Currency Momentum Factor: Making Money Move

The currency momentum factor is a widely observed feature that many exchange rates trend on a multi-year basis.

The momentum factor exists across asset classes, including equities and bonds, and it is a widespread phenomenon that has been researched well by many academicians, statisticians, and experts. While the momentum strategy in equity and bond markets is quite talked about, not many know about the momentum factor in the FX, crypto, or currency markets.

In this article, we talk about the features and importance of the currency momentum factor, but before that, let’s understand momentum trading.

What Is Momentum Trading?

Momentum is a typical asset behavior to continue moving upwards or downwards until a significant market force or event compels it to change its direction. We can also say that the asset price tends to follow a trend for a considerable period or that momentum is a trend-following strategy that typically generates positive returns over time.

Momentum returns in the financial markets are applicable across asset classes, challenging the age-old standard finance theory. Many experts believe that the momentum profits in different asset classes could spring from a common factor.

Purchasing assets with recent high returns and selling assets with recent low returns in a highly lucrative investment strategy whose returns cannot be understood through common risk factors.

American fund manager and investor Richard Driehaus used the momentum strategy to run his funds. He believed that “buying high and selling higher” could earn more money than buying underpriced stocks and holding them until market revaluation. Driehaus’s preferred strategy was to sell the losers and pile the winners while reinvesting the money gained from selling the losers into other promising stocks. Most of the techniques he used have become the foundation of momentum investing.

What Is a Currency Momentum Factor?

Even the currency market has a momentum factor that could be immensely beneficial to traders in the foreign exchange markets if they capitalize on it correctly. Experts have asserted that the exchange rates of currency pairs typically trend on a multi-year basis; therefore, a strategy following this trend could generate significant positive returns over time.

Momentum in the currency market is primarily driven by constant returns in spot rates instead of interest rate differentials, as in the prevalent carry trade. The carry trade, one of the oldest currency speculation strategies, implies borrowing currencies with a low-interest rate and lending those with a high-interest rate. On the other hand, the momentum strategy consists of going long or short on currencies based on their positive or negative past returns.

Momentum portfolios incur significant transaction costs and are biased towards highly volatile currencies with high country risk.

FX markets are relatively more liquid than those with massive transaction volumes and low transaction costs. Also, there aren’t any barriers to short-selling assets with past losses, so the forex traders are free to execute momentum strategies. Therefore, FX markets are in a great position to generate significant excess returns from momentum strategies.

It is important to note that the currency momentum returns are not related to carry trade returns. Currency momentum returns are also different from returns generated by technical trading rules.

Experts say that the momentum anomaly works because of the irrationality of investors. They either underreact or overreact to the new information or fail to factor the news into the prices.

Forms of Currency Momentum Strategies

Currency Momentum strategies come in two forms:

  • Time-series momentum, i.e., the legs of a particular currency pair are purchased or sold, based on momentum signals received by the trading strategy.
  • Cross-sectional momentum, i.e., one takes a universe of currencies and goes long (short) in a basket of selected currencies that witnessed the highest (lowest) returns over a recent period.9

Momentum returns in the foreign markets are not impacted by business cycle risk, liquidity risk, the carry trade risk factor, or volatility risk. It is also not affected by the three Fama and French factors or a four-factor model such as a US stock return momentum factor. In short, there is no single systematic risk factor that explains momentum returns.

The cross-sectional aspect of the currency momentum has recently gained prominence in the FX markets. Still, there is little evidence to it compared to the time-series analysis.

From only ten convertible and liquid currencies in the 1970s, there are over 30 currencies available today. Earlier, transaction volumes were handled by the FX traders of banks, but now various kinds of asset managers have emerged as some of the key players in today’s FX markets.

With the increase in the volume of tradable assets, the currency market has emerged as a vital asset class next to equities and bonds.

Momentum-based Currency Portfolio Benefits?

Grobys, Heinonen, and Kolari, in their research paper “Is Currency Momentum a Hedge for Global Economic Risk?” stated that you can use it to hedge your stock portfolio during bear markets because momentum-based currency investment portfolios have a low correlation to the traditional equity market factor. Thus a currency momentum portfolio can supplement conventional equity-heavy asset allocation.1

Empirical Evidence of The Currency Momentum Factor

The use of momentum trading in foreign exchange markets is well-established among practitioners and well documented.

In their work titled, “A Test of Momentum Trading Strategies in Foreign Exchange Markets: Evidence from the G7”2, Bianchi, Drew, and Polichronis tried to answer three key questions: (A) do foreign exchange markets have momentum; (B) how transactions cost impact excess returns; and (C) can excess returns come through a consolidated trading signal.

Their work illustrated that the zero-cost momentum strategy’s spread is more significant in the states with high return dispersion or the crisis states compared to low RD states. They also found that the relation between these momentum payoffs and the global economic risk increases linearly.

They used the total return momentum strategies in the currency markets of the G7 between 1980 and 2004 to arrive at the following answers:1 momentum was detected, but it was temporary, especially for more extended look back periods;2 transaction costs have a significant adverse impact on excess returns; and3 consolidated signal garners excess returns through a function of autocorrelation.

Menkhoff, Sarno, Schmeling, and Schrimpf, in the Currency Momentum Strategies, evaluated the momentum strategy from 1976 to 2010 across a batch of over 40 currencies.3 They detected a massive cross-sectional spread in excess returns of up to 10% p.a. between a previous winner and previous loser currencies. In other words, currencies with recent high returns outdid currencies with recent low returns by a significant margin.

Interestingly, Grobys and Heinonen have found a strong link between the returns of the momentum anomaly implemented in currency markets and global economic risk, measured by the currency return dispersion (RD). They have found that the spread of the zero-cost momentum strategy is significantly larger in high RD states (worldwide crisis states) compared to low RD states.

Okunev and White (2003), who analyzed a universe of eight currencies over 20 years, observed an exception to the time series from January 1980 to June 2000.4 At the end of each month, the investor bought the currency with the best performance in the previous month and sold the worst-performing currency. This yields a return of about 6% p.a., irrespective of the base currency and the trading rule is chosen. Thus, there is enough evidence that currency momentum strategies may be profitable.

Burnside, Eichenbaum, and Rebelo (2011) analyzed returns to an equally-weighted momentum portfolio aggregating over momentum positions in individual currencies.4 They concluded that common risk factors do not impact currency momentum returns.

Shaojun Zhang, in her January 2021 study, “Dissecting Currency Momentum,” studied nearly 48 developing and emerging market currencies between March 1976 and November 2020.6 She cited the research findings that “past currency returns contain information predictive of future currency returns.

In the cross-section, past winning currencies earned higher returns when compared to loser currencies, which is evidence of momentum in currencies. To further analyze the relation between momentum strategies and other factors, she dissected currency returns to systematic returns explained by the carry and dollar factors and unexplained returns. The carry factor corresponds to the change in exchange rates between baskets of high and low-interest-rate currencies. In contrast, the dollar factor corresponds to the average change in the exchange rate between the U.S. dollar and all other currencies.

Past currency factor returns offer a strong prediction of future returns. The carry and dollar factors also make negative or insignificant returns following losses. Momentum returns and factor returns are closely related despite the low unconditional correlation.

In other words, while factor momentum explains returns to momentum strategies, the carry and dollar factors cannot explain the returns to momentum strategies. Thus, Zhang concluded, is that: “factor momentum can explain most time-series momentum currency by currency. However, the momentum strategy returns cannot span factor momentum, and the factor momentum alphas are large and significant.”

Cass Business School in London published research wherein the co-author, professor Lucio Sarno suggested that investing in momentum trading strategies for currency can yield 10% annually. The study analyzed 48 currencies against the US dollar from 1976 to 2010.7

Cass Business School said, “We find large currency momentum strategies yield surprisingly high unconditional excess returns of up to 10% per year.” The business school also added, “These returns are particularly striking given they persist in currency markets characterized by sophisticated investors, huge trading volumes, an absence of short-selling constraints, and considerable central bank interference.”

However, the study also cautioned that despite investing yield results, it also comes with risk to returns. Minor currencies are more likely to succeed with higher transaction costs – up to 50% of the momentum returns. According to Filippou, Gozluklu, and Taylor, in the paper Global Political Risk and Currency Momentum, the global political environment impacts all currencies, and investors who leverage momentum strategies get rewarded for the exposure to the global political risk of the past winning currencies they hold (the past winners).8 This paper played a critical role in investigating the role of international political risk in the currency market.

Tools for Measuring Momentum

There are several tools to determine the momentum of the various currencies in your portfolio. These are some of them:

Average Directional Index

The ADX measures the trend’s strength in a currency, but not the direction. It is a trading indicator to measure the overall strength of trends in the market, but not the direction. It often acts as a screener to enhance an existing trading strategy by doing away with several unwanted and losing trades. If the ADX values above 25 indicate a strong trend, the value below 15 indicates a calm market.

Moving Averages

The moving average( MA) is immensely popular among Long-term investors, swing traders, day traders, and algo traders. It is a versatile indicator that smoothens price action by calculating an average of the close price over the stipulated period. When plotted on the chart, the average helps traders see the direction and strength of the trend.

Moving Average Convergence Divergence

The MACD compares the difference between two moving averages with the moving average of that difference. It is an oscillating momentum indicator that detects the market momentum and identifies favorable entries and exits. A trader calculates the MACD by subtracting the shorter moving average from the longer moving average.

Rate of Change

The ROC measures the percentage change in a financial asset’s price between two time periods. The periods include the one with the most recent price and the price in previous periods. ROC is a momentum indicator used to indicate overbought or oversold conditions, chart divergences, confirm the trend, or foresee the trend change.

Relative Strength Index

The RSI is a momentum oscillator that measures the rate of change of up and down days. The RSI then depicts a value between 0 – 100, where high values are considered overbought, and low values are considered oversold. RSI measures the pace of price movement by comparing the up and down days over a stipulated period.

Stochastic Momentum Index

The Stochastic Momentum Index is a momentum indicator that compares an asset’s most recent closing price to the prices over a specified period. Traders often use stochastics to identify oversold and overbought levels that could reverse the trend. The stochastic oscillator’s readings range from 0 to 100, where readings above 80 indicate an overbought market, while readings below 20 indicate an oversold one

The Bottom Line

After investigating momentum strategies in FX markets, which rely on return continuation among winner and loser currencies, it is evident that these strategies yield high unconditional average excess returns of up to 10% per year. These returns cannot be explained based on covariance risk with traditional risk factors and systematic risk. Currency momentum strategies are not the same as the popular carry trade in forex markets. Hence, the global factors do not have as much impact on momentum strategies instead of the carry trade returns.

FX momentum returns are also not led by policy measures that include monetary regimes, currency intervention, or the implementation of capital account controls. Momentum returns arise primarily from hard-to-hedge currencies with high country risk. This is similar to the equity markets, where the momentum is concentrated in stocks with high credit risk, and corporate bond markets focused on non-investment grade bonds.

However, currency momentum returns also have a fair share of flaws. Experts have found that momentum portfolios in the FX market are primarily skewed towards minor currencies with relatively high transaction costs, and these currencies contribute over 50% of momentum returns.

The concentration of minor currencies in momentum portfolios requires trading positions in currencies with higher volatility, higher country risk, and higher expected risk of exchange rate instabilities. These impose additional risks to investors that aren’t detected by the standard risk factors in a covariance risk framework.

Also, momentum profits could vary according to the time, which could pose a threat or impediment to the arbitrage activity for proprietary traders and hedge funds, with usually a short-term investment horizon in the FX markets.

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