With talk about “currency wars” so common in the markets, will investors become collateral damage?
Currency markets are rarely dull but recently, the world’s biggest asset class has given followers more than their fair share of heart-stopping moments. These have ranged from jaw-dropping falls in former emerging market darlings such as the Brazilian real to the gauntlet thrown down by Switzerland last month when it capped the Swiss franc’s rise and put the credibility of the Swiss National Bank on the line in the process.
As currency traders have quipped, when even neutral Switzerland declares war, you know it must be serious.
It was Guido Mantega, the Brazilian finance minister, who coined the “currency wars” phrase in its latest incarnation, reflecting the worries his country, and other emerging markets, had about their competitiveness.
They have, however, waged more of a guerrilla-style warfare than Switzerland, sticking to taxing currency flows and quietly intervening.
Complicating matters further, the recent dramas come at a period of immense change in the currencies world. Electronic trading is helping volumes leap – 21 per cent in three years, according to the most recent Bank for International Settlements survey. On the spot market, turnover leapt 50 per cent in that period. An average $4,000bn is traded daily, the BIS said.
Electronic offerings are also bringing in new customers such as the fast-moving algorithm-based hedge funds, which value the forex world’s deep and near-constant liquidity. Smartphones and tablet computers are producing another mini-revolution; banks’ clients can often now trade with the bank from their iPhone standing on the street.
All this adds up to a huge shift in the way investors view, and use, currencies.
“There’s certainly a growing investor base that treats FX as an asset class and invests just to make a return. This goes all the way from specialist hedge funds to retail investors,” says Adam Cole, global head of FX strategy at RBC Capital Markets. “Parallel to that, you’re also seeing the growth of active FX management on the part of investors who have exposure to other asset classes.”
It is not just how, but when, business is conducted that is changing. FX traders have long boasted of their market’s genuine cross-border, round-the-clock habits. These are true, but only the biggest four or five currencies were ever really offered at good prices outside their regional time zone.
This is slowly changing. While the best liquidity, and therefore prices, for the Korean won or the Mexican peso are still to be found during their respective business days, liquidity is increasing out-of-hours too.
Currency markets can, like other asset classes, be very roughly divided into two periods, one corresponding to the boom times that ran until mid-2007, perhaps into 2008, and the other to the near-constant crises that have followed the collapse of the credit bubble.
Before the crisis, currencies were usually taken as straightforward macro-economic bets. Classic economic theory held that rising interest rates bolstered currencies, and they often did. Relative rates of growth – which could be transposed into likely interest rate policy – were also good indicators of direction. Other classic factors, such as the danger that countries with growing trade deficits risked suffering a fall in their currencies, also held sway.
That all still exists to some degree, but investors must now factor in other, powerful trend-setters, particularly the strong correlations between different asset classes as to whether they are viewed as “risk on” – growth bets such as emerging market currencies, commodities and equities – or “risk off” such as gold, the Swiss franc (before Switzerland pulled up the drawbridge) and top-rated government bonds.
To see how powerful these are, look at the dollar’s rally following the fall of Lehman Brothers in September 2008. Instead of falling as investors fled US assets, as many had expected, it leapt as investors sought the safety of the world’s deepest markets. The recent dollar rally has been attributed to similar haven-seeking by jittery investors.
Currencies have always struggled somewhat with their dual roles. One is the essential, but frankly quite dull role as part of the world’s payment system. The other is as an asset class in its own right. Now the FX world is enjoying its enhanced role as an asset class, underpinned by the knowledge that – unlike so many other markets – it did not fail during the crisis.
FX bankers, often previously derided as “spot monkeys” by their snootier bond or equity trading colleagues, are quietly revelling in the attention. Some say that three or four years ago, they struggled to get the latest crop of graduate trainees to spend time on their FX desks. Now, they’re having to limit those they take.
“There is a permanent shift in the way people look at FX,” says Mr Cole. “To some extent it reflects poor returns in other markets since people are more likely to take FX seriously when its returns are competitive with those in other asset classes.”
In other words, when equities or bonds are falling sharply, or just crawling higher, investors are increasingly interested in managing their currency exposure to at least minimise their risks. Some hope it could even add percentage points to their returns.
Some investors are even using FX as a proxy hedge. If the euro really does rally against the dollar, in virtual step with the S&P 500, then currencies can in theory provide a cheap way of gaining “exposure” without having to enter that market.
But Richard Usher, a senior spot trader at JPMorgan in London, cautions against trusting that approach too far.
“We’ve seen some market participants trying to use currencies as a proxy hedge but the links are very patchy – sometimes it’s about interest rates, sometimes it’s equities.
“They’re talked about a lot, but they’re not strong enough to rely on,” he says, instead suggesting that investors consider longer-term bets on the dollar resuming its slide.
“Everyone wants a weaker currency, but the US is the king of getting its currency down,” adds Mr Usher.
If he is correct, then the recent dollar rally is only a period of detente, before the currency wars begin all over again.
read more: Olympus Wealth Management
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