The Returns to Currency Trading: Evidence from the Interwar Period

Transcription

1 The Returns to Currency Trading: Evidence from the Interwar Period Olivier Accominotti and David Chambers * March 2013 VERY PRELIMINARY. PLEASE DO NOT QUOTE OR CIRCULATE. Abstract Modern foreign exchange trading first emerged in the interwar period. This paper studies the returns to currency speculation in the 1920s and 1930s. Our first finding is that the returns to simple carry and momentum currency trading strategies characteristic of modern markets are also present in the interwar years. Second, using archival data we analyze the trading record of a prominent currency speculator of that period: John Maynard Keynes. We find that, unlike most currency speculators nowadays who rely on trading rules, Keynes was a discretionary trader who founded his decisions on a sophisticated analysis of macroeconomic and political factors. However, Keynes fundamental-based strategy failed to match the returns to carry and momentum in the interwar years. These naïve strategies yielded particularly high returns in the 1920s and, as in the modern period, performed better than equities and bonds. * Olivier Accominotti is Lecturer at the London School of Economics and Political Science, Economic History Department, Houghton Street, London, WC2A 2AE, United Kingdom and CEPR Research Affiliate. o.accominotti@lse.ac.uk. David Chambers is University Lecturer in Finance at the Judge Business School, University of Cambridge, Trumpington Street, Cambridge, CB2 1AG, United Kingdom. d.chambers@jbs.cam.ac.uk. We thank Norman Cumming, Mike Humphries, Antti Ilmanen, Momtchil Pojarliev, Alan Taylor, and participants at the London FRESH Meeting for advice and comments. All errors are ours.

2 1. Introduction How large are the returns to currency speculation? Until recently, conventional thinking among economists was that currency trading was a zero-sum game. The Meese-~Rogoff result stated that the best currency forecasting model was a random walk with no drift and hence short-run changes in exchange rates were unpredictable (Meese and Rogoff, 1983a, 1983b). The risk neutral efficient market hypothesis (EMH) held that the forward exchange rate was on average a good predictor of the future spot rate and the uncovered interest parity condition (UIP) that high interest rate currencies depreciated against low interest rate currencies by the interest rate differential. Hence, standard finance theory implied that the expected return to currency speculation was zero. Yet, such a prediction is clearly rejected in the data. Early empirical studies have shown that UIP is violated at short or medium-term horizons (Hodrick, 1987; Froot and Thaler, 1990). Recent research has demonstrated that the carry trade strategy, which borrows low-interest rate currencies to invest in high interest rate currencies, has exhibited generally high returns since the 1970s (Lustig and Verdelhan, 2007, Brunnermeier et al., 2009, Burnside et al. 2011, Jorda and Taylor, 2012, Menkhoff et al., 2012a). Carry strategies exhibited large losses during the 2008 financial crisis, supporting the hypothesis that their profitability in normal times is compensation for tail risks (Fahri and Gabaix, 2008, Fahri et al., 2009). Moreover, a second naïve currency trading strategy, momentum, which shorts currencies with low past returns in favour of going long currencies with high past returns, has also proven to be very profitable (Okunev and White, 2003, Gyntelberg and Schrimpf, 2011, Menkhoff et al., 2012b) and continued to perform well during the recent financial crisis (Burnside et al. 2011). Exactly why such simple zero-cost investment strategies can be so profitable is the subject of debate. Some authors have argued that the profitability of carry and momentum strategies can at least be partly explained by limits to arbitrage, whether due to myopic traders, high transaction costs and the existence of price pressure (Lyons, 2001, Burnside et al., 2011, Menkhoff et al. 2012b). A second view claims that the returns to carry and momentum strategies are compensation to investors for risk-taking (Lustig and Verdelhan, 2007, Menkhoff et al., 2012b, Fahri and Gabaix, 2008, and Fahri et al., 2009). As such, these returns represent beta or factor returns in currency trading. When factor models are used to benchmark currency trading performance, much of the excess returns of modern currency managers are absorbed by these factors and the average manager fails to generate positive alpha after fees (Pojarliev and Levich, 2008, 2012). 1

3 Foreign exchange trading as we know it today first emerged in the 1920s and 1930s. Most economists and historians associate the interwar period with financial turmoil and repeated speculative currency attacks, but this period also marks a major transformation in the foreign exchange market. Until World War 1, currency markets were characterized by dealing in bills of exchange, which acted both as instruments of credit and of foreign currency exchange. Beginning in 1919 however, dealings by telegraphic transfer replaced transactions in bills giving birth to the modern spot exchange markets with which we are familiar today. Furthermore, the forward exchange market developed apace in the early 1920s (Einzig, 1937). An active forward exchange market emerged for the first time in London, which quickly established itself as the world s dominant currency center. The Financial Times began publishing quotations of forward exchange rates on a daily basis. Historians of foreign exchange markets have documented the increasing intensity of currency trading activity among both professional and retail foreign exchange traders in the interwar years (Einzig, 1937; Atkin, 2005). However, there have been no empirical studies of the returns to currency trading in this period to match the considerable literature on post-bretton Woods currency trading. In this paper, we provide the first study of returns to currency trading at the very onset of modern foreign exchange markets. We begin by analyzing the trading record of one prominent currency economist and trader of the interwar period: John Maynard Keynes. Keynes was the first economist to publish an explicit formulation of the covered interest parity (CIP) condition and among the first to examine the purchasing power parity (PPP) condition empirically (Keynes, 1923). Between August 1919 and May 1927, and again between October 1932 and March 1939, Keynes traded currencies via the forward market, betting on the future evolution of spot exchange rates. It is extremely rare to obtain detailed transaction data for any professional currency trader let alone a trader such as Keynes. We supplement our analysis of his currency transactions with that of his archival correspondence revealing the motivations behind his currency trading decisions. Our first main finding is the returns from pursuing the same carry and momentum trading strategies which have gained popularity today are also present in the interwar period. We follow the approach of the recent literature and explore the returns to these strategies in the cross-section of currencies (Lustig and Verdelhan, 2007; Menkhoff et al., 2012a, 2012b). Across the interwar period, our results demonstrate that the returns, both raw and riskadjusted, to the carry and momentum strategies were high both relative to stocks and bonds and to the same currency strategies in the 1990s and 2000s. When we decompose the interwar 2

4 returns into two sub-periods, we find that both carry and momentum currency strategies performed better than the UK stocks and UK bonds over However, the returns to the momentum strategy were much lower over and the carry trade recorded negative returns. Our second main finding is that Keynes was a discretionary trader who relied on a sophisticated analysis of macroeconomic fundamentals and political factors to form his currency trading views. As such, the correspondence on his currency trading showed no evidence of his systematic pursuit of the naïve carry and momentum strategies characteristic of modern currency trading. In keeping with the performance evaluation of today s currency managers, we benchmark Keynes performance against the returns to carry and momentum. Surprisingly, we find that despite being a well-informed trader, Keynes failed to match the returns on these naïve strategies with the important caveat that our estimates of the carry and momentum factor returns ignore any transaction costs, costs which at certain times during the turmoil of the interwar years may have become considerable. Keynes performance as a currency trader stands in contrast to his prowess as a stock picker (Chambers and Dimson, 2012). The remainder of the paper is organized as follows. Section 2 describes the emergence of modern foreign exchange markets in the interwar period. Section 3 discusses our data and sources. Section 4 documents Keynes currency trading strategy and analyzes his trading style. Section 5 examines the performance of carry and momentum strategies on interwar markets. Section 6 then benchmarks Keynes own performance against the returns to these strategies or factors. Section 7 concludes. 2. Foreign exchange markets in the interwar period 2.1. The emergence of forward markets Forward currency markets first emerged in Vienna and then Berlin in the second half of the 19 th century (Einzig, 1937: p.37-38, Flandreau and Komlos, 2006). There was no forward market to speak of in London at this time largely due to the fact that British exporters were able to invoice in sterling and generated little or no demand for foreign exchange cover (Einzig, 1937: p.48). However, a market did develop rapidly in London as soon as the war ended largely for three reasons (Atkin, 2005: 48-51). First, the rise of the US dollar to rival sterling as the leading currency in the 1920s led to a surge in trading of the USD/sterling 3

5 exchange. Second, forward exchange contracts replaced the use of bills of exchange as traders realized the disadvantage of using long-dated foreign bills which required settlement at the initiation of a contract compared to forward contracts where settlement is delayed until maturity. Third, the sterling exchange rate floated freely until returning to the gold standard in Currency business in London was conducted by telephone and with banks and an assortment of foreign exchange brokers either executing customer orders undertaken for hedging trade or investment transactions, for arbitrage or for speculation (Einzig: p.85-94). Paris for continental European currencies and New York for sterling/dollar were the next most important markets after London in the interwar years. Whereas in the early 1920s currency speculation was largely the preserve of professional investors, considerable retail investor interest was to emerge thereafter (Einzig, 1937: p.145). Foreign exchange trading disappeared as the major currencies returned to the gold standard in the second half of the 1920s. Although trading recovered following the end of UK Treasury foreign exchange restrictions in March 1932, activity remained subdued compared to the 1920s for several reasons. A continued slump in world trade depressed business demand for foreign exchange. In addition, both the emergence of a Sterling Bloc comprising Dominion and Scandinavian countries among others pegging their currencies to sterling and the adoption of exchange controls by Germany and Italy considerably reduced the number of trading options down to the currencies of Britain, the United States, Canada, France, Netherlands, Belgium and Switzerland (Atkin, 2005: 69-72). Even then attempts were made by the authorities in London and Paris to enforce embargos on forward exchange transactions undertaken for purely speculative purposes from July 1935 onwards (Einzig, 1937: p.79). How large was currency trading activity in the interwar period? Both Einzig (1937) and Atkin (2005) suggest it was significant. Unfortunately, no systematic attempt was made at that time to collect information on foreign exchange turnover in a similar way as the Bank for International Settlements (BIS) does today in its triennial survey. Nevertheless, an internal Bank of England document dated January 1928 estimated daily foreign exchange turnover on the London market between 4.9 and 5.5 million, representing roughly 30% of British GDP and 20% of the volume of world trade on an annual basis. 1 USD/ transactions dominated the London foreign exchange market and represented between 73% and 82% of all currency transactions according to the estimate. The other major currencies, French franc, German 1 The estimate of foreign exchange turnover is from Archives, Bank of England, EID3/281, Approximate amount of foreign currency changing hands on the London market. The GDP estimate and estimate of the volume of world trade for 1928 are respectively from Mitchell (2007) and Maddison (1995). We assume 250 trading days per year. 4

6 mark, Italian lire, Dutch florin, Belgian franc, Swiss franc, accounted for between 7% and 11% of currency turnover Interwar currency instability These profound transformations of the foreign exchange market took place in a context of dramatic currency instability. We can divide the interwar years into three periods: the floating exchange rate era, January 1920 to December 1927; the gold standard period, January 1928 to August 1931; and the managed floating era, September 1931 to August The floating exchange rate era from January 1920 to December 1927 represent those years when all major currencies embarked on a long road back to the gold standard. During WW1, fluctuations in the belligerent countries currencies had been dampened through a combination of exchange restrictions and official foreign exchange market interventions. In 1919 however, capital controls were removed and the US stopped intervening on currency markets. As a consequence, European currencies depreciated sharply. Sterling fell a long way below the pre-war USD/ parity of 4.86 and down to a level of 3.50 while the French franc and German mark depreciated even more. Yet, expectations that European countries would soon return to the gold standard at their pre-war parity remained prevalent at that time (Keynes, 1924, Einzig, 1937, Mixon, 2011). Continental currencies traded at a premium against sterling on the forward market in , whereas the US dollar exhibited a forward discount, which led Keynes to write that the market was a bull of sterling. 3 However, any thoughts of a swift return to gold were soon banished by the sharp recessionary experience of Although the Genoa Conference of 1922 issued recommendations on how to reconstruct the international monetary system, it was not until the mid-1920s that the gold standard system was fully re-established. The British government played a long game in pursuing its objective of returning to pre-war parity. Despite strong opposition by Keynes on the basis that sterling was overvalued by 10-15% (Keynes, 1925), Britain finally re-established the link to gold in April The road towards gold convertibility was even more turbulent for France and Germany, whose economic policies were dictated by the negotiations over German reparations. The failure to settle the reparations issue led to economic stagnation, as Keynes (1919) had warned, and both countries efforts to stabilize their currency were undermined by budget 2 This section draws heavily on Eichengreen (1992) and (1998) ch.3. 3 Quoted in Einzig (1937, p. 263). 5

7 deficits and high inflation. Germany slid into hyperinflation and lost its currency. The depreciation of the French franc reached crisis proportions when fears of a capital levy forced French investors to flee the country and reduced the currency to a level of FFR200/ 1 in July At this point, Poincare s return to power removed the threat of a capital levy and the budget was balanced. Although France did not officially reintroduce gold convertibility until June 1928, the franc was de facto stabilized (at a new gold parity) by the end of The transition in December 1927 to the gold standard period which followed was complete when the Italian lire, the last of the eight major currencies in our sample, returned to gold. However, currency stability only lasted a short while. The first signs of the strictures imposed by the gold standard appeared among the commodity-exporting developing world. Facing ongoing commodity price deflation, they had no choice but to devalue as early as Shortly afterwards, the industrialized world then began to run into trouble following the sharp stock market declines in the autumn of that year. Nonetheless, the major currencies clung on to gold until banking and balance of payments crises forced first Austria and then Germany in July 1931 to suspend convertibility and to adopt exchange controls. The final managed floating period then began with the Sterling Crisis of September The financial crisis in Central Europe rolled on to London and the speculative pressure on sterling became immense (Accominotti, 2012). Sterling departed the gold standard on September 21 st and the US dollar became the next target for currency speculators. The Federal Reserve defended its gold parity for the next 18 months but as in the case of Britain the deflationary consequences for the domestic economy of staying on gold became intolerable and the new Roosevelt administration took the dollar off gold in April Both in the case of the departure of Britain and the US, a succession of countries followed. In Europe, a hard core of gold bloc countries hung on to gold parity until they too departed one by one Belgium in March 1935 and France, the Netherlands and Switzerland in September Although all the major currencies came off gold, this did not herald a return to the floating exchange rate period of the 1920s. Rather, this was a managed floating exchange rate regime characterized by frequent central bank intervention and the imposition of capital controls. In such a regime, currency volatility was dampened and in the case of some currencies transactions became either too expensive or infeasible. The economic literature has focused on two main aspects of interwar foreign exchange markets to date. First, authors have tested important exchange rates theories on the floating exchange rate era of the 1920s. Taylor and MacMahon (1988) examined the validity of the purchasing power parity theory. Peel and Taylor (2002) have explored the covered interest 6

8 parity condition on the sterling/dollar market. MacDonald and Taylor (1991), Philips, McFarland and McMahon (1996), and Diamandis et al. (2008) have tested the forward exchange market efficiency hypothesis. Second, economic historians have studied in detail the contribution of exchange rate regimes and exchange rates policies to the Great Depression (Eichengreen, 1992, Temin, 1989, Bernanke, 2000, James, 2001). However, we believe that to the best of our knowledge we are the first to examine the economics of currency trading during the interwar period. 3. Data and sources Keynes began trading currencies on his own account in September 1919 as soon as he returned from the Versailles Conference. He was continuously active across two periods from August 1919 to April 1927 and from October 1932 to February The intervening period was marked by currencies returning to the gold standard. He recorded all his spot and forward purchases in his personal investment ledgers which are kept in the archives at King s College, Cambridge. In total, 714 transactions are recorded, 355 forward market contracts and 359 spot trades. In addition, there are 18 continuation trades in the database. For each spot transaction, we record the date of the transaction, the nominal value of the contract, and the exchange rate versus sterling at which he contracted. For each forward transaction, we again record the date, the nominal value, the exchange rate at which he contracted to buy or sell foreign currency against sterling and the date on which delivery was to take place. From the latter we calculate the duration of each of his forwards. Typically, Keynes took out a forward contract to buy or sell a currency and then chose one of three options: (i) to close the position with a spot purchase in the days immediately before the delivery date; (ii) to close the position well before the delivery date; and (iii) to continue the forward position by renewing it. Table 1 summarizes the annual time series of all his currency trades for his personal account. In the 1920s, he mainly traded US dollars (USD), German marks (MKS), French francs (FFR), and Italian lire (LIRE) versus the sterling pound. Consistent with the description of interwar currency markets in the previous section, Keynes s investment opportunity set had shrunk in the 1930s due to the introduction of exchange and capital controls. He only traded 3 currencies, USD, FFR and the Dutch florin (DFL) and his trading was dominated by his USD position. For each year, we report the number of trades in each currency, the average sterling value and the average duration in number of days of the nominal forward position. 7

9 Alongside trading on his own account, Keynes speculated in currencies beginning in January 1920 on behalf of a syndicate managed together with O.T. Falk comprising their own capital and that of friends and family (CWKXII: p.5-6). As is well-known, this syndicate soon ran up considerable losses and was closed out in May The trading positions undertaken for the syndicate are similar to those undertaken for his own account. He also traded currencies for his Cambridge College where he was bursar. In this case, he only traded during the 1930s and his trading was even more dominated by the US dollar/sterling contract which accounted for 80% of his positions. We supplement the detailed transaction-level data with a careful analysis of Keynes currency views drawn from his correspondence located in the archives of King s College Cambridge and at the British Library s manuscripts section. Finally, we assemble a monthly dataset of spot and forward exchange rates (against sterling) for the major currencies traded in London during the interwar years. The data on spot exchange rates cover the period whereas forward exchange rates are available as of 1920 only. These data are taken from published sources including Diesen (1922) for 1918/1919, Keynes (1923) for 1920/1921, Einzig (1937, pp ) for and The Economist for Exchange rates correspond to end-of-month quotations (last Saturday of each month) 4 rather than monthly averages. 4. Keynes currency trading 4.1. Descriptive evidence In this section we describe Keynes currency trading activity in the 1920s and 1930s. Figure 1 displays his cumulative gross position in all currencies (long and short) expressed in pounds sterling from August 1919 to March Keynes gross position fluctuated between zero and 100,000 over , peaking in August In May 1920, January-March 1922, November 1923-March 1924, and December January 1925, Keynes closed all his forward positions. Thereafter, he traded only occasionally until May 1927, at which point he stopped trading completely. Keynes returned to currency trading in October 1932, one year after the UK had left the gold standard. During the following period, the value of his cumulative gross position 4 Except for 12/ /1920 (first day of the following month) and 11/ /1921 (first Wednesday of the following month). 8

10 progressively increased until it reached 250,000 in December This higher level of activity in the 1930s compared with the 1920s reflects Keynes increased personal wealth which averaged over 150,000 in the 1930s compared to slightly more than 40,000 in the mind-1920s (CWK XII, p.11, Table 3). From December 1936 onwards, he progressively reduced the volume of his position and he definitively stopped trading in March Figure 2 and Figure 3 provide the breakdown of Keynes monthly position across the different currencies in and respectively, distinguishing between long (+) and short (-) positions. Figure 4 graphs the evolution of his position in each individual currency against the spot exchange rate against sterling. Keynes constantly shorted the French franc, German mark and Italian lire from 1919 to 1925 with few exceptions (Figure 2). Interestingly, he interrupted his trading in the French franc during the speculative attack of November 1923-March He also took small long positions in the French franc and Italian lire in July 1926 at the very height of another speculative attack against these two currencies, presumably believing that they had overdepreciated. In comparison, Keynes trading of the US dollar was less consistent during the 1920s. Although he generally went long the US dollar in this period, he did adopt a short dollar position on several occasions, in January-February 1921, November-December 1922 and October When Keynes resumed currency trading at the end of 1932, he initially alternated between short and long positions in the US dollar, French franc and Dutch florin (Figure 3). He shorted the dollar in October 1932-February 1933 but closed his position on 2 March 1933, just before the US devaluation. In the following months (April to June 1933), he even went long the dollar believing that its depreciation following the departure from the gold standard had been overdone. However, from July 1933 until March 1939, he constantly bet against the dollar with his short position reaching a maximum in December Keynes trading in the French franc and Dutch florin also reveals his lack of confidence in the ability of France and Holland to endure the Great Depression and remain on the gold standard. He first shorted the franc and florin from March 1933 to December 1933, expecting France and the Netherlands to follow the US off gold. He then once again speculated against the French and Dutch currencies from July 1934 until September When the two gold bloc currencies were eventually devalued in September 1936, Keynes immediately closed out his franc and florin positions and did not trade them again in the years that followed. 9

11 4.2. Keynes trading profile Overall, the descriptive evidence does not seem to suggest that Keynes relied on specific rules to determine his currency investment decisions. In the following, we review the qualitative evidence from his correspondence in order to identify the motivations behind his currency decisions. The correspondence confirms that Keynes approach to currency trading was not rule-based. On the contrary, we find that he was a discretionary trader who relied on his personal analysis of macroeconomic fundamentals, which he interpreted in a nonsystematic way. In 1919 and 1920, much of Keynes correspondence on currencies was with his then investment confidant, syndicate partner and stockbroker O.T. Falk (PP/JMK/SE/2). The focus of this dialogue was almost always on macro-economic fundamentals such as expected changes in official interest rates, European reparations and international capital flows and the inflation outlook. Keynes along with Falk was part of the British negotiating team at the Versailles Peace Conference and was as a result well-connected in the world of international finance in the 1920s. One exchange of letters with Falk refers to his lunching with the US diplomats and bankers involved in the discussions as to whether to extend US credit to Europe in 1919 (PP/JMK/SE/2/1/13-14). Did his connections make him an insider? We cannot be sure. However, in general, we do not find among his correspondence any clear evidence that he had privileged access to private information. A very good example of Keynes fundamentals-based approach is the most detailed of his memoranda on currencies, a note on the sterling exchange rate written for the board of a leading closed end fund on February 1932 (PP/BM/6/6-18). His analysis is split into two parts. First, he begins by analyzing and quantifying his expectations as to future changes in the UK Balance of Payments, including the trade account, the invisibles account and capital transactions. Second, he tries to dissect the interventionist policies of the main central banks, in this instance the Bank of England and the Bank of France. His focus is always on those areas where his forecasts differ from the consensus. In this particular instance, he considers it a great mistake to be too bearish of sterling because he is more optimistic about the prospects for improvement in the trade balance following sterling s devaluation and the introduction of tariffs, the continued likelihood of the Sterling Area prospering and accumulating foreign balances in London to the benefit of sterling and the willingness of the Bank of England to intervene in support of sterling. 10

12 The other notable passage in this note is his conclusion that more countries would come off the gold standard as early as 1932, particularly, South Africa, Holland and Belgium, but not Switzerland, France or the US. His directional forecast was correct in all cases but his timing was off by several years in the case of Holland and Belgium. Indeed, in December 1934 he himself recognized the great difficulty in forecasting the timing of large currency moves stating that: Nothing is more rash than a forecast with regard to dates on this matter. The event when it comes will come suddenly. The best thing is to allow for probability and put little trust in forecasts of the date, whether soon or late (BM/1/178) In the 1930s, most of his correspondence dealt with his views on the US dollar consistent with at least four out of every five of his currency trades being in the dollar. His views on the dollar once it had come off gold proved incorrect. Based on his reasoning that it was difficult to see how a creditor country can keep its currency depreciated, he concluded on 21 April 1933 that the dollar is probably undervalued and ought to be bought at today s price of 3.90 (PP/BM/70-72). Later the same month, he confessed that I am still very much in the dark and apart from the opinions in the press have nothing to help me except my own ideas (PP/BM/78-79). A sentiment he repeated on several occasions and further evidence that if he had been an insider in international finance in the early 1920s, he certainly was not one by the 1930s at least as far as the US was concerned. 5. Carry and momentum strategies in the interwar period The qualitative evidence reported above suggests that Keynes strategy was based on fundamental analysis. Most currency traders today avoid this style of trading in preference to rule-based trading (Pojarliev and Levich, 2010). Indeed, empirical studies since the 1980s have shown that structural exchange rate models perform poorly at predicting future exchange rates at short-term horizons and fail to do a better job than a simple random walk model (Meese and Rogoff, 1983, 1988, Chinn and Meese, 1995, Cheung et al., 2005). Furthermore, recent empirical research has revealed that naïve trading strategies have performed very well in the post-bretton Woods period. Among them, two classes of strategies have attracted attention from the literature. First, the carry trade, which goes long high-interest currencies and short low-interest currencies exploits the forward premium puzzle. Second, momentum 11

13 strategies which go long currencies with high recent returns and short currencies with low recent returns exploit the fact that currency movements persist over short or medium term horizons. Whereas the empirical literature has documented extensively how carry and momentum strategies have performed in the last thirty years, there have been no studies of the returns to these strategies during the other period during the 20 th century when exchange rates were floating. In this section, we document their performance in the 1920s and 1930s. We consider a set of currency speculation strategies focusing on the eight currencies for which an active forward exchange market existed in the interwar years: the pound sterling (GBP), the US dollar (USD), the French franc (FFR), the German mark (MKS), the Italian lire (LIRE), the Dutch florin (FFL), the Belgian franc (BFR) and the Swiss franc (SFR). Forward exchange rates quotations were not always available for all currencies in this period. In the case of the German mark, no sterling/mark forward transactions occurred during the hyperinflation period from September 1923 to October 1924 and after the introduction of capital controls in July Table 2 summarizes the information on data availability for our sample currencies. We study the returns to a carry strategy (CARRY) and four different momentum strategies (MOM1, MOM3, MOM6, MOM12) during the 1/1920-9/1939 period. In doing so, we follow the recent literature and explore the returns to these strategies in the cross-section of currencies (Lustig and Verdelhan, 2007, Menkhoff et al. 2012a, 2012b). At the end of each month, we rank the eight currencies according to each of the following five rules: (i) their forward discount (CARRY); 5 (ii) their increase in value (against sterling) over the preceding 1 month (MOM1); (iii) their increase in value (against sterling) over the preceding 3 months (MOM3); (iv) their increase in value (against sterling) over the preceding 6 months (MOM6); and (v) their increase in value (against sterling) over the preceding 12 months (MOM12). 6 5 If covered interest parity (CIP) holds, the forward discount is equivalent to the interest rate differential vs. the London money market rate. Peel and Taylor (2002) show that deviations from covered interest parity were arbitraged between the London and New York markets during the 1920s when an annualized profit of at least 0.5% was available. Covered interest parity between other markets is more difficult to test, as comparable shortterm investment instruments were not available on all European money centers (see Einzig, 1937). 6 We also computed the monthly returns to an alternative momentum strategy sorting currencies according to their 1-month lagged return rather than lagged appreciation on the spot market. This strategy is therefore more similar to that described by Menkhoff et al. (2012a). The performance of this strategy was similar to that of our other momentum strategies during The results are available from the authors upon request. 12

14 For each rule, we form two currency portfolios at the end of each month. The High portfolio is formed from equal weights in the two highest ranking currencies and the Low portfolio from equal weights in the two lowest ranking currencies. We then compute the monthly excess returns of the 2 Long-2 Short strategy which adopts a long position in the High portfolio and a short position in the Low portfolio at the end of each month. We also consider an alternative version, the 1 Long-1 Short strategy, which takes a long position in the highest ranked currency only and a short position in the lowest ranked currency only. Table 3 summarizes the performance of the 2 Long-2 Short carry and momentum trading strategies for the period January 1920 to August For each, we report the mean annualized return over the period, the annualized standard deviation of returns, the annualized Sharpe ratio, as well as the skewness and kurtosis of monthly returns. We also compare performance with that of UK stocks, represented by the DMS UK market index, and of UK government bonds, represented by Consols. Given the shifts in currency regimes in this period, we further examine performance during three sub-periods corresponding to the floating exchange rate era (January 1920 to December 1927), the gold standard period (January 1928 to August 1931) and the post-sterling crisis era (September 1931 to August 1939). The German mark collapsed under hyperinflation in August While forward quotations for the German mark were available up to this month, the rapidly escalating counterparty risk effectively made forward contracts in marks unavailable to currency investors from early 1922 onwards other than in the smallest amounts. Keynes, himself, only engaged in five forward transactions in marks during these twenty months and these were all for amounts lower than 500 compared to his average trade size of 7,292 in other currencies during these twenty months and of 3,529 in marks in the two previous years. Hence, we exclude the German mark from the sample from January 1922 to August The striking result from Table 2 is that the same naïve currency trading strategies which have gained popularity over the recent years also performed well on the early foreign exchange markets of the interwar period. Over the whole sample period , the carry strategy returns on average +4.49% and the four momentum strategies yield returns ranging from +2.63% to +5.81%. Both the carry strategy and the momentum strategies, except for MOM6, display higher Sharpe Ratios than those available on alternative assets, UK stocks and UK Consols. A Sharpe Ratio of 0.51 on the carry trade strategy over the 21 year sample period compares very favorably with that on the same strategy over the last twenty years when trading the major currencies. For example, the Deutsche Bank G10 Carry Index exhibits 13

15 an annualized Sharpe ratio of 0.38 over Momentum strategies also performed well in the interwar years with MOM12 exhibiting the highest Sharpe Ratio (0.61). This performance again compares very favorably with that of the Deutsche Bank G10 Momentum Index with a lower Sharpe ratio of 0.26 during Figure 5 displays the cumulative performance of the CARRY strategy and two representative momentum strategies, MOM1 and MOM12, over The graph reveals that most of the gains of these strategies were made in the floating exchange rate period, During these years, the returns to the CARRY, MOM1 and MOM12 strategies were high, %, % and % respectively, relative to the following two sub-periods (see table 3, panel B). The returns to currency speculation then vanished during the period when all currencies in our sample had a fixed parity with gold and exchange rate fluctuations were very muted as can be seen in the comparatively very low standard deviation of returns on all currency strategies in Panel C. The UK s departure from gold in September 1931 marked the beginning of a new era of currency volatility. However, carry and momentum strategies did not perform well during the 1930s compared to the UK stock market or consol. The carry trade recorded negative returns (-0.95%) during , as did MOM1 (-0.03%). Only MOM3, MOM6, MOM12 yielded positive returns ranging between +2.24% and +3.11%, but these were highly skewed, reflecting the abrupt changes in exchange rates during the 1930s. Returns to the four momentum strategies are positively correlated with each other over the whole sample period and the three sub-periods (Table 4). However, there is no correlation between the momentum and carry returns over and the correlation turns negative during Therefore, as in the post-bretton Woods periods, carry and momentum were very different strategies during the interwar years. 8 When we include the German mark through , returns to all four momentum strategies significantly increase but the returns to the carry strategy disappear (Table 5). The abnormally high returns to momentum in 1922 and 1923 reflects the limits to arbitrage since shorting the mark during these months carried huge country risk. The elimination of the carry 7 The db-xtracker Currency Momentum ETF index goes long (short) the three G10 currencies that have exhibited the greatest (lowest) currency appreciation (against the US Dollar) over the preceding 12 months. Increasing the number of currencies in the sample significantly improves the performance of carry and momentum strategies during the recent period. Menkhoff et al. (2012b) find that a carry trade strategy implemented on 48 currencies over the period yields a Sharpe ratio of Menkhoff et al. (2012a) find a Sharpe ratio of 0.95 for a 1-month momentum strategy implemented on a sample of 48 currencies during the years 1976 to Menkhoff et al. (2012a) report evidence that the returns to carry and momentum strategies were not correlated in the period. 14

16 trade profits by the inclusion of the German mark is consistent with the previous finding in the recent empirical literature that carry trades incur losses during high inflation events (Bansal and Dahlquist, 2000). Finally, Table 6 summarizes the results for the alternative 1 Long-1 Short carry and momentum strategies when we include the German mark for Whilst the riskadjusted performance is similar to that of the 2 Long-2 Short carry and momentum strategies, returns are higher and the cumulative performance is much stronger (figure 6). 6. Keynes performance on interwar markets The overall results of the previous section show that carry and momentum strategies performed well in the interwar years, particularly in the 1920s. The implication is that currency returns in this period exhibit the same systematic factors that explain currency returns in the recent past. Despite our discovery in section 4 that Keynes appeared not to follow such explicit rule-based strategies in preference to relying upon his own analysis of fundamentals, we proceed to benchmark his performance against these carry and momentum factors in this section. Figure 7 displays Keynes cumulative profits and losses in sterling pounds from August 1919 to March 1939 and reveals that his strategy of shorting continental European currencies and going long the US Dollar did not pay off initially. He registered a substantial loss in May 1920 when European currencies temporarily appreciated against sterling, contrary to his expectations. Thereafter, his currency views were correctly borne out and his strategy yielded positive returns over the rest of the 1920s. A similar pattern emerges in the 1930s. Initially, betting against the French franc and Dutch florin incurred losses. However, these losses were offset when both currencies were devalued in September 1936 and he was left with an overall profit at the end of the 1930s. Next, we compare Keynes s performance with the returns on the carry and momentum strategies. First, we need to convert his monthly sterling pound profits and losses into a rate of return. Since he did not operate a fund, we infer the notional equity with which he traded his currency positions. The archival correspondence with his broker Buckmaster & Moore reveals that he was required to post a 20 per cent margin on all his forward currency transactions. Hence, we estimate Keynes equity as 20 per cent of his maximum gross position over and then again over Whilst the assumed level of cover and implied equity 15

17 affects any estimate of his average return and standard deviation, it does not affect the Sharpe ratio. In Table 7, we compare Keynes s monthly returns with the returns on both the carry and momentum strategies over the two periods during which Keynes traded and when forward exchange rates data are available, January 1920 to May 1927 and October 1932 to March The results reveal that the returns on Keynes fundamentals-based trading approach compared poorly with returns to the carry and momentum strategies (Panel A). Keynes mean annualized return of +5.40% over the both periods of trading were exceeded by a return of 5.91% on the carry strategy and +7.15%, +6.24% and +8.60% on the three of the four momentum strategies. Only the MOM6 strategy (+4,51%) did relatively poorly. Furthermore, the returns to Keynes strategy were also much more volatile and his Sharpe ratio of 0.16 is much lower than the Sharpe ratio of the carry strategy (0.57) and of the momentum strategy which ranged from 0.41 to When we decompose returns into the two sub-periods, Keynes underperformance relative to the carry and momentum strategies is mostly explained by the pattern of returns during the 1920s (Panel B). However, the carry strategy which did particularly poorly (- 1.75%, Panel C) in the 1930s due to those high-yielding currencies fighting to stay on the gold standard ultimately capitulating and devaluing their exchange rates. His eventual success in shorting the FFR and DFL in 1936 enabled Keynes to generate returns of +2.49% and to outperform the returns to the carry strategy. However, momentum continued to do relatively well other than over 1 month. Overall, his Sharpe ratio of 0.23 in the 1930s although similar to that on UK consols was much lower than that on UK equities (0.60). As we saw in Table 1, out of his 355 trades all but 11 were in five currencies, USD, FFR, MKS, LIRE, and DFL. Since Keynes did not trade all eight currencies in our sample, we also estimate returns on the carry and momentum strategies from the restricted sample of these five currencies. Our findings regarding his underperformance remain qualitatively unchanged. 9 Keynes registered a severe loss in May 1920, when his prediction that European currencies would depreciate against the US dollar initially proved incorrect (figure 7). The exclusion his first five months of trading radically boosts his returns to % and % in the 1920s and 1930s respectively (Table 7, Panels D and E). Now we find that he outperformed the carry strategy (+6.64%, %) and the best-performing momentum 9 These results are available from the authors upon request. 16

18 strategy, MOM12 (+8.21%, %) in both periods. He also did better than UK stocks (+11.42%, %) and Consols (+2.29%, +2.67%). His Sharpe ratio also exceeded that on any other strategy in both periods. We return to discuss this issue below. Finally, we benchmark Keynes performance by regressing his monthly returns against the returns on the carry and momentum strategies or factors following Pojarliev and Levich (2008). R t 2 1 CARRY MOM (1) where CARRY and MOM are the returns on the 2 Long-2 Short strategy among the eight currencies which are ranked on the forward discount, the increase in value (against sterling) over either the preceding 1 month (MOM1) or 12 months (MOM12). The results for each of the whole sample period (Panel A) and the two sub-periods (Panels B and C) are summarized in Table 8. The positive and statistically significant coefficient on CARRY in the regressions for the January 1920-May 1927 period indicates that Keynes tended to borrow in low-yielding currencies and invest in high-yielding currencies. Indeed, until mid-1924, the US Dollar was almost always quoted at a discount (against sterling) on the forward market and Keynes generally went long the dollar. By contrast, continental European currencies exhibited a forward premium against sterling in and Keynes shorted them actively. The positive and significant coefficient on MOM12 also reflects Keynes belief that European currencies would continue their long-term depreciation against sterling and the US dollar in the early 1920s. However, the low R-squared for regressions (B1) and (B2) suggests that the returns on Keynes largely fundamentals-based strategy during cannot be explained by carry and momentum factors. Our results for the October 1932-March 1939 period are strikingly different. Whilst the 1 month momentum factor still plays a role in explaining his returns, the coefficient on CARRY in both regressions (C1) and (C2) turns negative and is statistically significant. This reflects Keynes decision to short the French franc and Dutch florin in This strategy contradicts the carry trade since these currencies both exhibited a high forward discount (against sterling) until their devaluation in September Our results indicate that Keynes discretionary approach to currency trading and his strategy based on the analysis of fundamentals did not perform very well. Of course, his performance in the period was substantially undermined by the gigantic loss he 17

19 recorded in May 1920 and benchmarking his returns beginning in June makes his record look much better. One possible justification for this approach is that Keynes learned how to trade in these early months and became a more skilled speculator as a result of this experience. Yet, the evidence from his correspondence dismisses this interpretation. His currency views before and after May 1920 were unchanged. As a result, we believe there is no particular reason to exclude the first months of his trading in assessing his performance. From this perspective, Keynes performance as a currency trader looks unimpressive. Following naïve currency speculation strategies would have allowed him to achieve higher returns in the 1920s while taking substantially less risk. We also fail to find evidence that Keynes became a more skilled trader in the 1930s, a period in which returns on carry and momentum strategies were considerably below those of the 1920s. 7. Conclusion This paper has provided new evidence on the returns to foreign exchange speculation in the interwar years when modern spot and forward foreign exchange markets first emerged. Recent empirical research has persistently demonstrated the returns to simple zero-cost currency speculation strategies such as the carry trade and momentum during the post-bretton Woods era. This result remains a challenge to finance theory and the traditional assumption that currency speculation is a zero-sum game. However, no studies of the returns to currency trading in the other era of floating exchange rates in the 20 th century have to date been undertaken. In this paper, we provide evidence that the returns to the same carry and momentum strategies also existed in the interwar period. Carry and momentum strategies yielded high returns during the 1920s but lower returns during the managed float period of the 1930s when currency markets suffered numerous speculative attacks and sudden devaluations. Overall, carry and momentum strategies performed similarly or better than UK stocks and bonds over By contrast, we find little evidence that the discretionary and fundamentals-based trading approach of John Maynard Keynes was able to generate substantial profits on interwar markets. Despite being a major contributor to exchange rate theory and a well-informed trader, Keynes did not succeed as a currency speculator. His performance over the 1920s was undermined by substantial losses in May 1920, when the European currencies he had shorted temporarily appreciated against the US dollar. His record after May 1920 looks much stronger. However, Keynes relatively poor performance over the whole sample period 18