Currency managers rejoice: RORO is fading

By:
Peter Garnham
Published on:

There is hope for FX investors looking to escape the tyranny of the risk-on/risk-off (RORO) phenomenon.

RORO has been the scourge of currency managers, undermining the carry trade – one of the investment styles that form the pillars of arguments that FX should be treated as an asset class.

However, there is good news for those hoping that FX investing is set to return to normal after years of slavishly following the fortunes of the world’s stock markets.

RBC Capital Markets tracks RORO using its World of One Trade model, which monitors the number of the 45 G10 currency pairs that are correlated to equities.

The bank says there are now more currency pairs uncorrelated to equities than at any time for five years.

Indeed, RBC says equity/FX correlations have started to break down to the extent that a majority of G10 currency pairs – 27 of 45, the most in the post-financial crisis period – were uncorrelated with equity returns during the last three months.

"On the face of it, we appear to be finally exiting the world of one trade," says Adam Cole, global head of FX strategy at RBC.

 G10 currencies shift away from RORO's influence

 
 Source: RBC, Bloomberg

However, that is where the good news for currency managers stops.

Cole suggests treating the fall in correlation with caution, especially since G10 interest rates and growth expectations, previously key currency drivers, are converging rather than diverging.

"Until this changes, the risk is that the equity neutral window in FX snaps shut again," he says.

Indeed, this is the fourth time that correlations between FX and equities have appeared to be breaking down since the financial crisis, and on each prior occasion the trend rapidly reversed.

Cole also notes that virtually all the currency pairs that are showing a correlation with equities have USD or JPY on one side. Equally, the only USD or JPY spot rate uncorrelated with equities is USDJPY.

"Put simply, recent price action implies that USD or JPY are the market’s choice safe havens and all other G10 currencies are equally risky," he says.

However, there is one glimmer of hope for those looking for an end to RORO: the tendency for correlations to be self-fulfilling.

The longer that cross-asset correlations persist, the greater the tendency for investors to use them, either by treating relative price movements as an arbitrage trade or by using FX as a proxy hedge for the asset price movements it seems to follow.

"The more the correlations get used, the more entrenched they become," says Cole.

"But this process, hopefully, should also work in reverse, and as correlations start to weaken, the process should become self-sustaining, which should at least work to moderate cross-asset correlations going forward."