Currency trading goes bipolar
So-called risk on/risk off trading has become the most powerful influence on foreign exchange. But this all-or-nothing approach known as RORO keeps currency traders guessing.
RORO is one of the great headaches of the currency trader’s existence. Short for “risk on/risk off,” RORO has been the most powerful influence on foreign exchange in the past few years. The idea: When market participants are confident in the economic outlook, they take on risk by piling into currencies like the Indonesian rupiah and the Brazilian real. When confidence ebbs or a crisis hits, they rush to shed risk, seeking safe havens like the U.S. dollar.
“It’s almost as if the market is being bipolar,” says Mark McDonald, a London-based quantitative foreign exchange strategist at HSBC Holdings. “It’s extremely hard to consider currencies without taking this force into account.” In the old days, McDonald explains, traders would try to come up with models for valuing currencies based on interest rate differentials and other macro factors. But now when risk is off, investors sell everything from Brazil to Hungary, regardless of the fundamentals.
Ilan Solot, an emerging-markets currency strategist at Brown Brothers Harriman & Co. in London, says the strategy is less about individual currencies than about perceived risk. In risk-off mode investors dump all of their riskier assets, no matter where those assets are located. That goes for equities as well as currencies, Solot says.
How to tell when risk is on or off? McDonald says every trader gauges whether investors think that things are getting better — in which case risk is on — or whether they think the financial crisis will continue. Lately, all it takes to trigger a wave of selling around the world is a report from Athens saying the prime minister is considering a referendum on budget cuts.
HSBC has a group that tracks RORO. In early January the bank’s RORO Index of 34 assets hit the highest level since its November 2010 launch. When the index surges, assets are highly correlated; investors can use that information to make a RORO trade. But lately, some new wrinkles have profoundly changed currency trading.
The biggest change, according to Jane Foley, a London-based senior currency strategist at Rabobank International: The euro — formerly a leading risk-off trade, along with the U.S. dollar, the Japanese yen and the Swiss franc — no longer counts as a safe haven. That’s because the biggest risk today may be the European debt crisis, which some fear could force a breakup of the single currency. The Swiss franc has lost its risk-off status too since the Swiss National Bank set a floor for the currency’s valuation against the euro.
Foley notes that two currencies once regarded as risk-on plays are moving into the risk-off camp. Investors had deemed the Canadian and Australian dollars to be riskier assets because they were so-called commodity currencies, with the loonie dependent on oil and the Aussie beholden to coal and other resources. But as Foley points out, the Canadian dollar is strongly correlated with the greenback and Ottawa’s budget deficit ranks among the lowest in the developed world. Australia is also in good fiscal shape. That means both currencies don’t get sold as much when investors unload riskier assets.
There are basically two ways to do a RORO trade, BBH’s Solot says. One is to stay long risk-off currencies like the U.S. and Singapore dollars. The other, a subtler trade called relative value, plays two risk-on currencies, such as the Turkish lira and the Hungarian forint, against each other. If a trader goes long the lira and short the forint, Solot says, chances are both will rise or fall by an equal amount when risk goes on or off. Consequently, it’s possible to use local fundamentals to construct a relative-value trade. For example, the Polish zloty currently offers stronger fundamentals than the forint, so long zloty–short forint qualifies as a good relative-value trade.
When making a RORO trade, Rabobank’s Foley warns, the top consideration must be a currency’s liquidity. Although the U.S. dollar suffers from lousy fundamentals such as a large current-account deficit, it has vast liquidity. “Without liquidity, you’re stuffed,” Foley says. “You can’t get out of a trade when you want to, and you may take a very large hit before you can get out.”
As the euro zone crisis worsens, Foley is looking to a long U.S. dollar position to keep her in the black. “When things get intense, liquidity is probably the most important factor,” she says.