Currency risk in a global investment portfolio may be quite a headache for a portfolio manager. Although hedging such risk is generally straight-forward and relatively cheap (especially for major currencies), opting for the easy way out is a) not always an option and b) not necessarily the right decision to take. Hence understanding the strength or otherwise of one currency versus another is a necessity not only because of its direct impact on the value of the portfolio but also on the impact such currency could have on the underlying global investments in the same portfolio.

We all know the recent happenings in Europe and how these impacted and determined certain decisions taken by the European Central Bank (ECB). Today Europe is not yet out of the woods but it has definitely moved a couple of steps away from the cliff edge.

Mario Draghi, the ECB president, has applied a number of tools and policies in order to provide stability and win time for the peripheral economies to get back on their feet. The tools and policies applied were possible given the economic realities in the background such as the low inflation rate in the eurozone, which is at the lowest level since the introduction of the euro.

All other things being equal, with a set nominal rate, as the inflation rate drops the real rate rises. However, we know that other things have not remained equal and that nominal rates have also been declining. Therefore, the statement only remains valid if the inflation rate declines faster than the nominal rate.

Let us assume, for the sake of this article, that both rates have been declining equally and that the real rate has remained unchanged. Given the current low levels of both inflation and the nominal rates, is there a risk of deflation as the ECB considers lowering rates further to kick-start Europe? There are two reasons we may be at the beginning of a deflationary cycle: nominal rates cannot fall below zero (for a long period of time); and when inflation falls below a certain level, monetary velocity hits a wall.

Once this cycle kicks in it becomes a vicious circle which does not have a successful tried and tested antidote. Japan is still trying, after more than two decades, to get out of this vicious circle with Abenomics.

The eurozone needs to have a weaker currency, but unfortunately circumstances have not allowed this to happen. For example, the Asset Quality Review (AQR) exercise within the European banking industry resulted in a stronger euro as banks reduced their foreign asset holdings to ensure that risk was adequately capitalised in their balance sheets. This trend could actually continue if banks start experiencing deflationary pressures on their balance sheets – this will cause the banks to consolidate, causing the euro to strengthen even more. However, given that the end-of-year date for AQR has passed we could see some euro weakening as banks close some or all of their foreign currency hedges.

So far, the ECB has not been aggressively proactive in addressing deflation risks given that its projections suggest that the two per cent inflation (rate) target will be reached within two years. However, one must note that while other central banks have kept expanding their balance sheets, the ECB has shrunk its balance sheet by 28 per cent from its peak in December 2012. Furthermore, peripheral European economies have been slowly addressing their problems (some more than others; countries such as Greece, Italy and Portugal remain fragile while Spain and Ireland seem to be experiencing a stronger recovery with Ireland now reaching investment grade status from all three major rating agencies) and hence the risk premium attached to peripheral Europe is now almost completely priced in.

The ECB could be fast approaching its next crossroad. It can either deploy an aggressive reflation strategy (if indeed we are on the doorstep of deflation) causing the euro to weaken by increasing the supply of the currency via balance sheet expansion. Alternatively it can maintain the status quo and hope the markets achieve the desired result without intervention. For Europe’s sake the euro needs to weaken.

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This article is the objective and independent opinion of the author. The information contained in the article is based on public information.

Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

Karl Micallef is an executive director at Curmi and Partners Ltd.