Currency managers put faith in volatility

After a period of calm, caused by historically low interest rates, expanding central bank balance sheets and a decline in corporate hedging, there is a growing sense that the animal spirits in the currency markets may soon reawaken.

In focus are the Japanese yen, which has fallen sharply since October, and sterling, the world's worst-performing major currency this year. Sterling has declined against the euro from €1.24 per pound on the first day of 2013 to about €1.15 at the beginning of March. This 7.5% swing represents more volatility than during the whole of 2012.

Moves in the yen have come before and after the election of new prime minister in Japan, Shinzo Abe, in December 2012. Mr Abe vowed to boost inflation in the moribund Japanese economy, raising speculation the Bank of Japan will look to weaken the currency after it appreciated by more than 30% against the dollar in four years. Volatility against the dollar is up to 12%, from 7% in August, as the currency declined 15%.

Still waters

Renewed price instability is in stark contrast to 2012, when trading ranges were near or at their lowest levels in decades. One-year implied volatility on the euro to US dollar hovered at about 15% at the beginning of 2012, but fell to less than 10% by the end of the year, a decline reflected across most major currency pairs. One-month volatility on a basket of leading currencies was 30% in 2009, but 7% at the end of last year, according to Bloomberg data.

Low volatility meant currency pairs remained in ranges. The euro started 2012 at about $1.30 and ended it at $1.32, a period of inactivity interrupted only briefly at the height of concerns over the eurozone sovereign debt crisis.

Not surprisingly, few currency managers will remember the past year with much affection. The Parker FX Index, which tracks the reported and risk-adjusted returns of 49 global currency managers, shows reported returns of -1.06%  in the year to the end of January net of fees, and risk-adjusted returns of -0.45%.

“In some senses, whatever you did in 2011 and 2012 you were trading the euro, because with such a high correlation between currencies it was the same trade again and again,” says Daniel Brehon, vice-president of foreign exchange (FX) strategy at Deutsche Bank. “Now those correlations are breaking down, which means if you have five conviction trades you have a good chance of at least three working out.”

Four cores

Currency managers traditionally split trading strategies into four core areas, which are carry (or forward rate bias, the tendency of markets to over-estimate changes in exchange rates), momentum, fundamental value and volatility, and those strategies explained nearly 76% of average annual excess returns generated by currency managers from 2001 to the end of 2006, according to a 2008 study by Richard Levich, a New York University professor of finance, and FX manager Momtchil Pojarliev.

Carry and momentum trades provided steady returns of between 7% and 8% over a near 20-year period from 1989 to 2009, according to Deutsche Bank data. Carry comprises selling or borrowing in low-interest-rate currencies and buying currencies of countries with higher rates. Momentum consists of going long (or short) currencies for which long positions have yielded positive (negative) returns in the recent past.

Momentum has been very difficult, says Deutsche Bank’s Mr Brehon, with a weakening trend in the euro, for example, persistently interrupted by central bank policy statements and manic reverses of sentiment. “You could be short but not have large positions because some finance minister may say something which could mean you lose 150 basis points on one headline. You could end up being most short on the bottom, then be pushed out of the trade and then least short when the downtrend resumed," he says.

Correlations break down

London-based Record Currency Management runs a combination of carry, momentum, value and emerging market strategies, using a systematic approach based on periodic reweighting. In risk terms it regards carry and emerging markets as 'risk-on' strategies and value and momentum as risk neutral. The fund has moved cautiously to higher levels of risk in the recent period, after winning in emerging markets and losing in momentum strategies last year.

“Carry and emerging markets have middling to high correlation with risk assets such as equities, which means they offer more attractive returns but can be prone to bigger drawdowns,” says Record’s chief executive officer, James Wood-Collins. “We are cautiously overweight risk premia but with a fair amount of caution taking into account the macro backdrop.”

A strong buy signal on a particular currency is generated when it produces pronounced signals across strategies, Mr Wood-Collins says. For example, Japan’s low interest rates and falling currency point to short positions in carry and momentum strategies, while the yen is also the natural short leg on an a emerging market currency pair. A long on a similar multi-signal basis may be the New Zealand dollar.

Central to currency managers’ potential for generating returns this year is that the world continues to move away from high levels of correlation and so called 'risk-on/risk-off', to idiosyncratic moves sparked by local events.

“A good example of the change is the Canadian dollar,” says Deutsche’s Mr Brehon. “Last year it was highly correlated to equities, on the basis that Canada would benefit by improved economic conditions in the US, which would be reflected in share prices. Now that correlation has broken down, and that is reflected across a lot of currencies. In short, the market is no longer contingent on QE3 [quantitative easing]. There are other things going on in individual countries.”

Dollar strength

One of those other things is the US dollar, which seems to be losing its long-standing inverse relationship with equities. The dollar rises as equities fall in a risk-on/risk-off environment, and vice versa, as investors move back and forth between risky assets and safe havens such as dollar-denominated US treasuries.

That change, alongside expectations of faster growth in the US compared with Europe, has prompted a slew of analysts to predict further rises in the dollar in the year ahead.

One firm looking to take advantage of idiosyncratic news flow is London-based macro strategy fund Harmonic Capital, which focuses on non-core markets, such as Brazil, Chile, Turkey and Israel. "It’s all about being positioned when a move happens and you can’t tell when it will happen so you need to be equally allocated across the board," says the firm's investment partner, Patrik Safvenblad. "We are in a post-currency war environment, and not all countries are in the same situation. For example, Brazil cut rates last year even when the economy was still growing strongly, while Turkey said it would welcome a higher lira."

The reappearance of diverse policies and economic conditions is helping currency managers attract money back into the asset class, according to Mr Safvenblad. “By focusing on non-core markets we have performed well, but for the industry as a whole it has been a tricky couple of years,” he says. “Now we are seeing money coming in from various sources.”

Option strategies

One product area that is seeing increased interest after the recent uptick in volatility is currency options, and traders are recommending strategies based on volatility breaking its 90-day trading range amid stronger currency moves.

“Volatility tends to cluster; if last week was volatile there is a strong likelihood that this week will be similar,” says David Rodríguez, a quantitative strategist at DailyFX, the research arm of FX broker FXCM. “We expect that strong moves may continue through the foreseeable future until we have concrete signs of market calm.”

Still, volatility remains inexpensive compared to previous periods, according to Mr Rodríguez. At-the-money three-month implied volatility on dollar/sterling was 8.75% in early March. That compares with 5.25% in December, but is still less than the 14% seen in 2010. “For currency managers the big moves we have seen in volatility in January and February are good news,” says Mr Rodríguez. “People are happy how the year has started, because 2012 was ugly.”

Prime broker model

With the currency markets offering signs of life, currency managers are also in the midst of a broader secular change in the way they operate, and an increasingly important area of business is the provision of hedging solutions to asset managers investing in other asset classes – for example, a European pension fund buying US equities.

Hedging can either be passive, mirroring the exposure in the underlying, or dynamic, which is thought of more as an investment product because the hedge is put on or taken off depending on whether the exposure is making or losing money. “The tough times we have seen in currency trading have led to a marked change in attitudes to pure investing, and in fact the majority of our business is hedging now,” says Record’s Mr Wood-Collins.

Another key area of change for managers is in their relationship with banks. The traditional model for managers would be to maintain relationships with a bank panel, and to trade FX on the back of credit lines extended by individual institutions. However, as banks come under pressure from the impact of legislation under Basel III, they are increasingly constrained as to how they can use their own balance sheets to service clients. One of the results has been a higher demand for relationships based on prime brokerage models.

“The big trend we are seeing now is a move away from bilateral relationships to prime brokerage,” says Andy Woolmer, a partner at currency manager P/E Global. “It makes a lot of sense now [for clients of currency managers such as pension funds] to have one bank with which you centralise your currency exposure, which may give you access to 18 or 20 FX prices and all of the services around that.”

One of the key drivers for adopting a prime brokerage model is that banks have become more commercial, and are increasingly willing to accept securities as collateral rather than cash. They may also ringfence those assets in the client’s favour, waive initial margins on forward contracts or be more flexible around variation margins.

“Prime brokerage has been growing in popularity, particularly for our larger clients, and Record is spending more time negotiating those prime brokerage account arrangements for them,” says Record’s Mr Wood-Collins. “The key for us is to make sure our clients have the best choice between bilateral trading and trading through a prime broker.”

Prime brokerage arrangements usually work better for larger clients because of the relatively high cost of set up, fees and collateral administration. “For larger clients it is often the case that the benefits of having positions in our favour fully collateralised outweigh the concentration of credit risk that accumulates through the prime brokerage mechanism,” says Mr Wood-Collins.

Rising platforms

Another area of increased focus for currency managers is dealer platforms such as Morgan Stanley’s FX Gateway and Citi’s CitiFX Access, launched in 2011 to try to take market share from Deutsche Bank’s dominant dbSelect offering. The platforms bring together institutional investors and currency managers based on criteria such as investment style, indexes and performance volatility.

Morgan Stanley's platform directs investors to a hand-picked group of managers, while Citi provides swaps and structured solutions based on multi-strategy benchmarks and actively managed indexes licensed from industry index sponsors.

The platforms are a win-win for banks and managers, with the former collecting fees and offering add-ons such as clearing and structuring, and managers attracting new business.

“The role of banks is changing in the FX landscape,” says Mr Wood-Collins. “Before they were counterparties, buying and selling, whereas now they have become intermediaries, and have multiple roles. It is very much a game that is still playing out, but at the moment it is a positive for both banks and currency managers.”