Making directional calls in the currency markets has been difficult in recent months, with obvious mispricings few and far between.
“Most currencies look close to their fair values,” says Daniel Brehon, quantitative currency strategist at Deutsche Bank.
FX investors in momentum strategies have had an especially difficult time.
“It is slim pickings in FX these days,” says Christopher Brandon, principal at Rhicon Currency Management.
Kristjan Kasikov, global head of CitiFX Quant at Citi, adds: “Fundamentals-driven traders, who are looking for the next 5% move in currencies, have struggled because the strong themes, such as being short the euro or yen and long US dollars, have not played out very well.”
Deutsche’s Brehon continues: “It’s tough for momentum traders because central banks seem intent on intervening to prevent any trends that might develop. Without the [Reserve Bank of Australia], for example, you might see parity between the Aussie and US dollar, but it has been keen to talk down the currency.
“All central banks are concerned about the potential for currency strength to derail their recovery.”
This has created a subdued, and some might argue artificial, environment, where the usual relationships between indicators – unemployment and the labour market, for example, or inflation and growth – do not seem to apply.
“There is no pressure from the real world right now,” says Brehon. “It is all just debate between the markets and the Fed. If the Fed says something and the markets react badly, it can walk back its guidance to calm things.
“If the market felt the Fed was falling behind the curve, on inflation for example, the Fed may lose control of the situation. But for now sentiment is being driven by this debate.”
Yet the spectre of market turbulence and the extreme volatility seen periodically since the crisis looms large.
“This has led to a big focus on the liquidity and quality of investments,” says Richard Skelton, associate director for structuring, FX and precious metals derivatives at HSBC. “Investors need to be sure they have ready access to their funds,” leading to an emphasis on products offering periodic or daily liquidity and early close-out costs or charges.
“As a result, investors have been seeking clear and well-designed products, and banks have put a lot of effort into designing products which meet that demand. Arguably this has led to improved quality and clarity in the structured products space, compared to pre-crisis.”
Subdued volatility has forced investors to increase their risk appetite and created favourable conditions for a tentative return of the FX carry trade. The carry to implied volatility ratio for the three highest-yielding versus the three lowest-yielding developed markets currencies remains low by historical standards, about 2.7% annualized compared with anywhere either side of around 5% pre-crisis.
However, when adjusted for the near-record low implied volatility, the carry to volatility ratio of the same currencies rises to nearly 0.5, the highest reading since 2008. Similar patterns are evident in emerging market (EM) currencies.
“This rise in risk-adjusted carry has led to renewed interest in the FX carry trade, and both plain beta and more intelligent ways of trading FX carry have been increasingly in demand with clients,” says Citi’s Kasikov.
This interest has been rewarded with attractive returns, with carry strategies among the best performing, he says. In EMs, Citi’s beta carry strategy is up nearly 4% for a 7% volatility target in 2014.
Banks’ clients want to own volatility in the G10 space, though such exposure is expensive relative to current interest rates in the leading currencies, compared with rates in 2007, says Skelton.
“This has resulted in a focus on products that cheapen long volatility strategies, whilst not having to put too much capital at risk,” he says. “We are also starting to see interest in pure volatility products such as volatility swaps.”
Locking in low rates
The low volatility environment has also given investors the opportunity to put on tail-risk hedges, with long-term portfolio protection available comparatively cheaply.
Investors, particularly those in the US, are also locking in low rates to hedge their currency exposures.
“The paradigm of the long-term weak dollar trend seems to be shifting,” says Kasikov. “Currency managers are always interested in better ways of implementing currency hedges or increasing their profitability by using systematic inputs to decide when to hedge less or more.”
Meanwhile, correlations between currencies and asset prices have fallen relative to historical norms: the correlation of weekly changes in the S&P 500 Index versus AUD/USD has fallen to just 8% in the past year, the lowest level seen for about a decade on a rolling basis. In the period between 2008 and 2012, the same correlation used to oscillate around 80%.
The HSBC RORO Index, which tracks correlations between different asset classes through a single indicator, illustrates the same trend, showing low correlations between returns across different markets and geographic regions.
This has increased the diversification benefit of investing in currencies as an asset class and increased the efficiency of currency hedging.
“During and after the credit crisis, many foreign investors with risk-correlated asset exposures and USD exposure found that holding some dollar risk in their portfolio helped reduce volatility,” says Kasikov.
“In an environment where the risk-on-risk-off trade seems to be weakening and the correlations have come down, global investors will once again start seeing more risk-reducing benefits from currency hedging.”
Ultimately, the problems being experienced by FX managers are reflected to some extent in other asset classes too, meaning there is very little escape.
“The appeal of other assets is diminishing while FX is looking more competitive,” says Brehon. “The carry to volatility ratio is good relative to other assets.”