Mervyn King, the former governor of the Bank of England, famously once said that you would be mad to try to forecast currency movements. Now, however, it would appear that the only people madder than forecasters are those that are trying to trade FX.
As Steve Barrow, head of currency research at Standard Bank, notes, the chaos at the heart of the US government budgetary process has put most currencies in lockdown.
“Volatility is on the floor and who knows when, or how, it will rise again,” he says. “It makes trading conditions especially tough.”
Of course, before the US debt ceiling saga, it was the prospect of the Federal Reserve tapering its asset purchases that was suppressing volatility, and limiting returns from currency investing. Indeed, once the wrangling in Washington is sorted out, it is likely that Fed tapering will return as the focus of market attention.
All this has made returns from currency investing hard to come by, with CTAs posting gains of just 0.34% so far this year, according to calculations from Barclayhedge. Over 10 years, the picture is not much brighter, with average returns of just 2.6%, well below the 7.6% return averaged by hedge funds across all asset classes, excluding funds of funds.
Barrow says the problem is not just low volatility. That is because low volatility can be good for currency investing, generating strong returns from carry trades, provided that it is higher-yielding currencies that are seeing the low volatility.
“But herein lies the rub,” says Barrow. “While major currencies like EURUSD and USJPY have been very stable, many target currencies for the carry trade, like the rand, Turkish lira, Brazilian real, and more, have not played ball.”
Indeed, the sell-off in higher-yielding emerging market currencies prompted by the emergence of the Fed tapering debate in May has destroyed carry returns this year.
Meanwhile, among the most-traded G10 currencies, there has not been enough variation in monetary policy to encourage large currency swings. GBPUSD has been stuck in a fairly tight range since policy interest rates last moved in the US and UK in 2009, while EURUSD has been fairly contained despite the eruption of the eurozone sovereign debt crisis.
Admittedly, USDJPY did provide currency investors with a clear trend to trade after the re-election last year of Japanese prime minister Shinzo Abe, who delivered on his promise to weaken the yen. Still, the stability of USDJPY in recent months suggests Japan will have to increase its monetary easing efforts if it wants to produce further movement in USDJPY.
Barrow believes the prospects for easier trading conditions – that could allow currency managers to get closer to other asset managers in terms of performance – are not great, especially if the budget impasse in Washington is simply replaced by investors returning to the Fed tapering debate.
“Only when a real wedge opens up between central bank monetary policies might we expect better trading conditions,” he says. “But this is still some way off and, what’s more, central banks are working hard to try to make sure that their transparency and forward guidance are such that monetary policy shocks are kept to a minimum. If they succeed in doing this, one source of currency shock is likely to be suppressed as well.”
Not all subscribe to the view that returns in the currency market will be so hard to come by, however.
David Bloom, global head of currency strategy at HSBC, believes there is no longer a single paradigm that explains the behaviour of the whole of the currency market.
From 2000 to 2007, the carry model provided a “one-size-fits-all” mechanism for understanding currency movements. That was undone by the global financial crisis, which left currency markets in the grip of another universal model: risk-on/risk-off (RORO). The influence of RORO began to wane at the start of this year, however.
“Since then, markets have looked but failed to find RORO’s FX successor,” says Bloom. “The mistake has been to look for a single model that can be applied across the board. It simply does not exist anymore.”
Instead, Bloom believes the global currency market is made up of three broad groupings, or buckets, which are somewhat interlinked, but have distinct behaviours and drivers.
The first are the “carry candidates”, which are predominantly G10 currencies that are driven by the outlook for the economy and associated implication for relative interest rates.
The second are the “diminished safe havens” of the yen and the Swiss franc, which are no longer driven by RORO considerations.
The third is the “balance of payments club”. These currencies are largely in emerging markets, where the current account balance and the outlook for capital account financing are the key FX drivers.
Bloom says that far from complicating matters, the realization that multiple models are in play actually makes life easier for currency investors.
“The earlier confusion was driven by the misplaced hunt for a single model, which made for apparent contradictions, inconsistencies and potentially poor strategy,” he says. “Instead, when one accepts that there are different models for different currencies, it is simply a question of deciding which bucket a particular currency belongs in and analysing its prospects accordingly.”
In the first bucket, that means interest rate expectations are key for the major currencies. Indeed, as the chart below shows, carry had replaced RORO as the driver of EURUSD, with the three-month correlation between the currency pair and US/eurozone interest rate differentials rising from 0.06 at the start of 2013 to 0.57 currently. The same effect can also be seen in GBPUSD.
| EUR is becoming more correlated to rate expectations |
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The second bucket reflects the fact that the ability of the Swiss franc and the yen to act as safe havens has been undermined by local shifts in policy.
As can be seen in the chart below, the Swiss franc’s correlation with RORO factors has been undermined by Swiss National Bank’s imposition of a SFr1.20 floor in EURCHF in September 2011.
| EURCHF has a mixed performance as a safe haven |
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Meanwhile, the yen’s correlation with RORO has disappeared since Shinzo Abe’s re-election last year and subsequent campaign to weaken the yen.
| USDJPY no longer a safe haven |
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For the Swiss franc and yen, then, it is important to gauge the interplay between the global and local drivers of the two currencies.
The third bucket reflects the fact that countries’ balance of payments, in recent years crowded out by the RORO effect, have re-emerged as a driving force of currency movements, principally in emerging markets.
Indeed, after years of not bothering about growing current account balances in emerging markets, the prospect that the Fed would move to taper its asset purchases, and turn off the global liquidity taps, prompted a change of heart among investors, with current account deficits suddenly seen as unsustainable.
That can be seen from the relative performance of emerging market currencies, shown below, during the initial stages of tapering fears, with the winners and losers broadly falling along the lines of which country had a current account deficit and which had a current account surplus.
“Understanding that current account balances are important for these currencies provides some basis for deciding where they may head next,” says Bloom. “Our EM FX forecasts still continue to broadly favour those currencies which are not reliant on external funding, thus reducing their sensitivity to the vagaries of the reduction of the quantity of money being provided by the US Federal Reserve.”
| Current account balances helped explain EM FX performance from May 1 to September 1 |
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For those currencies already in the limelight because of their current account deficits, the policy chosen to deal with the imbalance – raising interest rates or allowing currency depreciation – will be central to their outlook, Bloom adds.
He says understanding which bucket a currency generally belongs in makes gauging its likely path easier.
“The common mistake is trying to identify a single one-size-fits-all explanation for the behaviour of all currencies,” he says. “This may have worked when the carry model was enjoying its universal heyday in the 2000s, or during the global dominance of RORO following the 2007/08 crisis, but it is not a luxury the FX market is enjoying at the moment.”
Accepting this new multi-layered FX world might provide some welcome relief for beleaguered currency investors.