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How the Market Works

The Exchange Rate Double Whammy:  How the Market Works 

Posted by kdadmin on October 27th, 2016.

The Exchange Rate Double Whammy:  How the Market Works 

‘Tis the season for weirdos and charlatans, and not just because it’s almost Halloween. During stagnant market highs, all sorts of “new and exciting” investment products begin to flood the streets. Usually promising “secret international strategies” or some such hogwash, they tempt the amateur investor to try to pump some zest into their stagnant investment portfolio.In reality, it’s nothing but a marketing ploy for investment houses that need to raise new funds as money bleeds out of their high risk portfolios. They advertise these things as “alternative investments,” or “precious metal portfolio protection,” or “opportunities in foreign bonds,” or some other tripe.

These investments are almost always a stupid choice. Especially the last one. Here’s why.

Foreign Bonds Lag

If you look at the chart above, you’ll see three lines, TLT (long term US government bonds),AGG (intermediate term US corporate bonds), and IGOV (foreign government bonds).

Now, what do you notice about their performance since January 1, 2009? TLT has outperformed both AGG and IGOV, albeit with significantly more risk (volatility) than AGG. Sure it’s outperformed AGG by 30% since 2014, but before that, it was down 25% from mid 2012 to the end of 2013, and underwater from mid 2009 to mid 2011. (For my money, I’d prefer AGG over that period.)

IGOV, the foreign bonds, weren’t even a competitor. Somewhat outperforming way back in 2009 and 2010, and then just sucking wind since 2011. To be fair, IGOV isn’t composed of as many long term bonds as TLT, but it also isn’t restricted to only AAA rated bonds, dipping even into the much higher yielding BB, with certain government issues, so it somewhat balances out. At least for our illustrative purposes.

I’m not the only one who can see this. Imagine that you’re foreign investor. You have the opportunity of buying a foreign bond with IGOV’s crappy performance, or a USA bond with TLT’s great performance, or a safer, less volatile USA bond with AGG’s solid performance. You would buy TLT or AGG. The end. Foreign investors push up demand for USA bonds. This is how the market works.

The Exchange Rate Double Whammy

Honestly, it’s hard to listen to investment houses try to hock “opportunities in foreign bonds” when the domestic bonds are kicking the crap out of them. Moreover, given the current drastic changes in exchange rates, its very unlikely that foreign bonds that are denominated in foreign currencies have a much of a prayer of keeping pace. Here’s what I mean.Unless you’ve been living under a rock, you’re probably aware that there have been MAJOR shifts in currency valuations in the last two years. First the Swiss Franc decoupled from the Euro, which sent the latter plummeting to near parity with the US Dollar (it had been as much as 35% just months before). Second, the British citizens voted for Brexit, and watched their currency drop by nearly 25% against the USD.

This is HUGE for any investment denominated in these foreign currencies. They just lost 35% and 25% respectively. Not because of any internal valuation issues but because the currency in which they were traded changed over night.

Now, consider the chart above. The US Dollar is up 30% over the British Pound Sterling and the US Dollar us up 27% over the Euro, in the last five years. Foreign bonds denominated in either the British Pound Sterling or the Euro would have to have to outperform USA bonds by 30% and 27% respectively to achieve the same results. In other words, for every $1 that a USA bond produced, a British Pound Sterling bond would have to produce $1.30 and a Euro bond would have to produce $1.27.

This is not going to happen. At least not for the same risk level. And to produce 30% more return, you’re going to have to take a LOT more risk. Which is NOT what bond buyers are prone to do. So, what DO bond buyers do? They buy USA bonds.

This Won’t Last Forever

Sure, it’s very unlikely that the USA will continue to outperform both on bond performance and currency value forever. But it’s also unlikely that it will end tomorrow. Or the next day. In fact, it’s FAR more likely that we’ll see a slow slide of both bond prices and currency valuation over several years.

Of course, if the USA stock market crumbles, or experiences a major setback over the next few years, that could certainly buoy the bond market as investors flock to safety.

But, for now, the demand for USA bonds is unlikely to wane. Which is why we haven’t had the famed, and as yet unrealized, broad bond market bubble.

What Does This Mean to You?

While it’s important to own bonds in this peaking stock market, and slumping foreign market, it’s also important to own the right bonds from the right countries.

Just picking a bond from the thousands of options out there, or the dozens in your 401k plan, makes about as much sense as picking your spouse, randomly, from the crowd at a football game. In both cases, it’s important to get exactly the right one.

The Next Steps?

Learn about bonds. Start here.


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