“Special FX”: Forex Themes as 2009 Draws to a Close

Our last article focused on the widespread impact of change engineered by ongoing challenges to conventional wisdom and considered various trading styles that have subsequently evolved due to increased volatility and price turbulence within FX markets.
Not much has altered since although it’s fair to say markets have calmed down somewhat as players mull financial and behavorial effects to date on business conditions. With a degree of stability returning, players are turning their attention toward the debate on future expectations for FX market conditions, for example attempting to understand the increasinglly elevated status of and need for non-deliverable forward contracts and potential deregulation of ‘minor‘ currency markets as the currency world slowly, perhaps ironically, evolves.

Why ironically? Because FX is one of the faster-moving asset classes as far as execution, yet anecdotal evidence shows that even inevitability is always resisted (at least initially) by the human element; despite the advancement of technology, human resources is still the major component of influence in the world of currency trading and therefore can cause devlopments to move more slowly and more randomly than might otherwise be expected. For example, how many textbook traders would have expected the USD to remain so relatively steady during a bout of Quantitative Easing (QE), or simply put, printing money? The human factor cannot be underestimated because psychology must definitely have played a role in determining the USD’s floating market value, defying the odds against almost inevitalble devaluation. Players are buying USD even though algo systems and modelers may have specified QEto be a key component of a ‘sell‘ strategy.

Nevertheless, technological improvements are continuously underway and the topic of FX markets facing fresh regulatory issues in the U.S. and Europe may also have impacted recent psychology. This holds true despite obvious potential efficiency improvements that would be attainable in certain instances if people pushed beyond the limits human comfort zones. That‘s an issue not faced by the robots, black-box models or dark pools, which are emotionless and all about the price at a given point in time rather than what the price might be after an event.

The fanfare and buzz that continues to surround the asset class of Forex has been accompanied by reminders through observations and analysis that although entry into the Forex market perhaps rightly generates a great deal of excitement, developing and executing an FX plan efficiently is of far more importance than the speed of its completion. This theme is highlighted by the growing phenomenon of managed accounts and the boom in retail FX volumes, where significant non-correlated returns can be achieved—and not necessarily with leverage. The prospect of ‘easy money‘ is a common but potentially misleading theme in this market space, and it is worthwhile to consider professional advice before deciding to bet the farm on where the markets might be heading.

We think these emotional and psychlogical sides of trading FX are worthy of mention, and in an attempt to expand dialog with our readership we would like to know more about your respective thought processes, encouraging related questions and opinions that we’ll enjoy using and debating in subsequent articles with intent to continually spread awareness of prevailing market factors and dynamics. What does Forex really mean to our readership and how can we expand upon truly relevant issues?
On the subject of change, our research indicates that many companies and individuals are merely scratching the surface and may not yet be at an advanced stage of recognition or cognisence when it comes to analysis of actual and latent portfolio risks, being more in the camp of general unawareness regarding the advantages to be gained via better management of FX exposure. Indeed, many professional traders see opportunity where peripheral players see risk, and the opposite is also true; in either case, money is being left on the table.

For example, available enhancements such as transparency or price discovery are sometimes not introduced or not used quickly enough, and this affects a multitude of factors that range from simply getting a speculative deal done at the best rate to generating or reducing FX exposure for a business reason and even opening a retail or managed account in order to participate in the market from a P&L standpoint.
The phenomenon of liquidity ‘dark pools‘ is a growing topic of discussion, and apparently participation, within the institutional FX space. The simplest definition of an FX dark pool is an electronic arena with liquidity supplied from a multitude of sources (banks, hedge funds, sovereign wealth funds, etc.), usually via Prime Brokers, that provides participants with anonymity—thus ‘dark’ because the order books do not provide depth of market in price, direction or size. Their purpose is to enable execution of large trades without overtly or negatively impacting the market. The privacy angle is highly valued by leveraged institutions and has been enjoyed successfully for some time in equity and fixed income markets.

Recent developments in credit markets provide a good example of how dark pools may be used in FX: an entity forced to liquidate positions and therefore push the market adversely if discovered may use a dark pool and preserve its valuable proprietary information, potentially saving itself millions on large trades in the process. A growing recognition that FX can provide valuable ’Alpha’ as other asset classes wane means that many entities are now using these tried and trusted tactics to generate revenue in FX, particularly because a dark pool circumvents the need to trade on an exchange or an ECN (Electronic Communication Network) where orders with bid/ask and volume data are published.

Institutions still allude to the fact that underhedging is preferred to overhedging— in other words, erring on the side of leaving some aspects of benchmarking to chance. ‘Price discovery‘ is, surprisingly, still a relatively unknown or unpopular term for many FX participants, even as we approach the second decade of this millennium. Of all governing factors in FX, these aspects are likely to change very soon and very rapidly, not least because the infrastructure already exists to get around these issues. Live Forex prices are available from a multitude of providers, and the threat of future regulation will cause users to source pricing from more than one source. Entities that are seriously involved and eager to learn what the Forex market has to offer them in the way of meaningful improvements in facilitating business—improvements that happen to result in potential for greater profits—are raising awareness regarding what may be available in the currently unregulated Forex markets, finding pleasant surprises along the way with professional guidance.

On a macro level, although the FX market has seen a decline from the estimated daily volume of around $3 trillion per day of 2008 by around 17% year-on-year to an estimated $2.5 trillion per day currently, there is still plenty of action, volatility and opportunity to consider when placing an FX trade. Some of this action has resulted in a new wave of enthusiasts for the carry trade, for the first time ever featuring the once-mighty USD as the funding currency.

We talked previously about the carry trade (buying a currency with a high interest rate and selling a currency with a low interest rate) and how it can be lucrative on the one hand but also end in tears for those players that are too highly leveraged or too late to pick up on the trend, entering just as the smart money exits.

One of the most interesting discussions taking place right now is the recent trend of a declining USD and the question of the sustainability of this move. If it does continue we will see the USD used widely as a funding currency to enable profits in other currencies as they outperform the greenback on a relative value basis.

We previously projected a more bullish currency environment for LatAm currencies versus market expectations, and based on recent performances by commodity-based currencies such as the Australian and New Zealand Dollars we see no reason to change this view anytime soon.

In particular among more established and liquidly traded markets the Aussie has benefited most from recent negative sentiment against the US unit due to the interest rate environment and the perpetual (albeit reduced) demand for its commodities and associated infrastructure by Asia, in particular China. This theme may continue with the Reserve Bank of Australia hinting that a rate rise may soon be in the cards given economic stability and significant improvements in Australian labor markets.

Economically speaking we suspect a new currency order is gradually taking shape as established markets falter and emerging markets evolve. As with any controversial or even non-mainstream theory, we expect the usual channels of progression with our views at first being met with ridicule or skepticism, followed by fear of the status quo being disrupted and finally acceptance as fundamentals come into play.

We do not have a timetable but the clues are all there, including possiibly one of the most important in regards the USD carry trade from the U.S. Federal Reserve itself, repeating again its mantra of keeping rates at extraordinarily low levels for an extended period of time.

We are not expecting a ‘lost decade‘ in the U.S. like Japan experienced, as there are many different factors at work. Japan has a shrinking population; the U.S. has a growing population. Japan had delayed policy responses; the U.S has had an unbelievably quick, meaningful and sustained response. Japan relies on exports to maintain its economic power, but as we all know the U.S. could arguably become largely self-sufficient at some future point if it managed to curb its enthusiasm for consumer spending and dependence on fossil fuels. The 2020 program supported by the current Administration is certainly suggestive of intent to reduce the energy footprint of the U.S., the effects of which would be a long way off but ultimately bullish for the USD.

It may indeed take several years for the U.S. to work its way from the present debt-laden situation and labor force decimation. If the recent decline of the USD Index (DXY) is anything to go by, the next few years will see reserve asset divesification gather momentum, and we will no doubt see the economic baton of power passed to other regions while the repair job goes on, at least from a standpoint of foreign currencies gaining in value as a more stable store of value than the USD. Perhaps one reason the Dollar has not fallen dramatically is due to China’s reported $1.3 trillion of USD-denominated assets and a global realization that there really is no true alternative just yet—try paying for your new home, vehicle or groceries with a gold bar—and when the cost of carry and insurance is calculated on holding gold as opposed to currency, this somewhat fuzzy logic begins to make some sense.

So although the USD with zero interest rates enables the Dollar to become the carry trade currency, we are mindful that this vehicle is not always the best means with which to express a view should the trade become crowded. That said, for now and for reasons stated we stick by our previous estimations for a lower USD in the near-term.

With a generally bearish USD outlook, our earlier projections for an appreciation in LatAm currencies are in good shape. It is generally advantageous to place a trailing stop-loss on all positions to ensure a satisfactory exit level should maket sentiment suddenly reverse, although any such danger or signal will most likely manifest itself against the major currencies, at least initially.
Q4 is always volatile in FX, and prices can move quickly in either direction, but for now we will stick with a general view of rising LatAm currencies over the foreseeable future.

Kevin Sollitt gained international FX trading experience in various financial centers including London, New York, Los Angeles, Sydney, Hong Kong & Tokyo. Kevin’s career began in London during the 1980s, later transferring to Sydney. In the mid 1990s he returned to London under the challenging financial conditions of that era, experience that equipped him to successfully deal with more recent turbulent market conditions. In 1998, Kevin teamed with former colleagues at a super-regional bank in the U.S.A. and through strategic alliances, development of professional relationships & continuous positive trading results, became Head of Foreign Exchange Trading in 2006.
www.alternativelatininvestor.com

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