Like the Ancient Mariner dying of thirst on his ship despite being surrounded by water, investors today are taunted by a cruel paradox. Years of cheap money and quantitative easing mean there has never been so much money sloshing around the system looking for a home. The problem, as with the mariner's salty water, is that this money is increasingly difficult to digest.
Investors are caught between two contrasting imperatives. They are desperately seeking yield, but also facing an environment where many economies are suffering from anaemic growth and high debt.
Markets are also being driven more by a series of crises than by fundamentals, making them highly unpredictable. Managing money in such an environment starts to look less like investing and more like gambling – not generally something investors like to think they are paying their managers to do.
Andreas Konig, head of FX at Pioneer Investments, says the market has become increasingly barren of clear investment themes in recent years. “In the last two years we had some clear trades, for example around monetary policy divergence, which favoured USD/JPY and USD/EUR," he says. "But those trades are not working any more. Opportunities are scattered; there are no central themes to trade around."
This leaves fund managers with a problem. Investors have targets to hit and – after a difficult first half of the year and with summer months traditionally quiet – many might be starting to feel under severe pressure to generate returns.
“Investors have to take risk; they have to show their clients they can generate returns," says Konig. "Rightly or wrongly, central bank liquidity is feeding the perception that there will always be a backstop.”
The result is an environment of prolonged, and arguably reckless, risk taking, punctuated by intermittent periods of risk aversion. It also ensures that few market trends last, making it harder for fund managers to profit from them.
“We're in a market where trends barely last for days, let alone weeks," says Konig. "The constant and rapid change in the market is the key problem for trading FX at the moment."
Neil Staines, head of trading and execution at ECU Group, a currency-focused investment and advisory firm, says that the conviction trade is very difficult at the moment. "The market is very concentrated and liquidity is poor – that lends itself better to short-term trades, even if you are playing a long-term theme," he says.
The problem has been exacerbated by a series of shocks. Some, such as Brexit, were a long time in the making, giving traders time to prepare. James Wood-Collins, CEO at Record Currency Management, says: “Preparing for the referendum vote was largely about anticipating elevated volatility and increased transaction costs, so for example rolling forward positions outside of a 20-day window either side of the result being announced.”
But other events, such as terrorist attacks in France and an attempted coup in Turkey, defy preparation.
What about sterling?
One market trend that has emerged, and has lasted for longer than a few days, is the bearish view on sterling that prevails among many traders, although Konig says the level of consensus has convinced him to step away for now.
“Sterling is more at the lower end of its recent range, and sentiment and positioning is so one-sided on the currency at the moment that we have closed out our short GBP positions temporarily,” he says.
But Staines believes sterling might surprise on the upside. Recent talk of monetary and fiscal relaxation should weigh on the currency after its relief rally, but in the medium term could prove very positive for the UK, and for sterling, he says. “We are not bearish GBP and envisage a return to economic and currency outperformance as soon as Q4, once deferred investment and consumption are put back into the economy.”
In particular, Staines expects sterling to strengthen against the euro. “The summer looks set to be difficult for the eurozone,” he says. “There is the Italian banking crisis, and we expect its cyclical bounce to start to tail off, which will see growth slow. It's made absolutely no progress in its structural reforms. There is also the matter of sanctions on Portugal and Spain for missing their deficit targets. So the political and economic backdrop is not strong, and sterling could make gains against the euro in coming months.”
Traders are also watching Japan, where there is much anticipation ahead of a Bank of Japan meeting on July 29. Konig says: “I think we could see a move of 3% to 5% either way, depending on what it decides. If there is no action the market will be disappointed and the yen is likely to rise sharply. If it delivers a strong response then yen will likely weaken. We will make a call on that, but we have not yet decided on which side we'll be and what instrument we use.”
Staines predicts that the Bank of Japan will provide more stimulus, which, alongside the reduced volatility around Brexit, should weigh on yen. If US rates rise too, that should be positive for dollar/yen, he says.
US rates have themselves been the subject of constantly changing expectations. “The US has been seeing some good numbers, but nobody seems to expect the Fed to act and sentiment is dovish," says Konig. "But the Brexit risk seems to have faded; its impact has been local rather than global. So the Fed could turn hawkish, at which point there could be an opportunity to buy the dollar.”
But one US-based investor says the nature of dollar strength has changed “fairly dramatically” compared with last year, which is creating opportunities.
Dollar strength was previously seen against commodity-currency weakness – particularly in emerging markets – and dovishly inclined developed markets such as Japan and the eurozone. “Recently, however, dollar strength has been picking up again, but in a different pattern," adds the investor. "The pound and the euro are still drifting lower, but the yen has been strengthening."
Although emerging markets performance has been mixed, there does appear to be a broad strengthening or recovery in many places that last year experienced significant stress, for example Brazilian real and South African rand. Commodity currencies have also outperformed, the investor adds.
But the dollar's most important gains, he says, are against the renminbi. As emerging markets, including China, deleverage their dollar-denominated debts, dollar strengthening is putting pressure on the Federal Reserve, and other central banks, such as the People's Bank of China, to adopt a dovish monetary policy response. “For FX traders this implies the carry trade being back – indeed FX carry trade returns have been strong, a sharp reversal from last year,” says the investor.
Wood-Collins agrees. “A structural long exposure to emerging markets currencies has done well this year,” he says. “Diversifying on both the long and short side minimizes the risk of being caught out by US dollar strengthening, or the impact of geopolitical events like we saw in Turkey.”
|Carry trade is back on: chart via Bloomberg|