Risky Business
VOLATILITY IN THE FOREIGN EXCHANGE MARKET HAS SPIKED, LEAVING INVESTORS AT A CROSSROADS. MICHAEL HOARE LOOKS AT WHETHER THEY SHOULD HUNT FOR OPPORTUNITIES OR SEEK SAFETY
The will-they-or-won’t-they guessing game on interest-rate hikes has ushered in the type of volatility in foreign exchange markets that has seldom been seen this year. While that’s good news for currency traders watching the market and making moves by the nanosecond, it’s potentially bad news for your portfolio. Earlier this year, the JP Morgan G7 Volatility Index fell to its lowest level in two years. The index, which tracks fluctuations in the world’s major currencies, was becalmed. However, in September, the bank’s foreign-exchange strategist John Normand declared volatility was back, although at a level below what professionals may consider “healthy”.
David Kohl, head of currency research at Julius Baer in Frankfurt, agrees with this analysis. “After a period that I would describe as being very quiet, where there’s been no one trading, we’re now starting to get to the stage when we see opportunities begin to appear,” he says. A Swiss-based private bank, Julius Baer has branches in more than 25 countries and regions including Hong Kong as well as a representative office in mainland China.
Kohl says the recent spike in forex activity and volume of transactions has come as a “consensus call” has emerged on the US dollar. Mixed economic data has fashioned a divergence in monetary policy, which in turn has created an imbalance in markets. The dollar has appreciated by more than 5 per cent against major currencies so far this year.
Safety first
Teck Leng Tan is a forex analyst at the UBS Chief Investment Office’s Wealth Management section. He is keeping an eye out for December’s guidance from the United States Federal Reserve. In that bulletin, he expects the central bank’s chairwoman Janet Yellen to offer a clearer vision for the winding down of America’s loose monetary policy regime, otherwise known as quantitative easing. “Clearer guidance of the Fed’s rate hike timing is likely to reinforce our house view for a broadly stronger US dollar,” he says.
About US$5 trillion in currency trades flow around the globe each day, in a non-stop ballet of bid and ask that moves at lightning speed. Investors like the system for its efficiency
and relative transparency, and there is that vast pool of liquidity to tap – some of which will evaporate as interest rates climb.
With both the Federal Reserve and the Bank of England “visibly shifting away” from the policies that have flooded markets with billions of dollars and kept interest rates low, Tan sees the US dollar and British pound appreciating in the next three to six months.
“We expect these two central banks to raise policy rates earlier than other major central banks, which points to further gains in these currencies, especially versus the Euro and Swiss franc,” he says.
UBS forecasts that Britain will hike interest rates this November. In America, rates are likely to rise sometime in the middle of next year.
Tripping point
One of the speed humps to sustained growth is the mainland’s economic health. In late September, the Goldman Sachs Group joined the prevailing consensus among the investment houses that economic growth over the border will continue declining in the next two years.
It has forecast 7.16 per cent growth next year – down from a prior estimate of 7.6 per cent – that will shrink to about 6.7 percent in 2016. Likewise, UBS expects growth in gross domestic product to shrink next year. It has forecast GDP growth of 6.8 per cent.
The slowdown’s effect will be most sharply experienced by the mainland’s biggest suppliers of commodities, particularly Australia and Indonesia.
A report published in September by Roubini Global Economics, the research house set up by Nouriel Roubini – a man known for his bearish forecasts – sees the Australian dollar sliding by about 20 per cent against the US dollar.
While mainland China’s growth slowdown has Australian miners seeing red, there are other currency pitfalls to be wary of, looming just beyond the horizon.
Avoid euro, yen?
With the Eurozone countries returning consistently disappointing economic growth data, there is an ongoing argument there for a greater slackening of monetary policy. And the situation is similar in Japan, where GDP collapsed in the second quarter. The annualised contraction for Japan’s economy was 7.1 per cent – the fastest pace since 2009. The third most traded currency, the yen, has reacted accordingly, flagging against the US dollar.
“Economies in the Eurozone and in Japan are losing momentum, and there is a bias for further monetary easing,” says Tan. “We’d advise avoiding the euro and yen, as further quantitative easing will negatively affect the value of these currencies.” Avoid the Swiss franc too, he says.
But Kohl points out that poor economic data tends to be a “short-term driver of currency exchange rates”. Over a longer time frame of six to 12 months, holding the yen or the euro might be a sound strategy. “These currencies will not be affected by the data coming up next month, not now, not next week but in exactly the next six to 12 months,” he says.
Of course, where there’s risk, there’s reward, especially for investors with an eye to holding Asian currencies through to next year. If you have the stomach for risk, the Philippine peso and Indian rupee offer potentially attractive returns, according to Tan.
“While these currencies are less liquid, which explains their higher volatility, we believe an ongoing tightening cycle by the Philippines central bank (Bangko Sentral ng Pilipinas) should translate into a moderate appreciation of the peso,” says Tan.
Also worth a look is the “fragile five” favourite – India. The rupee is a favourite for currency carry trades, where investors sell short one currency to take a position in another denomination yielding a higher interest rate. When leveraged, these deals can have tremendous payoffs. In the rupee’s case, UBS predicts a high-yield carry of between 6 per cent and 7 per cent.