It has been equated with flipping a coin, ridiculed by Alan Greenspan, and is universally thought to be the least successful sort of financial forecasting out there. How do currency strategists stand it?
Quite well, it seems.
“What I like about FX is although our forecasting ability is actually as bad or good – depending on your point of view – as the others, people have this preconceived idea we’re worse, so they expect less of us,” says David Bloom, head of FX strategy at HSBC. “We’d argue all markets are as unforecastable as each other.”
That’s not what Alan Greenspan said. The former chairman of the Federal Reserve, nicknamed the Maestro for his power over the markets, once told Congress: “There may be more forecasting of exchange rates, with less success, than almost any other economic variable.”
HSBC, however, went on to analyse the performance of currency forecasts against predictions for both stock markets and interest rates. Controlling – as much as was possible – for the different factors in each, it concluded that consensus FX forecasts were not a good basis on which to trade, but were no more unreliable than the others.
“In our equity sample, only 3 out of 50 had the market falling. In FX, we get it wrong, but we’re unbiased. Equity guys are biased and bad predictors. We’re just bad predictors,” says a triumphant Mr Bloom.
Currency markets are a key part of economic theory, but hands-on analysis got going only after currencies began floating freely in the 1970s. It was only in the decades since then that ever-greater numbers of companies and investors began to trade and invest across borders, and banks considered offering analysis to their clients.
Initially, analysts were economists schooled in macroeconomic theory. For currencies, this centres around relative interest-rate differentials, which should drive currencies higher or lower, depending on who has the higher interest rates.
However, over the past decade, “analysis” has largely morphed into “strategy”. Technological advances have opened the FX markets to forces such as institutional investors and hedge funds. Most still want some medium-term macroeconomic view of currencies, but increasing numbers, led by fast-moving hedge funds, want specific ideas they can trade.
“It’s all part of the service now, and can be invaluable to the investor who may have formed his own opinion of the probable direction of the market, but may lack the expertise or experience to choose the most effective trade to successfully express this view,” says Nick Beecroft, consultant to Saxo Bank.
The good news for investors is that the sheer size and depth of the market means there is an almost endless pool of potential trade ideas.
The tough part for strategists is that to have successful trade ideas, they still have to be able to call the market direction. With some $3,200bn worth of currency traded daily around the clock, that can be hard. Participants in the market range from central banks and governments through companies going about their daily business to fund managers and bank traders. None of these groups are necessarily driven by the same motivations, leaving strategists walking a tightrope between their economic training and the need to understand market fads.
“Its always alive and always different,” says Stephen Jen of BlueGold Capital Management. “You have to be street smart as well as book smart to apply the right tools at the right time because there are different drivers of the market at different times.”
Currency strategy today does not really have an agreed framework like other assets classes. Equity strategy, for example, is driven by valuations of each company.The exact models used will vary but the underlying methodology – around calculating the present value of future cash flows – stays the same.
“Bonds, commodities, stocks – they’re all like looking through a key hole. Currency market analysis is like having a picture window to look through,” says Marc Chandler, head of FX strategy at Brown Brothers Harriman in New York, who believes clients can accept wrong calls so long as the strategist has an opinion and can back it up.
“A broken watch is still right twice a day,” he says. “Most participants in FX aren’t profit-maximisers, they’re companies and fund managers who need to hedge. For them getting it right isn’t ‘buy now, sell later’, it’s about understanding the risks involved and the best tools to deal with those.”
The trials and tribulations of FX analysts are continuing. The dollar has been in a long-running downtrend since 2002 as the market has fretted about the need to finance the yawning US current account deficit.
After the collapse of Lehman Brothers in September 2008, most expected the greenback’s slide to pick up pace as investors considered its flattened financial sector and stayed away. Not so; the dollar turned into a so-called “safe haven” as US investors repatriated funds and others seemed to take the view that if the US was in deep trouble, others were in even deeper.
Since then the dollar has broken its traditional link with the US stock market and currently tends to gain whenever the market falls (implying risk aversion), and vice versa.
“This is probably [still] a conundrum for many analysts,” concedes Mr Beecroft.