While factor investing in equities appears to be gaining traction, investors ignoring momentum in the foreign exchange (FX) market may be exposing themselves to undue risk. Below, we examine the trends in technicals for the U.S. dollar, euro, Japanese yen and British pound to find clues for where FX markets could head next.

Methodology

Through our research on currency markets, we identified three distinct factors that help explain movements in FX markets over the short, medium and long term. In the short run, momentum can be a powerful predictor of future FX returns. This idea is based on currencies that recently have appreciated tend to do so until those moves are exhausted. In the medium term, carry (or interest rate differentials between countries) can also influence relative exchange rates. The idea that higher interest rates attract foreign capital causing the exchange rate to appreciate is widely cited in academic research. Finally, in the long-run, the concept of purchasing power parity also helps explain exchange rates. Over time, currencies cycle from being overvalued to fairly valued to undervalued. It stands to reason that currencies that are overvalued should be hedged.

While we have shown that all three factors can be combined to improve currency hedging decisions, this analysis focuses on the short-term drivers of exchange rates: momentum. In this case, should the 10-day moving average cross above the 240-day moving average, that currency is likely to continue to appreciate. Below, we highlight broad-based positioning in the dollar as well as the euro, the yen and the pound.

Broad Dollar

After an impressive run from 2011 to mid-2015, the dollar1 generally has been in a corrective phase. This appears to have changed at the end of 2017. In May 2018, the 10-day moving average crossed the 240-day moving average, signaling a move higher for the dollar. In our view, looking at broad-based measures of the dollar against other major markets and trading partners can help signal broader trends. Interestingly, from 2011 to mid-2015, virtually no foreign currency appreciated against the dollar. With the exception of the Mexican peso, no other foreign currency has appreciated against the U.S. dollar since it broke out on May 10, the day the momentum signal was triggered. In our view, investors should continue to reassess currency risk in the current strong dollar environment.