Over the past month headlines using the words ‘currency wars’ have become familiar in news about the financial markets. While most of the shots that have been fired have been verbal, particularly between the main protagonists, the US and China, unilateral actions have spanned the globe.
This has manifested itself in sales of local currency, most notably by Japan in mid-September, but also by Israel, Thailand and Indonesia. Additionally, Brazil and Thailand have implemented measures to contain capital inflows, and, to some extent, South Korea, the host of the G20 meeting last month.
Add to the mix the widening of currency bands by Singapore and Russia and the surprise 25 basis point renminbi interest rate rise by China, the US mid-term elections, the Federal Open Market Committee decision on further quantitative easing, and the G20 meeting, and you have the most confused and combustible currency background seen for years.
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This has led to a resurgence in trading volumes after they had tailed off during the middle months of the year, says Simon Jones, global head of e-trading at Citi. “Granted it was a very quiet summer… but in the first week of September things came back with a vengeance,” he says. “Volumes are now up year on year although not quite up to the peaks of the first quarter.” Weakness in the US dollar since the summer has given the market an identifiable trend after no clear direction, which for some clients must have rescued what was looking like negative or flat returns. “Since early-September the concerted moves in EUR/USD and dollar/Asia have been great trades for macro accounts,” Jones says.
While continued uncertainty surrounds the final G20 meeting, volumes should remain healthy, he says. “Spreads have been narrowing, partly because there are more banks focussed on FX this year. We’ve seen a lot of newcomers to the FX space and they have been investing heavily, which means spreads have narrowed, possibly by more than market conditions justify.”
Emerging market countries are now having to deal with big capital inflows for both cyclical and structural reasons – cyclically from recent and expected US quantitative easing but also structurally from economic growth that outstrips the west, and favourable demographics. This has resulted in big reallocation of investment portfolios.
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“The problem is that in most developing countries the government and corporate bond markets are too small – they can’t yet cope with inflows of this size” Vincent Craignou, HSBC |
Vincent Craignou, global head of FX and precious metals options at HSBC, says this is not just hot money. “This is not a fad – real money as well as hedge funds are involved in the move from G3 to emerging Asia,” he says. But the flow of capital is now inundating emerging markets. Craignou says: “The problem is that in most developing countries the government and corporate bond markets are too small – they can’t yet cope with inflows of this size.”
But they are also finding that intervention doesn’t work. Craignou continues: “In Brazil it clearly didn’t work and Korea also realizes that it can’t hold its currency, hence further capital controls – in Brazil with its IOF [the tax imposed on the purchase of fixed-income instruments by foreigners] now at 6%, in Thailand which has reintroduced withholding tax, and in Korea which is said to be considering doing the same.” With these unilateral actions and the upcoming events in November including the G20 itself “there are many loose ends in the market, a great potential for brutal, digital moves in FX, hence higher implied volatility.” Implied volatility began a strong move up at the start of September.
A further factor underpinning volatility is the one-way nature of the interest, which is leading to some decrease in liquidity – the market-maker base is finite as is the appetite to run short volatility or long dollar positions.
“Everybody is looking at the same thing, dollar weakness, and this has an impact on liquidity,” says Craignou. “There’s a dearth of participants taking the other side of the trade.”
Nothing gained
There is unanimity in the belief that the main G20 heads of state meeting will settle nothing – despite the vague intention to limit trade imbalances emerging from the G20 finance ministers and central bank governors meeting.
Craignou points out that “Brazil is doing its own thing, even sending deputies to the preliminary meeting – the G20 looks to be in disarray”. Jones is just as downbeat on the G20. “The G20 will try to show some agreement but no one can see a Plaza-type accord arising… nothing comes out of these things.” But perhaps the most caustic comment came from a global head of FX at a main player: “G20 can only agree that they disagree and they will probably argue about that too.”
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