Here’s a trade for those fearful that quantitative easing will eventually end in tears: Buy currencies of countries whose central banks are refraining from money printing, while selling short the currencies of those that do.
It’s a trade that Camilla Sutton, Bank of Nova Scotia’s chief currency strategist, has found to be a money maker this year as investors fled currencies of central banks engaging in QE, the unorthodox monetary policy involving the creation of vast quantities of freshly minted money out of thin air through the purchasing of government debt.
So far this year, investors could have made about a 5.5-per-cent gain on the value of the currencies they put at risk, although this profit figure understates the potential of the trade because players in the foreign exchange market can employ enormous amounts of leverage to amplify profits.
The idea of simultaneously buying and selling currencies based on whether a country’s central bank is engaging in QE is an alternative to investing in precious metals, the traditional way those nervous about certain fiat currencies try to profit from central bank profligacy.
In the QE trade devised by Scotiabank, investors buy equal value amounts of Canadian, Australian and New Zealand dollars, along with Norwegian krone and Swedish krona. The five currencies are issued by central banks that have refrained from extreme money printing since the financial panic in 2008-09.
On the other side of the coin are currencies from the four serial money printers: the euro, U.S. dollar, Japanese yen and British pound.
Investors sell equal amounts of these short, a transaction involving the sale of borrowed currency.
The overall idea is to have the same value of currencies bought, as sold short, and then to profit as relative exchange rates change.
Baskets of currencies can be bought and sold on what’s known as the forward market, operated by major banks.
Ms. Sutton says she’s found this trading strategy of interest to institutions and hedge funds, investors with the credit profile that allows them to participate in the forward market.
Retail investors can try their hand at a slimmed down version of the trade through the futures market, where major currencies trade. It is possible to buy Canadian and Australian dollars, for instance, offsetting them with a short sale of the yen, pound, U.S. dollar and the euro.
The strategy seems to work because many investors fear that QE amounts to currency debasement, leading them to yank money from countries running the printing presses and place the funds in more monetarily conservative countries.
Investors typically measure money creation by looking at the expansion in central bank balance sheets.
Since the financial panic began five years ago, the Bank of Canada has increased the size of its balance sheet by about one-third.
In the meantime, that of the Federal Reserve Board has tripled, creating a huge flood of new U.S. dollars, along with market worries about the ultimate value of the American currency.
According to Ms. Sutton, relative currency values, such as the exchange rate between the Canadian and U.S. dollars, haven’t changed by the full amount suggested by quantitative easing, because countries with more disciplined central banks have tended to lower interest rates to discourage investors from pushing up the value of their currencies.
Last month, for instance, the Riksbank, Sweden’s central bank, surprised markets by unexpectedly cutting interest rates, in part to ward off currency appreciation.
To be sure, the QE trade has risks. “It doesn’t necessarily always work, so you have to have some [correct] timing on it,” observes Andrew Busch, global currency strategist at BMO Nesbitt Burns.
He points out that, in the past week, the Canadian dollar slumped by about 2 per cent because of concerns the Bank of Canada was becoming less hawkish on monetary policy, which would have eroded profits on the trade.
The Australian dollar is also vulnerable to slower Chinese growth, while Norway is dependent on the price of oil.
Another danger: When investors become spooked about risk and flee to safe harbours, as they did in Tuesday’s trading, the trade goes awry. “Then people want U.S. dollars, they want yen,” Mr. Busch says.