Be smart to find returns in foreign exchange

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Foreign exchange markets are slowly returning to their pre-crisis state, four years after the collapse of Lehman Brothers. Although difficulties remain because of market jitters and uncertainty over central bank action, Tim Carrington, Global Head of FX at RBS, explains how investors can benefit.

Tim Carrington, Global Head of FX
The FX environment that emerged in the aftermath of the 2008 financial crisis was marked by low interest rates and high volatility, fuelled by central bank attempts to revive ailing economies and fears of further economic catastrophe. A collapse in risk appetite reduced market liquidity. Carry trades – in which investors would seek yield by profiting from the difference in interest rates between currencies and which had been dominant in the 15 years running up to the crisis – were dumped. They were too risky. Instead, traders sought to profit from volatility by trying to predict how far one currency would move against another in a set time. Now some investors are once again hunting yield as they look to generate returns above their benchmarks. Because of uncertainties surrounding the eurozone, central bank actions and nervous markets, they have had to become smarter. They have evolved from being simply yield-searchers, a strategy that worked well from 2003 to 2007, to being much more selective. Building a broader portfolio with greater exposure to emerging markets could be a winning strategy. Asia has the world’s strongest growth rates and a macro-economic story that is widely understood. The best-performing currencies in the past year include those belonging to the Philippines, Australia and New Zealand – all closely exposed to China’s robust economic growth. The Australian dollar, the best-performing currency over one-, two- and three-year 2012 horizons, has the advantage of being seen as a safe haven. The country has retained its AAA rating and this, combined with its developed market status, has made the AUD attractive to both sovereign wealth funds and central banks seeking to diversify their collective USD10 trillion-plus in FX reserves. Investors need to be aware, however, that timing is critical because the environment is not as benign as it was before the crisis. Central bank policy-making is now in the realms of the experimental, and is harder to predict in both nature and timing. The results of policies such as Quantitative Easing are not necessarily clear. Markets have also undergone a seismic shift in mentality. They expect the worst, and prices reflect this. In the pre-crisis world, a 70 basis point move in the euro/dollar rate would not have triggered panic as most investors would assume that it would end there. The attitude now is that if it can move 70 basis points, it could easily move a further 200 basis points. There are technical tools that can help. One is Bollinger bands, which can be used to measure the volatility of a linked pair of currencies, such as euro/dollar, to help determine whether they are overbought or oversold. Buying when a currency pair is oversold and selling when the bands indicate they are overbought is a common strategy which has been a successful tactic in some areas over the past year. Examples include euro/Swedish krona (EURSEK), which has made a return of nearly 20 per cent. Before the crisis, the market saw extreme points as opportunities of which to take advantage. This remains a sensible approach. But now, because the market still expects the worst, the appetite for such risk-taking has declined. Many investors have yet to fully realise that the market is shifting back to its pre-Lehman crisis trend. Which means that those prepared to be smart and bold, may benefit.

Bollinger bands

This technical indicator consists of a middle line (the exponential moving average) with an upper and lower band (plotted with a defined number of Standard deviations designed to show variations from the mean) above and below the middle line respectively. As the width of these bands varies depending on a currency pair’s volatility around the mean, they can be used to signal impending volatility increases. Band levels may indicate if a currency pair is overbought or oversold. Investors often buy a currency pair when the price closes below the lower band (indicating the currency pair is oversold) and selling when the price crosses above the upper band. 

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