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September 20, 2012 6:17 pm
The currency runes are becoming harder to read. The latest victim of the confusion in financial markets as global growth slows and central banks intervene is the so-called proxy trade.
Proxy trades, where investors express a view on equities by buying a currency pair instead because it is cheaper than buying stocks, are becoming less and less successful, forex investors say.
The phenomenon became popular after the financial crash of 2008 caused nearly all asset classes to become highly correlated, leading to the rise of the “risk-on, risk-off” trading pattern that has since dominated markets for long periods.
But there were some benefits to the ‘roro’ trade. Currency investors started to notice that equity investors were moving into their territory to take advantage of certain currency pairs that had become highly correlated with the US stock market.
In particular, a popular strategy has been to use forex options rather than equity options to hedge an equity position, because currencies tend to be less volatile than equities, making the cost of protecting against sharp swings cheaper.
Selling the Australian dollar against the Japanese yen – for example, to hedge against a position on the US stock market – has been one of the most popular proxy trades. The Australian dollar is traditionally correlated with global equities, whereas the yen is a haven currency, which in theory falls when risk appetite rises.
But traditional proxy currencies, such as the Australian dollar, the Japanese yen, and the Swedish krona, have been behaving oddly of late.
Instead of rising or falling with global risk appetite, they have been harder to predict, responding instead to central bank interventions or demand from bond investors for higher yielding havens.
“Proxy trades are less accessible than in the past,” says Stephen Jen, founder of SLJ Macro Partners, the hedge fund. “The main reason is that global economies are decoupling so you don’t have a clear roro trade.”
The yen, for example, has gradually strengthened in recent weeks in response to Fed easing, rather than getting weaker because of higher risk appetite. Meanwhile, the Australian dollar and the Swedish krona, both traditionally correlated with global equities, also have among the highest yielding government bonds of the developing world. That has led some investors to treat them as havens, creating demand for the currencies even as global equities are falling.
While the Aussie/yen pair’s correlation with the S&P 500 is still much stronger than it was before the 2008-09 financial crisis, it has now come off its highs.
“Reserve managers actually make the proxy trades worse as when they allocate that’s completely independent of how the S&P is doing,” notes Mr Jen.
“Equity investors this year more than ever are being forced to think about what they do with their forex exposure if the correlation changes.”
Proxy trades are also possible between different currencies. Record Currency Management, the currency investor, says it has often used the euro as a proxy for exposure to the Swedish or Norwegian krone because the single currency is cheaper and more liquid. But in recent weeks, it has removed these trades because the Scandinavian currencies are trading more like havens than risk currencies.
Currency traders have also struggled to make successful proxy trades of late.
“Proxy trades have become difficult,” says Richard Usher, head of forex spot trading at JPMorgan in London. “Last year, we tried the S&P via forex and it didn’t work due to all the central bank money in the market.”
However, some say investors could be throwing in the towel on proxy trades too soon.
Stacy Williams, a quant strategist at HSBC in London, insists that any talk of the death of roro trading is a “false dawn”. He says the bank’s roro index, which measures the effect of the phenomenon on global markets, is back at “insane” levels following a brief lull over the summer.
And many investors are still trying to express equity views via the currency market. JPMorgan’s currency desk says that the vogue trade this month has been to sell the Australian dollar to profit from falling iron ore prices and the slowdown in the Chinese economy.
Other investors are still holding on to proxy trades, but are learning to trust them less than they did before.
“The danger for the proxy trade is there are many factors affecting one currency,” says James Kwok, currency investor at Amundi. “It can hurt a lot if we don’t notice correlation changes.”
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