering the exchange rates for their
respective currencies. Devaluation is a crutch for a state
suffering from high unemployment or in pursuit of export-led
growth. As the price of a currency falls, the issuer country's
exports become cheaper while imports become more expensive. That
can boost employment as demand for domestically produced goods
increases. Devaluation is an alternative solution to unemployment
when other forms of stimulus, e.g., a boost in public spending, are
There are inherent dangers in systematic devaluation. First,
citizens' purchasing power can be crimped when they attempt to buy
imports or travel abroad. Ultimately, that adds inflationary
pressure. Another risk is retaliation by other countries. As
nations try to ship unemployment overseas, international trade can
be choked off.
States, through their central banks, can systematically devalue
their currencies with a mix of policy tools including direct
intervention in the forex market, lowering base interest rates, the
imposition of capital controls and, perhaps most famously,
Are we in one?
A true currencywar is a really roll-up affair. An individual
country's devaluation must, of necessity, involve a corresponding
rise in other currencies. Normally, non-devaluing nations
countenance small increases in their exchange rates, but may find
gains intolerable in dire economic circumstances such as
recessions. When a small number of states begin devaluing
competitively, other countries may be compelled to join the fray to
protect their export positions.
Is that where we are now? In a word, no.
Currency values are always relative, most commonly expressed as
dyads or pairs, e.g, euro/dollar (EUR/USD) or sterling/yen
(GBP/JPY). Comparing multiple currency pairs is a clumsy way to
detect systematic devaluation. A better method is to set each
currency against a common benchmark, namely gold. Pricing gold in
each currency allows for easy side-by-side trend detection. A rise
in the gold price is indicative of currency devaluation; a decline
Take a look at Figure 1 which plots the value of gold across
five reserve currencies -- the U.S. dollar ((
)), the euro ((
)), the pound sterling ((GBP)), the Japanese yen and the Swiss
franc ((CHF)) -- over the past year.
As you can see, all five currencies tracked more or less the
same trajectory until January 2013. Then the Japanese yen diverged
and began to cheapen, meaning it took more and more currency to
purchase an ounce of gold. In the span of a month, in fact, the yen
price of gold rose seven percent. The other currencies, meantime,
strengthened. In other words, the price of gold dropped in terms of
dollars, euro, sterling and francs. The euro for example
appreciated by three percent.
What precipitated this?
Simply put, Japan's central bank signaled its willingness to
pursue quantitative easing, via an open-ended bond buying program,
to combat the country's long-term deflationary recession. Despite
government assertions, however, the market attributed devaluation
as the scheme's objective. No matter. The truth is that the yen's
been weakening while other reserve currencies have
Not much of war, really. More like a skirmish.
The investor armory
If the prospect of open-ended easing emboldens investors to try
to directly capitalize on a further slide in the yen, they have few
options apart from the foreign exchange market or futures. For now
they'll have to trade through U.S. dollars rather than gold (more
on this later). That adds some risk but the greenback's been the
best bet against gold among the reserve currencies over the past
year (see Table 1).
For those who can't abide margin trades,
ProShares UltraShort Yen (NYSEYCS)
is the only extant option for playing the USD/JPY cross from the
short side. YCS is a passive fund that aims to provide twice the
inverse daily performance of the Japanese yen priced in U.S.
dollars. The fund does this through commitments in swap agreements,
futures and forward contracts, as well as options. Presently, the
fund's currency exposure is obtained through over-the-counter
forward contracts with two large dealing banks.
Investors considering YCS should know that the compounding of
daily returns over an extended investment horizon is likely to
produce a return that differs-in degree and, perhaps,
direction-from a target return for the same period. Case in point:
Over the first week of February, the U.S. dollar appreciated 2.8
percent against the yen, making the target for the period
(remember, YCS is geared to deliver double the inverse USD/JPY
return) 5.5 percent. YCS actually
0.6 percent then.
Returns are voluble. Over the past year the annualized standard
deviation of the fund's daily returns was 17.7 percent; the
volatility for the dollar/yen cross was a relatively tame 7.1
percent. Still, with a one-year return of 29.2 percent, YCS
investors can't complain about the fund's reward-to-risk profile.
The Sharpe ratio for the ProShares product is a very decent
The price for all this is relatively steep for an
exchange-traded fund. The YCS annual expense ratio is 95 basis
points (0.95 percent). Organized as a commodity pool, YCS also
spits out a K-1
return rather than a Form 1099, meaning accounting expense for this
product is higher than that of '40 Act funds.
There's a set of currency
currently in registration that includes a portfolio that prices
gold in yen rather than the U.S. dollar. Once launched, the
Gartman Gold/Yen ETF (anticipated as NYSE Arca:
will offer investors short exposure, versus bullion, to the
Sub-advised by Treesdale Partners LLC, GYEN is not a passive
product. Rather, the fund's gold exposure will be managed in line
with guidance published in newsletter editor Dennis Gartman's
. Bethesda, Md.-based AdvisorShares Investments LLC is the fund's
Practically, Treesdale will use the yen, obtained synthetically
through the sale of currency futures or forward contracts, as the
medium to finance long gold exposure through futures, forwards,
swaps and other exchange-traded instruments.
Neither the fund's expense ratio nor its anticipated launch date
have been disclosed.
Though Gartman, a frequent talking head on CNBC, recently told
panelists on the network's "Fast Money" program that gold was
headed higher in yen terms, he cautioned investors about gold
"It's not a safe trade," he said. "I'm always amused when
say gold is safe. Gold is
safe. Gold is a very speculative medium."
Therein lies risk. Gartman's been caught on the wrong side of
the gold trade himself. The throttling of gold exposure within GYEN
will subject investors to management risk they wouldn't have in a
Spreading the risk
While we're talking about managed products, investors can obtain
short, albeit dilute, exposure to the yen through the
PowerShares DB G-10 Currency Harvest Fund (
The fund tracks the performance of a Deutsche Bank strategy than
mechanically makes commitments to a half-dozen G-10 currencies at a
time. Long futures positions are undertaken on the three currencies
with the highest interest rates while contracts on the three
currencies associated with the lowest rates are shorted. The
strategy exploits the trend of higher-yielding currencies to rise
in value relative to currencies with low investment rates. The fund
is reconstituted quarterly and carries an 81 basis point expense
The G-10 currency universe includes positions in U.S. dollars ((
)), euro ((
)), yen ((JPY)), Canadian dollars ((
)), Swiss francs ((CHF)), sterling ((GBP)), Australian dollars ((
)), New Zealand dollars ((NZD)), Norwegian krone ((NOK)) and
Swedish krona ((SEK)).
As of the last rebalancing, a third of the fund's short exposure
was yen (see Table 2).
Over the past year, DBV produced a modest 4.1 percent gain. With
a volatility of 6.8 percent, the fund earned a 0.59 Sharpe
Investors inclined to ply the currency market with a passive
product can get a dollop of short exposure through the
PowerShares DB U.S. Dollar Bullish Fund (UUP).
The fund is essentially a proxy for the U.S. Dollar Index which
represents a trade-weighted basket of six currencies sold against
the greenback: the euro ((
)), yen ((JPY)), Canadian dollars ((
)). sterling ((GBP)) and Swedish krona ((SEK)).
The index's yen exposure, at 13.6 percent, is the second-largest
after the euro (see Table 3). While the Japanese currency's
allocation within UUP is just 40 percent the size of its current
share within DBV, it's a constant presence. If Japanese interest
rates rise relative to those in other G-10 nations, the short yen
exposure could be dropped from DBV.
Within the past year, UUP eked out a 2.2 percent return.
Volatility, at 6.3 percent, was on par with that of DBV, yielding a
0.33 Sharpe ratio.
Figure 2 puts the one-year track records of three short yen
exposures side by side. Just as we saw in Figure 1, the yen, here
personified by the ProShares YCS fund, is a standout.
Is the yen's weakness an opening salvo in a global currency war?
Well, talk of a currency war has been just that to date, at least
as far as the reserve currencies go. When you peek through the fog
of punditry, the real battle line seems to be drawn around the yen.
Going forward, investors should keep old Senator Johnson in mind.
And perhaps General Sun-Tzu who more succinctly averred "All war is
U.S. Economy: Between Monetary Expansion And