Fund managers mull trades in choppy FX markets

Solomon Teague
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Volatility is back with a bang as traders seek to make sense of an uncertain global macroeconomic outlook. Fund managers lay out trading strategies drawing from CHF and CNY lessons, and one fears Japan and China are now in similar situations to Switzerland.

FX umbrella choppy-R-600

The Chinese devaluation and the astonishing volatility of equity markets over the summer has bedevilled trading strategies, with returns in most major asset classes in the red year-to-date.

Chris Morrison, head of strategy at Omni Macro Fund, which generated 5.9% returns in August, says it is important to always consider fat-tail risks.

"We don’t want to be on the wrong side of convexity if there is a peg break, as with the SNB in January, or a spike in equity market volatility," he says.

"It is important to know where the risks are in your portfolio. We have a positive skew between up months and down months, which for me is the best single statistic we have over our peers. It’s as much about what we choose not to do as what we choose to do."

The Swiss peg debacle illustrates the point, says Morrison, adding: "EURCHF was at 1.20, but if you looked at what peripheral yields were doing it didn’t look right, it looked toxic.

"We could have held a long EURCHF position and might have made some money in the short term, but we didn’t want to become entangled in it as it was too big of a risk. If you want to avoid traps you have to accept you will miss opportunities."

Morrison believes Japan and China are now in similar situations to the one Switzerland faced at the start of the year, with their central banks sustaining a substantial overvaluation.

"As the Bank of Japan keeps buying Japanese government bonds, eventually its balance sheet is going to reach 100% of GDP and it is going to have to decide if it is willing to let it go any higher. When they end the policy, what will happen?

"In China, the People’s Bank of China (PBoC) is the only seller of US dollars. When they pull that offer, there will be a big move up in USDCNY. All central banks have constraints, it’s just a question of where the limit is and can you anticipate it."

Outcomes are not clear, and neither are the reactions.
People don’t know what the PBoC is going to do
Richard Benson, Millennium Global

The question is whether such a comparison will deter investors from these markets. That looks unlikely. On the contrary, since much of the hot money has been shaken out of China, there appear to be opportunities, says Richard Benson, co head of portfolio investments at Millennium Global.

"On Tuesday morning, a number of currency pairs, such as USD/SGD and USD/KRW, which are both good proxies for the China growth story, were back at the same levels they were at the day after the China revaluation," he says.

It is a reminder that, regardless of market volatility, managers should focus on valuations.

"If valuations look extreme, we don’t want to be there – either long if the valuation is high, or short if it is low," says Omni’s Morrison. "We are not trading momentum. The valuation and the fundamentals need to be right."

For example, Omni played the oil price theme by selling CAD and buying INR, but took profits after a substantial adjustment of that exchange rate, which took the prices away from valuations it was comfortable with.

"Timing is always difficult," says Morrison. "For us, it is about keeping the fundamentals on our side, looking for the catalysts and timing it to within six months."

Still, there is a mood of caution among many investors.

Millennium’s Benson says: "Outcomes are not clear, and neither are the reactions," he says. "People don’t know what the PBoC is going to do, and they don't know what the market reaction to any PBoC action would be. So this is leading to position squaring [closing out positions], and that creates opportunities."

The number of potential pitfalls is endless, and not confined to changes in central bank policy.

Neil Staines, head of trading at ECU Group, a privately owned asset manager, says: "One risk the market does not seem to be anticipating is the potential for a sharp rise in inflation going forward in places like the US and UK, which does seem to me a reasonable possibility."