It says that currency returns and asset prices in fixed income investments are positvely correlated, which means they are more important to hedge.
But if interest rates go up, then you (should) make positive currency returns, but your bond portfolio goes down in value. Anything I’m missing?
Suppose that your domestic currency is EUR, and that you have bonds denominated in CAD.
If CAD interest rates rise, the value of your CAD bonds decreases, and (assuming only interest rate parity is affecting the exchange rate), the CAD/EUR exchange rate should increase, or the EUR/CAD should decrease. Thus, you’ll get fewer EUR for each CAD.
You’ve lost value in your bonds, and you’ve lost (EUR) value in the currency exchange.
But emperical evidence tells us that higher (real) interest rates push the currency up chasing yield, not the other way round, at least not on the long term.
In the short term, I’m not sure whether the IRP effect or the supply/demand effect dominates. The correlation of returns you cited in your original post suggests that it’s the former.
You’re not sure because it is not a science. FIrst and foremost, it is the economic spread of interest rates that determines which direction it goes I reckon. High interest rate currencies with higher risk premia would see depreciation beyond the IRP, and vice versa. Speculators most likely dominate the supply/demand pricing, but that’s usually a short term/technical analysis issue.
I assume that correlation hedging asssumes IRP holds, thanks for the help.
My pleasure.