FX debate (part one of two): Currency markets in a post credit crisis world
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FX debate (part one of two): Currency markets in a post credit crisis world

Volatility in FX has increased because of the credit crisis but not as much as some expected. Inflation will bring more pressure and central banks face a dilemma.

FX debate (part two): Towards a golden age for foreign exchange

Euromoney February 2008

Delegate biographies: Learn more about the panelists

Emerging markets are driving investor behaviour but talk of the dollar’s demise is premature.

Executive summary

• Volatility in the FX markets has increased following the credit crisis but not as much as might be expected

• Volatility might become more intense as inflation (or, less likely, deflation) kicks in

• Central banks are caught in a dilemma about inflationary/deflationary expectations

• The continuing buoyancy of emerging markets has changed the rules of the game in FX markets

• FX risk management models have held up well compared with other markets as has the market infrastructure

SB, Euromoney How has the FX market responded to the unfolding credit crisis? RB, Investec Well, initially volatility spiked to extraordinarily high levels. The dust has settled but volatility is still on average 50% higher than it was in May. Many of the arguments people previously used to explain why volatility was so low still hold, yet the world seems a very different place and right now the biggest question for FX is whether we stay in this moderate to high vol environment.

PL, Polar Capital I’m actually amazed how little has happened in response to the sub-prime issue. Yes, volatility has increased by 50% but from multi-year low levels. Bank stocks have clearly suffered but lots of sectors are close to their high. Even the historically risky currencies, such as Turkey, Brazil or Poland, are pretty close to their highs too. In the bond market, the Fed may have slashed rates by 50 basis points in immediate response to the crisis [and then another 25] but it wasn’t so long ago that central banks adjusted rates in general by 50bp. Maybe I’ve just been doing this for too long, but I’ve been struck by the level of stability so far and not the level of volatility.

DB, HSBC The FX market is interpreting the market turmoil as a purely dollar problem but other markets aren’t necessarily interpreting it that way. If, for example, there is negative news on bank stocks in Europe, people sell the dollar and buy the euro. So we won’t see significant volatility as long as this is regarded as a purely dollar problem.

PL, Polar Capital But how much has the dollar moved in trade-weighted terms since August? Not very much. People get excited when the trade-weighted dollar falls by 3% in a month. Not so long ago trade-weighted dollar could move by 10% in fairly regular market conditions. The world is awash with liquidity, and that won’t change until people become properly concerned about inflation.

DB, HSBC The more you worry about a particular inflation problem, the better that currency does. I think the big move is still to come, some of this clear-out is much more than just a pure dollar sell-off, and when that move happens we will get the high volatility that Richard mentioned.

XP, FX Concepts Isn’t the danger that we’re all faced with deflation? If there is any kind of inflationary forces won’t we all sigh with relief?

PL, Polar Capital I think it’s more difficult to make a case for deflation now than it was three or four years ago, because some of the places that were generating the deflation don’t seem to be doing so now. Maybe we’ll see a further shift in the global supply curve and it will come back – but just in terms of the last couple of years – those places are suffering their own inflation now.

DB, HSBC Well, isn’t inflation also an exchange rate issue? If countries are reluctant to move their exchange rates, as far as the market’s concerned they’ve got an inappropriate exchange rate. So when inflation rises, it erodes competitiveness, and in that way you get a move in the real exchange rate. So despite nominal exchange rates not moving, inflation forces a move in the real exchange rate.

EP, UBS I think the mostly benign FX volatility we’ve seen thus far in response to the credit crisis may not be a great predictor of what we could see over the next six to 12 months. I’ll be interested to see how the current market structure, which has developed during a period of relative stability, will respond if steady state volatility rises to 11% or 13% from the 5% to 7% that has prevailed until recently.

VD, Bank of America One state that has changed is the behaviour of implied volatility, especially the change in skew for a given change in spot. This has added a new dimension and was especially extreme in the yen. In August, one-year 25 delta risk reversals traded over 7%. This was more than 50% of the at-the-money vol. This was unheard of. It was even worrying some of the central banks.

SB, Euromoney And how are central banks coping?

CK-G, Société Générale I think that the central banks perceive they are stuck with a situation of two potential "fat tails" in their outlooks and they have to decide which of these fat tails is the clear winner. On one hand they perceive they may have economic weakness, and on the other, they also believe they may have potential inflation concerns. For the ECB currently, this is clearly a tougher dilemma than it is for the Fed. The ECB is likely to be on hold for the foreseeable future but the Fed can clearly cut, though whether they can cut by as much as is now priced into the marketplace is another matter. For the Bank of England, they probably find themselves in a situation somewhere in between the two above – similarities in the state of the housing markets probably being the key and allowing some slight easing. It’s a tough balancing act. If the Fed over-adjusts because the economy is weak, then they risk their inflation-fighting credibility. If they don’t adjust enough, it exaggerates the existing problems in the US mortgage market and the economy weakens further. Ironically, until recently anyway, both scenarios have been seen as dollar bearish by the marketplace. The current extended currency valuations, or year-end may change this but it certainly explains the price action.

MF, Principal Global Investors The central banks have realized that, by creating stability, they’ve created a different problem. When you have low volatility and stability, the market will take incremental levels of leverage that they otherwise wouldn’t in a normal business cycle. Until volatility is described as normal rather than bad, the central banks will continue to be on the downside of fat tails. August should have scared the hell out of everyone in FX, because this wasn’t a balance-of-payments-driven crisis. It was in credit, in someone else’s asset class, and those guys got absolutely decimated and they haven’t recovered yet. If it had been in equities, the Fed wouldn’t have come to the rescue as quickly as it did. We were saved because of other asset classes’ close proximity to the Fed’s mandate.

CK-G, Société Générale What consequences would you expect to see in the market if you get this readjustment?

MF, Principal Global Investors Every asset class will probably have a risk event over the next 18 months and we’ll end up with an incremental deleveraging across every aspect of the financial market and the economy commensurate with normal levels of volatility. And this isn’t a crisis. This is FX vol going from 8% back to 11% and the VIX index going from 12 back to 21, and inflation cycles going back to 3%+ and a negative consumer price index print. So normal business cycles, normal inflation cycles, normal volatility cycles. We will then have to find the optimal leverage on corporate balance sheets commensurate with that environment, and that will be the new equilibrium.

DB, HSBC You could argue that emerging markets have changed the rules. G10 central banks and emerging market central banks have behaved totally differently. Look at Japan post-war. Emerging markets can live with 6% inflation and grow at 6% and it doesn’t matter, as long as inflation isn’t accelerating. We’re not growing in the west and so we need to put money in these emerging markets as a long-term structural future, and therefore we can look through some of the cyclical problems. I feel that that has made the market change the rules.

A forward leap

MF, Principal Global Investors Nothing has changed the emerging markets cyclically. You can argue that we’re in a structural leap forward but that’s going to have a definitive end. Everybody is investing and everybody’s behaviour is being patterned now on what’s taking place in the emerging markets. They’re deluded if they believe this is cyclically the effect the emerging markets are going to have on the world. Emerging markets haven’t changed anything other than the fact that they’re all growing at the moment and that they’re running current account surpluses in general.

CK-G, Société Générale I tend to agree with your point but the dilemma is trying to find the catalyst that triggers this event that you speak of. I think the positive factors causing people to invest in these markets now have changed dramatically from a decade ago. External balances, for example, are very good now. We have a bull market in commodities. We have consistency and sustainability of GDP in these markets. With the exception perhaps of China, and the Middle East pegs – and these may be good things – we tend to have more open economies in emerging markets, and clearer legal frameworks and investment structures, and that has created a sense of security that you can invest in emerging markets "safely". The issue that concerns me is whether we get a liquidity withdrawal here, as we have seen in other markets, driven by a "get me out" mentality, or funding issues. It’s a weight-of-money argument. And that’s always the tough one to call a halt to.

PL, Polar Capital The weight-of-money argument is a demographic argument. It’s clear that the G10 countries are not going to be able to finance their pensions with their own demographics. So people have figured out that the place to find the returns on capital is in the emerging markets where there’s all this labour without any capital. You shift the capital onto them, they get high capital productivity gains and everything’s fine. One problem with getting from A to B is the way that the emerging markets have chosen to conduct their monetary policy, not just in China but also in India and the rest of emerging Asia, and even Brazil to a lesser extent. Fix the exchange rate, allow productivity to rise and take market share. But that’s not sustainable when you’re bringing a billion people into the market. A dollar bloc is fine while everybody’s benefiting, as they were when you were exporting deflation. A deleveraging of the consumer in the US, and a rise in unemployment there, will quickly become politically unacceptable. There will be a proper rise in protectionism if you start to see an acceleration in unemployment in the US, and at that point there will be a change in monetary policy which really matters, outside the G7. These other exchange rates will be forced to change. There will be liquidity boosting inside the G10, and liquidity contracting outside the G10, because the G10’s politically forcing that to happen. So there could be a messy scenario between A and B, but we want to finance our pensions so we have to get to B. Next year we’ve got elections in the US. Unemployment is starting to rise. There’s already deleveraging in the US. The banking system isn’t operating properly in the US. There could be big bumps in the world economy this time next year.

DB, HSBC I’d argue that the US is becoming more competitive. In the G10, when food and energy prices rise, they represent only a small weighting in the CPI basket and therefore do not lead to wage inflation. In the emerging markets, food and energy is a bigger proportion of their CPI basket and this could cause a wage-price spiral. So emerging markets could face inflation concerns while the G10 countries do not, and that would make the dollar more competitive against those countries. So inflation rather than the nominal exchange rate is a tool for rebalancing.

MF, Principal Global Investors China, Russia and South Africa can use inflation because they’re in a structural growth spurt where you can accept a bit of inflation because you can grow out of it. But that’s only possible because you have inflation expectations anchored at such a low level globally. Without that backdrop we would be punishing every minor infraction on the inflation front in emerging markets. But because of the possibly irrational fear of deflation and because inflation expectations are well anchored in the developed world, emerging market authorities are able to test the waters as they like with no consequences at the moment. But in Indonesia, for example, where they let inflation get out of control and then had to tighten aggressively to crush the economy, the rupiah did not get rewarded until inflation started to come down. China is messing with this at the moment, and the rest of the world should be concerned. If they let the inflation genie out of the bottle in China it will affect everyone else on the board line.

DB, HSBC Japan provides an important lesson for all emerging markets and one they will be keen to learn from. Post-war, Japan had high inflation, high growth. This worked very well for them for 35 years. It is the way the expansion ended that lessons have been learnt and these are unlikely to be repeated.

SB, Euromoney Are investors in FX still bullish on the carry trade?

EP, UBS It still feels like a carry trade bull market. A great deal of trust is being placed in central banks, which successfully neutralized previous crises. It appears the historical pattern of a crisis-induced rate cut, followed by a moderate market response, followed by an additional rate cut, is beginning to unfold.

Poisonous scenario

DB, HSBC The carry trade seems to have changed its form into just a sell dollar scenario. People aren’t just using yen financing to buy high-yielders, they’re simply selling the dollar. I think it probably would have been better to sell the dollar against Canada in 2007 than against Aussie or New Zealand, yet Canada doesn’t have the yield of either Australia and New Zealand. So that’s why I’m questioning whether this is just a poisonous dollar scenario which just looks like a straight line decline in the dollar and nothing to do with the carry. The US has not completely decoupled from the rest of the world and, as such, we will find out this is not a pure dollar problem. This will put other currencies under pressure and not just the dollar.

VD, Bank of America Our institutional clients that focus on emerging markets continue to see growing assets under management, and this money needs to be put to work. When that inflows stop we will need to be concerned. However, some of this inflow is outflow from the previous hot asset classes, including credit.

SB, Euromoney It seems clear that in credit, the models have failed. What about your risk management models in FX?

CK-G, Société Générale The challenge in credit has basically been that a relatively small group of securities, sub-prime mortgages, packaged in structures so as to obtain the highest ratings categories, have then not behaved in a way consistent with the original ratings granted by the ratings agencies.

Fortunately, within FX, no single risk model dominates in the way that ratings dominate credit, so there is no broad model that can disappoint in the same way and cause systemic problems. That’s why, in general, I think risk management models in FX have held up well. The risks were more basic: would the dollar go up, or down and what would happen to volatility ? In theory, with an economic event in the US itself – sub-prime spurring US rate cuts – and with volatility going up in every other asset class at the same time, the answers to both these issues ought to have been reasonably predictable, risk management model or not.

That aside, the most common approach to risk-modelling in FX is still value-at-risk management. And since 1996, when VAR models were first enshrined within the BIS framework, both academics and practical experience have shown that following VAR can cause herding. That is, the process of measuring and managing risk can actually exaggerate the potential risks and cause people to do the same things at the same time – just look at dollar/yen in 1998 as an illustration. Fortunately, further sophistication in modelling and developments in exotic derivatives has helped damp volatility in general and meant that in August we had much smaller moves than might have been expected. It sounds a lot to say that volatility increased by 50%, but 50% of nothing is not a lot unless you are hugely leveraged.

JS, Deutsche Bank And on the option side, how we were risk managing in 1998 is different to how we’re risk managing it now. In 1998, the absolute level of volatility rose significantly and liquidity in the market dried up much worse than it did this time. That was driven by the large number of positions that were short volatility. However, this time the skew was different and the value of butterflies went up dramatically. Spreads are much tighter than they were nine years ago, putting a premium on pricing model accuracy. If one’s risk management of second order is poor the losers could be large this time. Specifically, you need to know what’s going to happen to volatility as spot moves.

PL, Polar Capital It wasn’t so much that dollar yen moved by X big figures and the vol smile did whatever the vol smile did. What was interesting was that on the same day Asian stock markets fell by 10%, on the same day that the S&P went up by 1%, on the same day that dollar yen moved down by 5%. That was where the market’s illiquidity was more obvious, rather than in the individual move in any particular instrument.

SB, Euromoney How has the infrastructure held up in the FX markets through this? How did the banks and platforms fare?

Dysfunctional markets

DB, HSBC Markets started to look dysfunctional on about August 16. There was a significant dollar/yen move on the 16th, the only time we’ve seen anything like a systemic fall. Otherwise the moves have been orderly, and because of the strong belief in the Fed, which cut the discount rates on August 17, everything calmed down.

HB, JPMorgan It was a surprisingly smooth period for us compared with 1998, when there really were enormous gaps in the market. There wasn’t a day during the August panic when we couldn’t get what we wanted done in the market. We do a combination of trading electronically and trading manually, and I was very reassured by the fact that we still had that ability to manually intervene and have the oversight. Having experienced traders was extremely valuable through that period. There were a couple of days when it really began to look quite nasty but our process is not going to react to every little twitch. We had some fairly significant volumes on a couple of days but they went through fine.

RB, Investec It was only dollar/yen vol that properly gapped at any point, and possibly dollar/Turkey on a couple of mornings, due to large asset management liquidations. With G10 spots, I’m sure every pip traded in hundreds of millions of dollars in every cross. And I’m sure the head of spot trading for a bank would probably confirm that. But there were definitely gaps in yen volatility and the way that risk reversal leapt would certainly distress any models that used it. Markets moved, but there weren’t huge gaps – seven yen in five days?

VD, Bank of America Everyone who’s been here more than 10 years has heard someone ask what big figure a certain spot price is on, but I didn’t hear that this time. I think there were big moves but they were orderly in the spot market. And I think that’s a reflection of the deepening liquidity that we’ve seen. The BIS estimates have, in recent years, seen daily turnover grow 100% to more than $3 trillion a day.

PL, Polar Capital You might not have liked the price you got, but there was always a price. But it really wasn’t that long ago that dollar markets used to move three big figures every day. That’s why most models are about 10 years old, because about once every 10 years they get taken out, and that’s why you need a blend of electronic and human trading.

SB, Euromoney And how has the changing make-up of the market affected its response to crises?

MF, Principal Global Investors The key changes have been the increases in the number of participants and in volumes. But there has not been a corresponding increase in the diversity of strategies. More and more people with larger amounts of money are doing the same thing. It isn’t very scientific, but we tend to analyse each crisis on how significant it appears to be from a fundamental perspective relative to the liquidity and the prices that we’re receiving, and I would definitely score August very low. I thought the price reflected fear on the part of the market maker, not actual liquidity in the market. FX market moves were not as big as, say, the CDOs or CDSs or the equity markets that they were citing as the sources of the crisis. And they’ve just aggressively widened out their spreads. In many cases we called up and they recommended that we deal away. We would do three or four calls to get a price. Given the size of that event, it was not very impressive. The way liquidity disappeared from a risk-taking perspective is a very negative indicator of what will come in the future.

DB, HSBC So is your argument that a lot of the rise in FX volume that we’ve seen is vanilla and some of it’s fictitious?

JS, Deutsche Bank I’d say the volume’s definitely increased. The problem we’re facing is that despite more liquidity and more client interest, those clients are trading more in a variety of different liquidity pools. Banks are extending more liquidity than ever to all these different pools, so at times of dramatic moves they get tapped for liquidity at six different pools simultaneously. So it’s counter-intuitive. We have more volume, but because we’re going through all these different pipes, it does not lead to a better scenario for banks or for clients.

MF, Principal Global Investors There is no intermediation going on. You can handle those six different platforms as long as they’re stable. As soon as they become unstable, it becomes more difficult than if you were just managing a single book with one trigger over the phone.

VD, Bank of America I agree with Mark. FX spreads in electronic trading are reflecting volatility in the market. Clients that want access to electronic liquidity discovered in August that it is not without cost and that some of the opportunistic new liquidity providers were less inclined to supply liquidity. Banks also need to manage a fair risk/reward trade-off. When the market is one way, costs go up.

MF, Principal Global Investors Once the cost goes beyond a certain level, no one wants to intermediate. That’s what’s happening in the credit market and everywhere else. Everyone’s willing to intermediate and they have the balance sheet to do it but as soon as the cost becomes too high they just switch off.

CK-G, Société Générale The marketplace in spot never stops changing. But the interesting thing to note is that while the volumes have definitely gone up, the profitability of the Street has not gone up in proportion to it and, if anything, you could argue that profitability of the Street has been pretty flat over the same period where you’ve seen spot FX volumes triple. So the disintermediation of the market through ECNs seems to be putting client A in contact with client B but not necessarily to the benefit of the bank providing the connections. It’s a volume-margin game and while one side of the equation is reported up, the revenue numbers are not as inspiring. But clearly you use your spot capability to make clients "sticky" with you in other, higher margin, products.

Human vs computer response

SB, Euromoney And what about options?

JS, Deutsche Bank Derivatives aren’t nearly as electronic as the spot price. That scenario was different because all of those moves were extremely severe in the second order. The butterflies and the risk reversals did things that had been unheard of in the last 20 years. The traders started thinking: "Let me take care of my surface first." That’s a human response, compared with the computer response on the spot side of these multiple pools of liquidity. So it was a fascinating August.

PL, Polar Capital But people took care of their surface because they knew it was important to do that, whereas in previous crises people were naive about the extent to which there were movements in the surface. In the previous crises people undervalued the wings.

CK-G, Société Générale We also have a world of different structures now as well. You didn’t do vol-of-vol 10 years ago, you didn’t have exotics. Whether it’s fixed income or foreign exchange, you now have a vanilla world coexisting with an exotics world. The vanilla world was prevalent 10 years ago. The exotics world is definitely prevalent now. And one of the features for us on the corporate and insurance side is that people are looking for yield enhancement, and those people sell vol. So you look at the implied volatility in the FX market and it seems as though there’s almost no volatility. But is that the real price of risk? Or is it just because somebody wants to try to enhance a yield?

But there’s also another story going on here. The volatility of the underlying factors affecting currency values has also been modest. Until we get volatility in the underlying variables such as trade deficits or inflation or relative inflation or interest rate differentials, we’re not going to see much volatility in the underlying currencies themselves.

EP, UBS Many new participants are successfully experimenting with market making, or showing an interest on one side of the market. Whether they’re proprietary trading shops or hedge funds, a number of participants are now behaving like market makers, but they do so opportunistically rather than with the same sort of allegiance a bank would demonstrate. Why? A bank makes markets because a client’s request for a price is an opportunity to either build a relationship or threaten it. In short, banks strive to maximize the long-run value of a relationship. In contrast the anonymous "jobbing" of electronic platforms is a new phenomenon, with participants trying to maximize short-term expected profit, rather than long-run expected relationship value. When volatility is low, as it has been in recent years, it’s not terribly risky to be a market maker. When volatility is 10% or 15% there will be a different interest in market making; it will be riskier to make a price by darting in and out of liquidity pools anonymously.

MF, Principal Global Investors That’s right. The consistent market-making capital that’s available from the banks has not grown commensurate with the growth in the volumes and the size of the real money under management. Each episode I think has revealed that, and that’s why I’m surprised people aren’t shocked, because what we experienced in August certainly wasn’t a big crisis for FX.

EP, UBS Carry is clearly a theme at the moment. However, if participants accrue significant rand, Kiwi and Turkish lira positions over the course of many months, and we then experience an exogenous shock, the rush to close positions in a short period of time could be disruptive. Overlay this with the recent trend toward opportunistic, selective market making and you have the ingredients for potentially large and disruptive market moves. We are therefore thinking more and more about stress risk in the system. This may seem strange given the low levels of market volatility we’ve seen in recent years but the world has changed in the last few months. The potential for significant gap moves is much higher and arguably increasing; I’m not at all convinced this is priced into option volatility or margin rates for collateralized clients.

Perfect example

MF, Principal Global Investors And your perfect example is the credit market. No one has come back to market-making in the structured product or the CDS market because at least half the liquidity was provided by hedge funds and opportunistic market makers, who have now left for another asset class. When we truly have our event in FX and the opportunistic market makers in all the emerging market currencies leave, what’s the pricing going to be like?

XP, FX Concepts FX itself is a safety valve. Flexible exchange rates allow these differences and contradictions in markets to regulate themselves. An "event" in FX, such as the sudden disappearance of liquidity, will widen spreads, increasing the profitability of market making again. Stress and divergence are the stuff that trends are made of. So in fact one opportunity disappears, but another appears. There’s a natural cyclicality.

MF, Principal Global Investors But you remember the peak of the dollar up-trend in 2005, standard unleveraged currency overlay managers lost 5% in that year alone because they were all maximum long dollars and the trend turned. There wasn’t a crisis. There wasn’t a war or anything. The Fed gave guidance that it was going to raise rates and that was it. And you have a P&L-driven decline that goes too far and then it overshoots, and then it overshoots further.

SB, Euromoney And what now for the dollar??

CK-G, Société Générale Well, the money market issue is still with us. That’s the problem. The OIS/Libor basis is still wide in every market going into year-end.

JS, Deutsche Bank But how much of that spoof dollar rally that occurred in the middle of the crisis was just purely technical driven by vehicles not being able to fund any more in Europe, and so had to buy dollars as a result. I think the assumption that the next shock will be dollar positive is probably 180 degrees off.

DB, HSBC I don’t agree. It’s happened. It’s happening. We’re in the bear market for the dollar. The market seems to think the answer to every single problem at the moment is to sell dollars. That’s why there is no volatility; a currency following a straight line, whether it moves up or down, as long as it just keeps going in the same direction means there is no volatility. I think that it’s going too far too fast. When it comes to capital markets there is no decoupling. This isn’t just a US problem. This is a global problem. However, because of the falling dollar, the US is becoming super-competitive in terms of its export growth. Nearly every single dollar bull has now capitulated. To me this is coming towards the end of the dollar bear market.

If we are heading for slower global growth, the defensive currency today is the US dollar. You don’t buy the dollar for growth any more. You buy it for defensive purposes. That dollar rally in early August coincided with equities falling heavily, which is an anti-growth story. So people bought dollars, but then the Fed came in on August 16 and cut rates, it turned the equity markets back up again, and hence the dollar kept falling. When we look back in history and look at the years from 1996 to 2000, the market bought the US for growth, so as equities went up and growth did well, the dollar did well. However today we buy emerging markets and Europe for growth, so as growth does well and equities do well, the dollar does badly. If you think the world’s going to be absolutely fine and equities will continue to rally, then you can stay in the dollar bear camp. But if you think there’s an ongoing problem out there, it’s going to be an anti-growth scenario. And if this happens, it becomes a pro-dollar world.

MF, Principal Global Investors The dollar bottomed in the last week of July and then rallied right up until the point the Fed cut the discount rate. So the dollar was clearly an anti-risk trade, but it wasn’t evident in every single risk position. Oil prices and commodity prices continued to go up. We couldn’t understand why. Several emerging market currencies were outperforming G10 currencies. So, as always, there was a subtle variant upon the risk trade further out, but at the very basics it was yen and dollars rallying, which was everyone’s funding currency.

EP, UBS It’s clear the commodity-linked currencies such as the Chilean peso and Canadian dollar have benefited from the abrupt rallies in copper and oil, for example. If the central banks embark on a multi-quarter rate cutting exercise, these commodity-linked currencies will likely continue to benefit disproportionately. As a result the market moves since mid-August feel like an acceleration of the commodity super-cycle inflation story.

PL, Polar Capital Bond markets have clearly rallied, but the market is still reluctant to really get too bearish. The experience of those in the market over the past five years is that you look pretty stupid, pretty quickly if you get too bearish. And I think human psychology is such that the market won’t go galloping towards a negative scenario now. It will be pulled towards it kicking and screaming by the unfolding news.

DB, HSBC But if that does happen, Paul, which way do currencies break? If it does develop into something more serious, then what happens? Does the volatility go up or do we just get a change in trend in every currency?

Avoiding the middle

PL, Polar Capital Volatility goes up in different countries and different currencies are affected to different degrees. And I’ve no doubt that the worst-performing currency in the world won’t be the dollar, but the best-performing currency won’t be the dollar either. If we take a half an hour sample period to try to prove the point, the things that performed very well today were the Swiss franc, the Brazilian real and the Turkish lira. It’s like a barbell. People were buying the really safe currencies, the really risky currencies and avoiding everything in the middle. We haven’t seen that kind of behaviour in markets for a long time.

C-G, Société Générale It’s also a case of timing. It is year end. We’ve just had a mini crisis. Balance sheets are being cut. We are at multi-year lows in the US dollar versus the majors, and at multi-year lows in the trade-weighted index for the greenback as well. So why would you want to bet big at the multi-year extreme? You don’t. You just wait and see if there’s a catalyst that will continue the move lower, in which case we are going to see a helluva a lot of further corporate hedging, or a catalyst to reverse the move. The irony is that the cost of buying options is still quite low. So I think we’re all waiting for something. If Bloomberg feel it’s newsworthy to highlight that Giselle Bündchen now doesn’t want to own any assets in US dollars, for me I might be tempted to go the reverse way now, long the greenback.

To be continued in the February edition

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