Traders, investors, businesses, and other market participants will note the frothy nature of global capital markets recently.
The global economy is now characterized by rising inflation and stagnating growth. A phenomenon known in economic circles as stagflation. This is a ruinous position for a country to find its economy is because unless there is substantive supply-side intervention by the government, the devastating effects of stagflation can perpetuate themselves, creating a vicious cycle.
Is it possible to invest and make money from investments during periods of stagflation? The answer is yes, you can. In fact, the smartest investors are those whose portfolios of investments make money regardless of the direction of the financial markets and the economy.
- Stagflation currently characterizes the global economy with high inflation and slow GDP growth.
- Investors and traders, especially the savvy ones, will know how to make money regardless of the economic environment this depends on the investment and trading strategies that they employ.
- Inflation, slow economic growth, high-interest rates, and a strengthening US dollar are all circumstances that traders and investors can use to their advantage with the right kind of investment and trading strategies.
This leaves the question of where the smart money goes during times of stagflation. One of the most important resources at their disposal besides the capital or dry powder they have to invest is information. This is arguably much more important a resource to an investor than the amount of money they have for investment purposes. Information is priceless because it enables the investor to appreciate the context in which they are investing.
The information enables the investor to know where the proverbial wind is blowing and which investments are attractive depending on the wind's direction. Of course, information for the purposes of investment needs to be legally obtained and obtained in a way that does not prejudice other investors and market participants.
Information that is obtained illegally or is not readily or easily available in the public domain once used for investment or traded on constitutes a criminal offence called insider trading.
According to the corporate finance institute, insider trading can be substantively defined as "the practice of purchasing or selling a publicly-traded company's securities while in possession of material information that is not yet public information. Material information refers to any and all information that may result in a substantial impact on an investor's decision regarding whether to buy or sell the security."
Investors are also prohibited from manipulating the markets in any way. Market manipulation is defined as "... the artificial inflation or deflation of the price of a security. Also known as price manipulation or stock manipulation, it involves the literal manipulation of a financial market for personal gain. It means influencing the behaviour of the securities with the intent to do so."
Both insider trading and market manipulation practices involve the improper use of market information. However, there are proper uses of market information which can result in an investor generating superior returns for their investment portfolios. The global economy currently is characterized by stagflation, which is discussed at length in this article that was carried by The Exchange here.
Other factors that have become increasingly topical in the global economy are slowing growth in all the world's leading economies, rising inflation, rising interest rates, US dollar appreciation, and the depreciation of emerging marketing currencies.
These circumstances are a valuable treasure trove of information for savvy investors. All the factors outlined have a bearing and implications on the financial markets. Investors who know how to read this information can configure and calibrate their investment portfolios to generate optimal returns. Investors and market participants in the foreign exchange market in this stagflation period would be well advised to go long the United States dollar and short its major trading partners and emerging markets and developing economy currencies.
- US dollar appreciation in recent times has led to investors and traders piling into the currency as they sell their holdings of other currencies, notably those of emerging markets and developing economies.
- Emerging market economies like South Africa have seen their currencies, like the Rand, slide against the greenback. This is a golden opportunity for traders and investors who can borrow Rand at the repo rate and use the proceeds to invest in US dollar-denominated assets that yield higher interest rates than their South African counterparts.
- Where two countries have different interest rates and exchange rates will require particular investment and trading strategies are collectively known as carrying trading and covered interest arbitrage.
The United States dollar has reportedly appreciated to levels last seen 20 years ago and shows no signs of slowing down. According to Capital.com, "The ICE US Dollar Index (DXY) - a measure of the currency's strength against a basket of rival currencies including the euro (EUR), Japanese yen (JPY) and British pound (GBP) - stood at 109.5 on 19 September 2022. The index was up over 14% from the start of the year, but down marginally from the 110.51 mark reached on 7 September - its highest level since 2002."
The Federal Reserve, the US central bank, is giving further steam to the greenback through its aggressive interest rate stance. The Federal Reserve has raised interest rates a total of four times during 2022 for a total of 2.25 percentage points.
The result is that investors are piling into the US dollar, salivating into the fray as they chase opportunities to earn almost riskless returns from purchasing US government securities. This has boosted the greenback's reputation as a safe haven currency.
For this reason, investors should take a long position on the US dollar and short other currencies, especially those in emerging and developing markets. In addition to the attractive United States dollar interest rates, conventional wisdom has it that investors should sell investments in depreciating currencies and buy investments in appreciating currencies.
Suppose it so happens that the interest rates in the United States are higher than those in emerging market economies or other economies, for that matter. In that case, this scenario gives investors an opportunity to generate superior returns through covered interest arbitrage and carry trading.
Carry trading involves, according to Investopedia, borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. A carry trade is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency. Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate. The proceeds could also be deployed into assets such as stocks, commodities, bonds, or real estate denominated in the second currency.
For example, according to the South African Reserve Bank, the repo and prime lending rates stood at 5.5% and 9%, respectively. Interest rates in the United States of America, according to the Federal Reserve, interest on one-year treasury bills stood at 3.88%. An investor could employ the carry trade strategy by borrowing ZAR 179,600.00 at the repo rate of 5% per annum, which is equal to US$ 10,000 and invest the cash by purchasing certificates of deposit for 1 year yielding 8% per annum.
- Carry trading and covered interest arbitrage can generate riskless profits for investors and traders.
- This is called carry trading, and the gain that investors and traders would make from such a strategy is called positive carry.
- Investors and traders can also use leverage in carrying trading and covered interest arbitrage strategies to amplify the returns they can potentially earn.
- Investors and traders can modify the carry trading strategy by engaging forward contracts in a covered interest arbitrage strategy.
- Conventional wisdom dictates that investment and trading strategies of market participants in a volatile global economy should involve the purchase of securities and assets of an appreciating currency. They should, conversely, sell assets and securities denominated in depreciating currencies.
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At the end of the year the investor receives (US$10,000.00*1.08) or US$ 10,800.00. At the same time, if the ZAR continues its trend of depreciating against the USD and trades at ZAR 19 to the USD, upon conversion to the ZAR, the investor receives (US$ 10,800.00*19) or ZAR 205,200.00. Deducting the loan interest of 5% or ZAR 8,980.00 leaves the investor with ZAR 196,220.00. After repaying the original loan of ZAR 179,600, the investor is left with a riskless gain of ZAR 16,620, which is approximately US$ 1,000.00.
Covered interest arbitrage, on the other hand, involves doing the same thing. The only difference is that this time around, the same investor locks in an exchange rate by taking out a forward rate agreement. Covered interest rate arbitrage is an arbitrage strategy where an investor seeks to profit from interest rate differentials of two currencies and hedges currency exchange risks with forwarding contracts. It allows investors to generate profits from higher-yielding currencies hedged against Forex fluctuations. So, the investor will repeat the same process as in the carry trade strategy as already mentioned, and they will then lock in a particular exchange rate which they settle their trade with at the end of the specified time. The investor will borrow the same amount in Rand at the repo rate, convert the cash to United States dollars, and place the money in similar security or certificate of deposit. The investor will then enter into a forward rate agreement to buy Rands using USD at a rate of ZAR 19 to the dollar upon settlement.
This strategy is what made foreign currency traders like Bruce Kovner and Joe Lewis billionaires. It needs to be said that these investment and trading strategies are not appropriate for novice investors and traders. They are for the seasoned practitioner. Broadly speaking, however, referring to the conventional wisdom mentioned earlier, investors will do better and secure superior returns for their portfolios if, in times of economic volatility like we are now, they invest in securities and assets denominated in currencies that are appreciating in value while selling assets and securities denominated in depreciating currencies.
