Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 251

The merit of currency exposure if equity markets fall

Is the Australian dollar set to lose its shine for a prolonged period? Australian investors are concerned that the currency will come under downward pressure due to an eroding interest rate differential between US and Australian rates.

When investing in foreign assets, Australian investors are exposed to losses when the AUD appreciates against other global currencies, and make gains when the AUD depreciates. This currency exposure, or risk, can be neutralised through hedging. However, it is common for investors to retain some unhedged foreign currency exposure, particularly for more volatile assets such as global equities. Investors typically fully hedge their currency risk on more defensive assets, such as fixed income, to prevent currency volatility dominating returns.

The temptation now is to reduce this type of currency hedging, but we urge caution as this strategy also increases portfolio risk.

Traditional interest rate differential gone

The AUD has long been a preferred ‘carry trade’ (that is, borrow in one currency and invest in another) due to the higher interest rates in Australia compared with the record low rates in other developed countries. However, the US Federal Reserve (Fed) hiked rates to a target of 1.5-1.75% in March 2018, which is the sixth increase since the near-zero levels in December 2015. The Reserve Bank of Australia meanwhile has kept rates unchanged at a record low of 1.5% since 2016.

Traditionally, investors and analysts believe that the interest rate carry trade is an important driver of AUD performance. This current negative differential is therefore raising concerns that the AUD is set for a sustained period of weakness.

The AUD/USD carry impact is a complex story

Investors generally believe that AUD rates above USD rates deliver better returns from buying AUD/USD. An analysis of the monthly AUD/USD returns, conditional on the difference between Australian and US interest rates, suggests a more complex story, as shown below.

Historical AUD/USD monthly performance statistics (Jan 1995 to Dec 2017)

For low and medium interest rate differentials, the average historical monthly returns are 0.26% and 0.31% respectively. When there has been a negative interest rate differential, the average monthly return falls to -0.60%. Surprisingly, for high interest rate differentials the average historical monthly return is also negative at -0.25%.

A deeper dive into the statistics also reveals that as interest rate differentials have reduced historically, so has the volatility of monthly returns. In addition, under medium and high carry levels, the AUD tends to experience more large-negative moves, known as negative skew. This analysis leads to a reasonable hypothesis that the AUD/USD is a lower risk currency when carry is lower.

Correlation and diversification

If both AUD/USD returns and volatility are lower when carry is low or negative, then reducing the level of currency hedging for foreign-currency-denominated assets, in our view, could make sense in the current environment. However, it is important for investors to also consider the correlation between Australian dollar returns and the foreign assets they are hedging.

Our analysis of the data suggests investors need to proceed with caution.

The underlying assumption is that the unhedged currency exposure will provide a diversification effect at the total portfolio level. For this diversification effect to be present, there needs to be a high positive correlation between the returns on the Australian dollar and global equities.

By way of illustration, when equity markets have suffered periods of negative returns, these have tended to coincide with a weaker AUD. For example, the AUD/USD spot rate fell 19.7% in 2008, while the S&P 500 Index also lost 38.5%. If the investor was unhedged in terms of currency exposure, the S&P 500 Index loss in AUD terms was much lower, at 18.8%. In this case, the weaker AUD has added value to the portfolio, partly offsetting the losses suffered on foreign equity investments. Investors were better off unhedged.

This relationship depends on the correlation between the investor’s domestic currency and equity market performance. The chart below shows the rolling 12-month correlation between the monthly returns on the AUD and the MSCI World Equity Index in local currency terms. While the correlation is generally positive, it is not stable and was negative for most of 2017.

12-month rolling correlation between the Global Equities and AUD/USD exchange rate

Source: Bloomberg and Insight Investment as at 30 March 2018. *Global Equities = MSCI World Local Currency Index.

As interest rate differentials increase, the correlation between the performance of AUD/USD and global equities has also increased. By contrast, with low interest rate differentials correlation falls, while at negative levels, the correlation is close to zero. Investors may need to reassess their assumptions regarding correlation and the diversification effect in the current environment.

Conclusion on the merits of hedging

We believe, based on the above analysis, that low or negative interest rate differentials have two key implications for AUD investors with global equity exposures:

  1. The impact of carry on the AUD’s performance is more complex than analysts suggest. Our study shows that the AUD is a more risky currency during periods of high carry. As carry levels fall, monthly returns also fall and the temptation for investors is to lower their currency hedging.
  2. If the objective of lowering hedges is to improve returns on foreign equities, we suggest investors proceed with caution. Lower correlation could mean the worst-case scenario occurs where the AUD appreciates when global equity prices are falling. In this case, the investor will face losses both on the underlying assets and their currency translation.

 

Adam Kibble is a Product Specialist at Insight Investment. This article is general information and does not consider the circumstances of any investor.


 

Leave a Comment:

RELATED ARTICLES

The Aussie dollar was floated 40 years ago

Does currency hedging provide an edge?

Benefits of holding gold in Australian dollars

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.