As broad FX volatility, measured by the ECB’s Global Hazard Index, hit its lowest level since July 2007 last week, and the VIX remains near decade lows, traders find themselves in a similar position to that before the global financial crisis: having to generate absolute returns for investors in a market where no clear strategy works.
“Low volatility means that mean reversion generates peanuts given the marginal swings, spread compression across the globe means that most carry trades don’t yield enough to compensate for the funding currency’s spikes, and there is no clear momentum in any currency pair over time,” says Robert Savage, CEO for hedge fund CCTrack Solutions, in New York.
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One of the traditional methods of dealing with such low volatility – looking down the credit curve by upping sovereign risk allocations into EM countries – is also not working, he adds, as the volatility, during current market conditions, is decidedly inconsistent.
This means directional currency plays have a high risk of being upturned against a temporary run of momentum, and that any gains from regional carry trades can be wiped out by a sudden P&L swing in thin volumes.
Indeed, buying a basket of the five highest-yielding emerging-market (EM) currencies – the Indian rupee, the Turkish lira, Brazil’s real, South Africa’s rand and the Russian rouble – with funds borrowed from the lowest-yielding currencies, such as the Japanese yen and Swiss franc, has lost around 3% this year so far.
What’s more, FX revenue levels are down 20% to 25% for the top 10 global trading banks as a whole in Q1.
George Kuznetsov, head of research and analytics for markets’ intelligence firm Coalition, in London, adds: “[These figures in themselves are] probably an underestimate, probably pertain to trading banks in general, and underline the pessimism over any possible return to more broadly favourable trading conditions – ie higher consistent volatility – that we have heard from our conversations with traders in the past few weeks.”
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Given this backdrop, and the ever-present pressure to make returns in absolute terms, it is little surprise analysts say hedge funds and perhaps even leading trading banks are seeking to increase the size of specific trading bets.
Jeremy Stretch, senior FX strategist for CIBC, in London, says: “It’s just like the situation in the two or three years before the [global financial] crisis: low volatility meant returns were much harder to come by from trading swings, so the only alternative to generate returns in absolute terms was by increasing leverage in key targeted trades, and that’s what people will be looking to do now.”
Adds Savage: “We’ve seen this sort of thing before in 2006/2007, and before, with no other way of trying to increase returns but to increase trading leverage. But it’s worse now, as before at least you could find returns down the credit curve, but even these aren’t to be relied on anymore.”
One hedge fund manager adds: “There’s pressure on [hedge] funds to make absolute returns always, and in this situation with no other strategies working, there’s only one option, which is to increase the size of the bets, which means upping the leverage.”
There seems little to lose by implementing such a strategy compared with trying to job in and out of positions, with the Parker Global Strategies’ Global Currency Managers Index – which tracks the performance of 14 funds it considers the elite in their class – down 2% this year, extending its decline since the end of 2010 to 10%.
The recent bankruptcy of FX Concepts and the closure of QFS Asset Management’s currency-only trading fund highlight the choppy trading environment.
“A lot of these sorts of guys will have been trying to play the markets in the usual logical way of looking at overall sustained momentum, or long-term risk reversals, but that’s not the way the markets have been moving, either in the DM [developed markets] or EM environment,” says CIBC’s Stretch.
Worse still for the traditional style of trader is there might be no end to low volatility any time soon, according to Charles Himmelberg, global head of credit strategy for Goldman Sachs, in New York.
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“Between 1984 and 2007, consumption, investment and GDP growth had become visibly less volatile in many countries, including the US,” he says.
“Not only is a return to this state not an unreasonable expectation, but also that our update of the evidence for the post-crisis period shows it may already be here. For example, the three-year moving volatility of US private-sector employment growth has already fallen to its lowest level in over 50 years.”
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The most obvious concern in this scenario, says Himmelberg, is that low volatility, if sustained over a long-enough period, will eventually lull investors into a false sense of security, and thus feed excess complacency towards risk. “And the further risk and leverage build, the greater the probability of a sharp increase in volatility,” he adds.
There are regulatory boundaries to how much leverage firms can take on, with a proposal that US banks be limited to a leverage ratio of 5% equity to assets, 6% for US bank subsidiaries and 3% proposed in Europe, which might serve to limit the more dangerous excesses that exacerbated the global financial crisis – but true market oversight is difficult in highly complex markets.
“Where traders want to increase their leverage dramatically then they will,” says Kwan Rivaldi, markets strategist for Insch Capital Management, in Lugano. “It is all part of the long-term cycle of markets, and this current situation is no different.
“Low volatility will see traders up their leverage, volatility will increase over time and then you may have the fallout from overextended credit. Simple as that.”