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FX debate: Executive summary
• FX is experiencing lower levels of volatility in a benign, low-risk environment but this is not necessarily a bad thing for the market and there are still opportunities to make money
• US sub-prime mortgage concerns should not be ignored but are not that big a factor to most market players. However, other areas of risk, such as geopolitical, need to be properly priced in and may not yet be so
• Emerging markets are an expanding asset class and offer a potential source of alpha but they require patience in order to spot the best opportunities
• Research is still an important service that banks can provide the buy side, which is always on the lookout for good ideas, but it needs to be carefully tailored and selectively distributed, not mass marketed |
Part Two: FX Debate: How to keep the buy side on side
FX debate participants
Potential areas of risk include sub-prime and geopolitical factors, but most players see the current market and future outlook as benign. Use of quant analysis and research, together with a patient approach to emerging markets currencies, should provide plenty of opportunities for alpha generation.
AE, Millennium Why is volatility at such low levels? Returns have been average for the past two or three years so do you believe this is going to change?
XP, FX Concepts Different years favour different strategies. As certain strategies and styles do well, they attract people. As more people come on board, they crowd out the opportunities, so returns diminish and you get this drop off in the performance of a given trading style. Trending has done quite badly over the past few years. What’s done well is something with a completely opposite return distribution to trending, which is carry or stocks. There’s a natural cyclicality to it.
RL, Barcap There is an assumption that lack of volatility means an inability to make money. That’s not true. In 1999, when the euro was launched it dropped like a stone. But that coincided with the lowest point in euro/dollar vol that we’d seen. Had you been short euro/dollar the fall in vol would have been irrelevant. The issue of the past two years has been declining vol and lack of directionality. From a macro point of view most people expected the dollar, as a representative of the global imbalances, to get slaughtered, but that didn’t happen.
DT, FFTW I totally agree, currency managers crave directional movement, not volatility. Fund managers would be quite happy in an environment where a currency appreciates by a small, consistent amount on a daily basis – it is important to remember that volatility and direction aren’t necessarily correlated. I also think the concern among market participants regarding low volatility and the lack of direction is really driven by the recent experience in G3 exchange rates. Large fluctuations in exchange rates tend to occur when national economic cycles are out of sync. Increasing synchronization of monetary policies across Europe, Japan and the US implies that business cycles in G3 countries are more correlated. Given this backdrop, it really is not surprising that G3 exchange rates have been range-bound. If we expand our horizons to the rest of the G10 currencies, we would find much less business cycle synchronicity and a good deal more directional exchange rate movement. In 2006, the New Zealand dollar depreciated more than 10% versus the US dollar from January to March and then rallied all the way back in the second half of the year. There are always opportunities in currency markets, the key is to have a large opportunity set.
PL, ABN Amro AM Lower volatility doesn’t mean the market is less risky, because correlation between currencies is now higher than what it used to be between G4 currencies. The difference is that the risk is now less apparent to the final investor as volatility has been replaced by contamination risk.
It is clear that currency managers have not generated much alpha in regard of what was expected. There are, however, some reasons for this. We’ve been through a disinflation period that drove most investors toward the same portfolio allocation: long bond, long equity, long commodities and emerging markets. Bearing in mind the Goldilocks scenario of low interest rates and inflation, there has not been much of an incentive or rationale for investors to shift their asset allocation drastically. Clearly, that’s not conducive to large cross-border flows and change in currency valuations. We feel this equilibrium will be disrupted at one moment either by inflationary pressure or possible monetary policy mistakes by central banks. This probably could trigger higher volatility and higher opportunities for currency managers.
RL, Barcap A number of central banks have supplied volatility to the market in never-before-seen quantities. It may be mildly asymmetrical, but they are effectively trading gamma. Particularly in the euro/dollar, that adds to the containment effect. The value in the wings is increasing, not lessening, but it is going to be low distribution.
PL, ABN Amro AM The present environment of perceived low volatility/low risk does not do good service to the end investor. It is generally a good thing to have some explicit risk premiums in markets as it drives investors toward more diversified portfolios and therefore better-quality risk adjusted returns. Clearly we are at a point where we swapped explicit risk, ie, volatility, for correlation risk, which is more difficult to estimate and to hedge.
MT, RBS With the opening up of the primary markets via prime brokerage and the addition of new electronic communication networks, some of this low vol environment may be due to these new pockets of liquidity that aren’t monitored effectively. Moves in the market seem to be absorbed more than in the past, the hot potato effect of a new order has less impact as it makes its way via non-traditional channels.