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| By Tim Carrington, Global Head of FX |
Central banks bring tail risk challenge to FX markets. The cast of participants in the FX marketplace is always changing: corporates hedging trade and earnings flows; hedge funds and real money looking for short term price misalignments and investment opportunities; banks servicing flow and managing client requests; and central banks and sovereign wealth funds managing national currencies and their reserves.
Recently we have seen a shift in the relative influence of these participants, with central banks playing a significantly more active role than before – a change that we believe has increased the tail risk for foreign exchange. First let’s look at central banks. The size of central bank balance sheets has exploded in the last five years. This has occurred due to both quantitative easing throughout the western world and a very large increase in currency reserves in emerging markets, especially in Asia.
Central banks act in a number of ways in the currency markets. One of their main aims is to diversify newly-accrued US dollar reserves away from the dollar and into other currencies, while also trying to keep their stock of reserves aligned to their long-term mandates. This usually means they are sellers of US dollars but also trade the range as currencies strengthen and weaken. An increase in reserves means they have more net US dollars to sell but also means they trade the FX spot ranges more aggressively. This suppresses volatility.
Central banks also manage their own domestic currencies. This occurs in two main ways: either they try to maintain a range and curtail excessive moves (volatility reducing) or they try to aggressively realign their currency with what they perceive as a more correct value (volatility increasing). For example, the Swiss National Bank (SNB) last year intervened in the euro to Swiss franc exchange rate to reduce the value of the franc by 15 per cent in a month, then placed a floor in the rate, thus moving from a high volatility environment to a low volatility environment in a short period of time. This demonstrates that although central banks, in general, tend to reduce FX volatility, there are times when they act in a way that massively increases it.
Hedge fund and real money behaviour has also changed. Below is a chart of the returns of global currency managers.
As you can see, returns since 2009 have been disappointing. This has led to a decrease in the number of market participants and, for those with a wider mandate, less focus on FX as an asset class. Hence, global currency managers have become less influential in the FX markets. The declining presence of hedge funds, which typically look for short-term fundamental misalignments in currencies, means that liquidity has been reduced and FX spot rates can now deviate further and for longer from fair value.
The role of corporates has had a separate influence on FX markets. Trade balances across Asia have declined dramatically since the financial crisis. Interest rates in many economies are near-zero, resulting in reduced opportunities for companies to earn a yield on their capital. In addition, many multi-national corporates now behave in such a global fashion that an increasing amount of their earnings are kept offshore rather than repatriated. All these factors have combined to reduce the natural FX flow in the market and hence significantly reduce liquidity.
Finally, there are fewer investment banks offering a broad spread of FX products and regulation has necessitated a reduction in risk taking amongst those that remain. Servicing such a wide spectrum of clients ourselves, we see this in our day-to-day activity. RBS has a long heritage of being one of the biggest players in FX volatility markets, indeed many people have described RBS as the ‘central bank of volatility’, reflecting our constancy as liquidity providers. We are well placed to warehouse volatility risk, but because there are fewer people willing to stake money when markets are ‘out-of-line’, it becomes increasingly difficult to hold such positions for long enough to realise the required returns. These challenges for the banking community have again reduced liquidity in the FX market.
So overall we have seen a dramatic drop in the natural flow of FX from trade and earnings flows. We have also seen a marked reduction in the liquidity provided by hedge funds and investment banks. Central banks, on the other hand, have become much larger and more powerful players. Furthermore, they have become the providers of liquidity of last resort.
The behaviour of central banks however is quite different from the previous mix of FX liquidity providers. On the whole they suppress volatility, but there are times when they are responsible for sharp one-off moves – such as when they step away from the market en masse or when they move from currency management to aggressive currency realignment.
Such behaviour in conjunction with reduced liquidity from other FX players dramatically increases the tail risk in the foreign exchange market. Our assessment suggests that tail risk is much greater than it was 10 years ago.
This makes it all the more crucial that participants are not lulled into a false sense of security by the prolonged periods of low volatility we are witnessing.
Far from being a sign to relax, this reduced volatility should be seen as a precursor to an eventual exaggerated price move, requiring increased vigilance and a more systematic use of derivatives and hedging tools.
So, will central banks remain the driving force of the currency markets? In the short-term, yes. But I believe the interest rate environment will become increasingly important in setting the agenda.
Though we are still seeing flat, near-zero rates in the main developed economies, there are already signs that growth rates are becoming more divergent.
At some point, this will filter through to forward expectations on interest rates. The opportunities that this will generate should encourage the entry of a broad spread of market participants and herald yet another change in market dynamics. The challenge for investors will be to catch the swing at the right moment.