After carry, RORO and tapering lose their allure, FX trading strategies are a-changing

Simon Watkins
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From the carry candidates, the diminished safe havens, and the new negative balance-of-payments club, FX trading strategies are navigating a differentiated and complex global landscape.

For at least 10 years up to the collapse of Lehman Brothers in 2008, the carry model proved time and again to be an optimal way to minimize risk and maximize returns in FX trading, and still provided a solid funding basis for the following five years of dealing based on the risk on/risk off paradigm, later refined with what can be called the talk of tapering variant. Now, though, as the US Federal Reserve has begun the tapering of quantitative easing, economic growth across key developed markets appears to be picking up, and the previous prospect of an enduring zero (or near zero) interest rate policy across other global growth drivers has diminished, future trading strategies are likely to take a much more nuanced approach of a number of tactics applied together.

“The mistake has been to look for a single model that can be applied across the board, as it simply does not exist anymore,” says David Bloom, global head of FX research for HSBC in London. “Instead, the global currency market is made up of three broad groupings, somewhat interlinked, but with distinct behaviours and drivers. These are: the carry candidates, the diminished safe havens, and the balance-of-payments club.”

In this brave new FX world, then, in which economic weakness and deflation have been replaced as the main fundamental drivers of strategy by optimism over recovery prospects, and the corollary effect on interest rates and thus currency directions, the dynamics of the carry trade are shifting, highlights Marc Chandler, global head of currency strategy for Brown Brothers Harriman in New York.

Predicated, of course, on the interplay of three key factors: wide interest rate differentials (between the currency being sold to fund a higher-yielding currency), stable interest rates on both sides, and low currency volatility on the first leg of the trade, Chandler underlines that there are many more funding opportunities in the main traded currencies now, according to where you go on the temporal curve, than there were even last year.

A good example of this is shown in the movement of the GBPUSD spot price compared with expectations for interest rate differentials between the UK and the US up to the end of 2015 (see chart below). This clearly highlights that the cable rate has begun to track the expectations for interest differentials increasingly as the year has progressed, and the UK’s economic recovery (and adjunct fears of a housing market bubble) has looked as if it might prompt an earlier rates rise than in the US.

As a corollary of this, though, says Jane Foley, senior FX strategist for Rabobank in London, the accepted wisdom of what constitutes a safe-haven currency has markedly changed in recent months, and continues to shift seismically on occasion; within these realignments the real money lies.

In broad terms, the most risk-on assets remain equities (the S&P500 is the most risk-on asset currently, replacing the FTSE100 from two years ago), with Asia and Latin America swapping places as the most risky of emerging markets over that time, and US 10-year government bonds generally occupying the least risky position on the correlations matrix.

In purely FX terms, though, says Foley, the Swiss franc remains a safe haven of choice for many, despite the imposition of a floor in the EURCHF rate of 1.20 Swiss francs per euro, and boosted instead in its role as a funding currency by Swiss National Bank president Thomas Jordan’s reiterations that the SNB will maintain the band for its benchmark interest rate at 0% to 0.25%.

The other former funding safe-haven standby, the yen, though, Foley adds, looks a less clear prospect, given the potential for volatility arising from a policy perspective. Although likely to weaken further over time, a good thing from the funding side, there remain questions over the effect that the imposition of consumption tax hikes will have on prime minister Shinzo Abe’s grand plan of targeting 2% inflation and a 3% nominal GDP rate (there has been no nominal GDP rise for 15 years), and over the extremely high sovereign debt and a concentration of government bond risk in the banking system. 

Indeed, according to the IMF’s Global Financial Stability Report (Update), October 2012, these latter two factors are as characteristic of Japan as they were of the eurozone sovereigns that required massive EU/IMF/European Central Bank bailouts.

The last of the broad-based strategies currently in favour – balance-of-payments positions – is more applicable to the emerging markets than to the developed ones, highlights Bloom, given their relative position on the risk curve, but the point of differentiating the potential winners from losers is how a country achieves its balance of payments, with a particular eye on the current account.

In this respect, he says, currencies of countries with current-account surpluses, and consequently not reliant on external financing (thus reducing their sensitivity to the vagaries of the reduction in the quantity of money being provided by the Fed) are favoured broadly.

Having said all this, acting as a brake on wild profit-and-loss swings in recent months has been an awareness that the world’s central banks have dramatically changed their modus operandi to target not just currency instability, interventions solely in which are always fruitless over time, but also broader issues that ultimately affect FX rates, such as levels of employment, growth, and inflation.

This, says Chandler, has meant that a broadly successful general strategy has been mean-reversion trading, particularly that based on volatility, not FX pair levels per se. “Non-directional term-structure volatility strategies geared towards reversion to the mean have provided sound returns in this new central bank managed FX environment,” he says.

However, concludes Thomas Stolper, chief currency analyst for Goldman Sachs in London, although mean-reversion forces would advocate that currencies rarely stay at extreme levels for long periods of time, fundamental drivers such as inflation make a continuation of the trend likely. “Among the extreme currencies with genuine mean-reversion potential, we find the Korean won and the Norwegian krone,” he says.