The role of USD in the portfolio of a leveraged Canadian investor (2/2)

Why does the USD outperform in times of market stress? Bekaert et al. have a paper on this called “Flights to Safety” (FTS) from back in 2016. Bekaert et al. define FTS as situation in which you simultaneously have high economic uncertainty, lower equity prices through lower cash flows and/or higher risk premia along with low real rates. This stress results in a flight to quality assets, which tend to be USD bonds.

This paper runs an empirical test with a regime switching model in which periods are classified as being FTS/non FTS regimes. I won’t go in to the weeds of the actual FTS identification model (in truth, I can’t fully understand it all myself). However, there are a few things worth noting.

• The paper only looks at stock-bond return correlations across 23 markets (from 1980 to 2015) to gauge FTS periods. “Economic uncertainty” isn’t all that easy to characterize, so they don’t specifically try to.
• They use a threshold model with flexible parameters. Returns are based implicitly on the CAPM model, which of course has its issues.
• Economic restraints are placed on the distribution to identify the FTS days. FTS days are defined as having the highest equity risk premia.
• Less than 2% of the sample itself falls within the FTS regime.
• This is important as, in the previous post, I outlined the fact that what I am trying to smooth in my leveraged portfolio is something akin to these rare events where market stress is high.

Ok, but this was a post about currency, you say. Yes, indeed it is.

Once they create dummy variables for FTS regimes by country, they then regress a variety of currencies against this. The three currencies with positive relationships were the USD, CHF and JPY. In other words, an investor who does not consume (or in my case, have margin loans) in these currencies would possibly benefit from holding them during periods of market stress.

2 final observations on the currencies mentioned. Firstly, in their sample, the USD actually had the weakest association of the three currencies mentioned earlier, though it was still positive. The second is that the JPY has performed abysmally in the current macro economic environment given the BOJ’s reluctance to raise interest rates as most other central banks around the world. I suppose we’re all macro investors now, eh?