Correlation breakdown heralds bull market for currency investing

By:
Peter Garnham
Published on:

The muted reaction in the FX market to the rise in equity prices underlines the shift away from the risk-on/risk-off (RORO) trade and the breakdown in currency correlation seen in recent weeks.

As the Dow Jones Industrial Average hit its highest level since October 2007, nearly a year before the financial crisis came to a head and prompted the collapse of Lehman Brothers, so EURUSD failed to gain any topside momentum.

Under the RORO trading regime that had dominated the FX markets since the start of the financial markets, such price action would have been unthinkable. Elevated optimism among investors would have pushed perceived risky currencies, such as the euro and Australian dollar, higher and weighed on demand for perceived havens, such as the dollar and the yen.

Now, however, with FX correlation dropping to its lowest levels since before the financial crisis, there is little uniformity in the reaction of currencies to swings in risk appetite.

Indeed, increased optimism that the worst of the financial crisis is over has seen FX correlation fall and allowed currencies to shrug off RORO and return to their previous pattern of trading – with carry, valuation and momentum returning to the fore.

Deutsche Bank runs models capturing different investment strategies in G10 FX and has a return history going back to the late 1970s.

It says its models suggest that carry, valuation and momentum returns have already returned to long-term average profitability.

The only laggard, Deutsche says, is its monetary policy-based model, which trades currencies on movements in short-end interest rates.

George Saravelos, FX strategist at Deutsche, says with more than half of G10 FX yields pinned close to zero, this makes sense.

“But central bank policy is looking increasingly divergent, and we think Fed re-pricing is likely to prove materially supportive of the dollar as soon as this year,” he says.

“So the outlook for FX investing based on monetary policy signals is also looking good.”

Saravelos says the models – which in the case of carry, for example, simply buy the top three yielding currencies and sell the bottom three yielding currencies – provide a useful cross-check to the bank’s own in-house views.

 Deutsche Bank FX models top currency basket

 

He says the models and the bank’s bottom-up analysis are well-aligned, with the models most negative on the yen, sterling, Swiss franc and Canadian dollar, on which Deutsche is bearish. The models are long of the New Zealand dollar, the Scandies and the dollar. That basket of currencies has returned 7% so far this year.

“We’d stick with this trend, because we think this year marks the beginning of a bull market for currency investing, where both model-based and discretionary FX analysis will provide profitable returns,” says Saravelos.

Such a rosy view of the prospects for the FX market, and its success in throwing off the shackles of the RORO trade, might well be expected from a sell-side bank.

The question, of course, is whether the FX market really has turned the corner away from RORO, or whether the past few months have been just a brief hiatus for currency managers seeking to extract return from the world’s largest financial market.

Consider that the main driving force of the rise in equity markets has been the so-called great rotation away from bonds into stocks.

With bond yields at ultra-low levels, the scope for further gains in bond prices is limited. And with investor appetite for low-yielding bonds falling, in a near zero-rate world, stocks are the natural alternative for investors.

However, Simon Smith, chief economist at FxPro, says there are signs the rally in stocks is becoming detached from the realities of the global economy.

He says even though the pace of positive economic data surprises has fallen, equities have continued to do well, ignoring the change in data dynamics.

If equities wake up to the underlying fundamentals and correct sharply lower from current levels, the likelihood is that FX correlation and the RORO trade will re-assert itself, according to Smith.

“Keep an eye on stocks, because if they do start to turn, risk dynamics will return, which would mean a stronger dollar against pretty much everything, with the yen not far behind,” he says.

Currency managers will be hoping that the world’s equity markets stay in denial.