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Foreign Exchange

Low trading volumes no impediment to further dollar losses

The fall in the dollar since the start of the year has come amid low trading volumes and has taken many by surprise, but that does not mean it cannot continue, says JPMorgan.

The dollar’s lurch lower so far this year, sparked in part by increased optimism over global growth and also by raised hopes for a deal on Greek government debt, has been accompanied by suppressed activity in the FX market. Trading volumes on the world’s leading FX trading platforms, while up on a lacklustre December, are much weaker than usual for January.

Icap, the leading interdealer broker, for example, announced that average daily spot volumes on its EBS platform were $116 billion last month, a decline of 23% compared with January 2011. Volumes at CME Group were down 16% year on year, while Reuters recorded a 12% drop.

Generally, when investors see moves in financial markets with low volumes, they question their longevity. This is true both in equities and FX, as people are suspicious of the degree of participation in such so-called low-quality shifts.

Low volumes are particularly unusual during a dollar sell-off, says John Normand, head of FX strategy at JPMorgan.

That is because the environment that usually generates dollar depreciation – firm global growth, loose monetary policy and diminishing credit stress – generally sparks a range of cross-border capital flows from FX carry trades to equity investments.

 Dollar sell-offs are usually high volume affairs

 
 Source: JPMorgan

Normand says the low volumes reflect scepticism over the move lower in the dollar, with the main arguments against it falling in 2012 being: nothing has changed in Europe; it is too soon to call the bottom in the Chinese economy; there is risk of escalating tensions in the Middle East; and the US is courting an abrupt slowdown unless it scales back programmed fiscal tightening.

“All fair points, but also somewhat fatalistic,” he says. “Our view has been even a modest reduction in such risks would generate dollar weakness since positioning was so defensive entering the year.”

Along with low volumes, it would appear there was narrow participation in the dollar’s move lower.

In a month when the dollar experienced one of its steepest monthly declines since the collapse of Lehman Brothers, falling 2.3%, heavy participation should imply above-average returns for fund managers.

However, only one fund composite shows such outsized returns: the Parker index of currency funds, which returned 1.2% year-to-date. Another currency fund manager composite, the Barclay BTOP FX Index, shows losses year-to-date, suggesting its constituent managers are long dollars.

Normand says, in theory, a narrow illiquid market move is viewed as a warning signal, since it signifies low conviction. However, he warns it could also signify the potential for a trend, since few investors have been involved or involved in any size.

“Since the glass is always half-empty or half-full to someone, liquidity and participation aren’t sufficient to conclude much other than the fact investors are sceptical,” he says.

“Thin liquidity and narrow participation would be more worrying if they ran alongside evidence of large short dollar positions or a very cheap currency.”

In fact, the opposite holds, Normand says, since accounts are still long dollars in general and short euros specifically, and the dollar is only cheap versus the commodity currencies – by 4% to 5%.

He says if global activity data continue to hold up and if Greece commits to the austerity demands required for continued funding, then the move lower in the dollar could also continue.

“January’s low volumes and participation will be seen as dollar-bearish, since the scepticism will have been excessive,” he says.

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