FX debate (part two): Towards a golden age for foreign exchange
Euromoney February 2008
Delegate biographies: Learn more about the panelists
Emerging markets are driving investor behaviour but talk of the dollar’s demise is premature.
Executive summary
• Volatility in the FX markets has increased following the credit crisis but not as much as might be expected
• Volatility might become more intense as inflation (or, less likely, deflation) kicks in
• Central banks are caught in a dilemma about inflationary/deflationary expectations
• The continuing buoyancy of emerging markets has changed the rules of the game in FX markets
• FX risk management models have held up well compared with other markets as has the market infrastructure |
SB, Euromoney How has the FX market responded to the unfolding credit crisis?
RB, Investec Well, initially volatility spiked to extraordinarily high levels. The dust has settled but volatility is still on average 50% higher than it was in May. Many of the arguments people previously used to explain why volatility was so low still hold, yet the world seems a very different place and right now the biggest question for FX is whether we stay in this moderate to high vol environment.
PL, Polar Capital I’m actually amazed how little has happened in response to the sub-prime issue. Yes, volatility has increased by 50% but from multi-year low levels. Bank stocks have clearly suffered but lots of sectors are close to their high. Even the historically risky currencies, such as Turkey, Brazil or Poland, are pretty close to their highs too. In the bond market, the Fed may have slashed rates by 50 basis points in immediate response to the crisis [and then another 25] but it wasn’t so long ago that central banks adjusted rates in general by 50bp. Maybe I’ve just been doing this for too long, but I’ve been struck by the level of stability so far and not the level of volatility.
DB, HSBC The FX market is interpreting the market turmoil as a purely dollar problem but other markets aren’t necessarily interpreting it that way. If, for example, there is negative news on bank stocks in Europe, people sell the dollar and buy the euro. So we won’t see significant volatility as long as this is regarded as a purely dollar problem.
PL, Polar Capital But how much has the dollar moved in trade-weighted terms since August? Not very much. People get excited when the trade-weighted dollar falls by 3% in a month. Not so long ago trade-weighted dollar could move by 10% in fairly regular market conditions. The world is awash with liquidity, and that won’t change until people become properly concerned about inflation.
DB, HSBC The more you worry about a particular inflation problem, the better that currency does. I think the big move is still to come, some of this clear-out is much more than just a pure dollar sell-off, and when that move happens we will get the high volatility that Richard mentioned.
XP, FX Concepts Isn’t the danger that we’re all faced with deflation? If there is any kind of inflationary forces won’t we all sigh with relief?
PL, Polar Capital I think it’s more difficult to make a case for deflation now than it was three or four years ago, because some of the places that were generating the deflation don’t seem to be doing so now. Maybe we’ll see a further shift in the global supply curve and it will come back – but just in terms of the last couple of years – those places are suffering their own inflation now.
DB, HSBC Well, isn’t inflation also an exchange rate issue? If countries are reluctant to move their exchange rates, as far as the market’s concerned they’ve got an inappropriate exchange rate. So when inflation rises, it erodes competitiveness, and in that way you get a move in the real exchange rate. So despite nominal exchange rates not moving, inflation forces a move in the real exchange rate.
EP, UBS I think the mostly benign FX volatility we’ve seen thus far in response to the credit crisis may not be a great predictor of what we could see over the next six to 12 months. I’ll be interested to see how the current market structure, which has developed during a period of relative stability, will respond if steady state volatility rises to 11% or 13% from the 5% to 7% that has prevailed until recently.
VD, Bank of America One state that has changed is the behaviour of implied volatility, especially the change in skew for a given change in spot. This has added a new dimension and was especially extreme in the yen. In August, one-year 25 delta risk reversals traded over 7%. This was more than 50% of the at-the-money vol. This was unheard of. It was even worrying some of the central banks.
SB, Euromoney And how are central banks coping?
CK-G, Société Générale I think that the central banks perceive they are stuck with a situation of two potential "fat tails" in their outlooks and they have to decide which of these fat tails is the clear winner. On one hand they perceive they may have economic weakness, and on the other, they also believe they may have potential inflation concerns. For the ECB currently, this is clearly a tougher dilemma than it is for the Fed. The ECB is likely to be on hold for the foreseeable future but the Fed can clearly cut, though whether they can cut by as much as is now priced into the marketplace is another matter. For the Bank of England, they probably find themselves in a situation somewhere in between the two above – similarities in the state of the housing markets probably being the key and allowing some slight easing. It’s a tough balancing act. If the Fed over-adjusts because the economy is weak, then they risk their inflation-fighting credibility. If they don’t adjust enough, it exaggerates the existing problems in the US mortgage market and the economy weakens further. Ironically, until recently anyway, both scenarios have been seen as dollar bearish by the marketplace. The current extended currency valuations, or year-end may change this but it certainly explains the price action.