JPMorgan states that although the G10 currency markets have not been at the centre of the financial crisis, they will inevitably be adversely affected by the fallout. However, it argues that foreign exchange has two big advantages over other markets; substantial leverage has already been removed; and as policymakers consider increased regulation it is likely that their scrutiny will not fall on FX. That might well lead to an increase in risk-taking in FX at the expense of other assets.
Although few would disagree that the latest crisis is almost unprecedented in its scale, JPMorgan points out that almost every decade has thrown up some kind of economic or financial crisis. The 1970s suffered from stagflation; the 1980s threw up the US savings and loan debacle; in the 1990s came the ERM crisis in 1992, the Asia and Russian devaluations and defaults in 1997 and 1998; and in 2000 the dotcom bubble burst. FX was a central component of some of those meltdowns and even when it was not, it was affected by subsequent changes in policy and asset allocation. Inevitably, the FX market will change as a result of the present environment and JPMorgan believes there are four key factors to consider: what leverage still remains in FX after 2008’s liquidations; will the new financial architecture extend to FX; what does lower financial sector leverage and corporate activity imply for FX liquidity; and how will this new environment affect volatility and the relevance of investment styles commonly followed in FX?
After examining these points at some length, JPMorgan concludes that there will eventually be a return to traditional asset classes in 2009, given their cheap valuations, the persistence of a low-leverage environment and the regulatory uncertainty facing a number of markets.