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Simon Derrick, one of the best known commentators on the foreign exchange market answered FT.com readers’ questions on the forces behind recent movement in the world’s currency markets.
As head of currency research at Bank of New York Mellon, Mr Derrick’s views and insights are widely read and listened to. He is probably most well known for correctly forecasting to the month China’s historic change of currency policy in 2005.
What effect do you think the collapse of Northern Rock in the UK will have on the GBP/EUR exchange rate? Do you think the pound is likely to weaken substantially against the euro in the coming months?
Simon Derrick: EUR/GBP is moving back into the kind of trading environment that characterised the early years of this decade with sharp pikes higher in volatility and increasing downward pressure on GBP. The most obvious cause for this would appear to be the differing outlooks for monetary policy in the eurozone and the UK.
From Europe the message continues to that in the short term the ECB will do what it can to provide liquidity to the market. However, as was made very clear last week, in the longer run the central bank continues to believe that policy remains accommodative. As a result the futures markets are implying that by the summer of next year the ECB’s official rate will still stand at least at 4 per cent (with the small possibility that it may have been hiked by then).
In contrast, events in the UK over the past four days have seen investors becoming ever more pessimistic about the outlook for the housing market, the economy as a whole and monetary policy. As a result the futures markets are forecasting at least one rate cut by the BOE by the summer of next year. As for the timing of such a move, it seems that expectations on the timing of any move are being brought forward very quickly. This expectation is also built into the two-year interest rate spread between GBP and the EUR which continues to narrow at a rapid rate (from 113bp last Thursday to 91 bp today).
The net result of all this has been that EUR/GBP has not only now broken out of the narrowing range that had defined trading since 2003 but is also accelerating rapidly. Indeed, last week’s move was the largest weekly rally since November of 2005. I think this is just the start.
The latest economic data suggests that a Japanese interest rates hike is not in the horizon. Persistent inflationary pressures will prevent the NZ central bank from cutting the official rate well into 2008. Why do you think carry trades have been cut so dramatically and what is the link between a credit crunch and a lighter appetite for carry trades?
Marco Nordio, Sao Paulo, Brasil
Simon Derrick: I would agree that there seems little chance of a move by the BOJ at any time soon. Equally, rates are likely to remain high for some time to come. Why then should carry trades have unwound so violently?
I think that the simple answer comes down to the fact that institutional investors (particularly the more leveraged players) are running more than one type of risk at any one time. The carry trade was, after all, being used for exactly the same reasons that investors were showing an increased interest in different debt instruments: to obtain a higher yield.
An investor that may have taken a sharp hit in an illiquid instrument in one part of his portfolio may therefore find himself needing to reduce risk elsewhere. It is also important to remember that investors didn’t need to limit there use of the yen as a funding currency to simply buying higher yielding currencies. It is perfectly possible that it could have been used to fund investments in more exotic instruments. Much as in past events of this kind (the third quarter of 1998 most obviously) the key message that comes back is that all too often seemingly unconnected trading strategies have an undisclosed link. The answer usually comes down to who was doing the investing.
While the Fed fund’s futures are now implying three full cuts by the end of the year, what would be the price target for the dollar against euro and yen? Will there be significant downside in the exchange rate considering expected decline in interest rate and US paper demand.
Aman Jain, India
Simon Derrick: The interesting thing about this quite how much monetary easing is already being factored in by the financial markets. With a 60 per cent-ish chance being given for a 50 basis point cut by the FOMC tomorrow, and more down the line, it seems to me that there is substantial risk for disappointment.
Interestingly, this was roughly how things played out in 1998 as well. After Alan Greenspan signalled a rate cut in early September of that year, equity markets recovered. However, when the FOMC only cut by 25bp the impact was like a bucket of cold water for investor sentiment. The final blow-out came in early October with a catastrophic collapse in dollar/yen. Subsequent to this, the Fed made an intra-meeting cut of a further 25 bp and then cut again in November. However, what was interesting to note was that the early October peak of the crisis also marked the point that the dollar finally began to recover against currencies such as the pound. Indeed, over the next nine months it managed to fall by 11 per cent against the dollar in pretty much a straight line.
In other words, if we are, to an extent, echoing the events of 1998, then I’m not convinced that this is totally a dollar negative.
Should one be buying dollars or do you feel the US currency will still weaken? If so how much more do you think it will weaken against the major currencies?
Yasmin Adamali, Kenya
Simon Derrick: I remain ambivalent about the USD. I certainly do believe that the USD will come under renewed pressure against the yen in the coming year. Our official forecasts for dollar/yen twelve months out are for it to hit Y108 at least. However, I also believe that a number of other currencies may actually be even more overvalued than the dollar.
Most importantly, I think that sterling looks increasingly exposed to a sharp pullback. With the likelihood growing that we will see rate cuts in the UK next year, a decline in support from carry trade activity anyway and a history of precipitous declines from the $2.00 area, I can easily imagine sterling falling hard against a wide range of currencies.
Is there still mileage in carry trades and shorting the yen in particular
Mio Sylvester, London
Simon Derrick: It is true that some of the yield pick ups available are still very attractive. However, for a trade like this to work you need a funding currency (i.e. the yen) that is stable to depreciating and a low volatility environment.
Trends such as this tend to be self reinforcing. When the yen was weakening through the second quarter of this year, every temporary rally that emerged saw fresh sellers emerging which, in turn, dampened the volatility even further. Unfortunately, the opposite is likely to remain the case for some while yet.
Although there was clearly a substantial clear out of positions in August, there remains the risk that some less leveraged players may still have short yen positions that they wish to close out. Remember that the BIS estimated that there were over $1000bn worth of yen loans outstanding during the first quarter of this year.
Most importantly though, I think the real question here is whether the current period of heightened risk aversion is close to over. The most likely answer to that is no.
If you were personally sitting on an excess of USD and believed that the liquidity and credit crunch issues were to prevail for some time, the stock markets will take another hit and stay down for several years, the US will fall into recession and the carry trade will further unwind - in which currencies would you build positions to protect purchasing power? Would you include the Yuan as an option with good appreciating prospects against USD, euro and GBP and if so what is the best way to gain exposure? Do you view gold as a global currency?
Simon Derrick: Let me first say that I broadly agree with your assessment of the risks ahead. The question is therefore what to hold in the circumstances. If we assume that the speculative froth is now being knocked off the currency markets and that what, for want of a better term, the fundamentals will prevail for several years then what currencies will outperform?
Putting aside previous yield driven favourites such as GBP or NZD or currencies such as the EUR that have benefited over the past five years from FX reserve diversification, I think there is only one obvious choice and that is to buy into Asian currencies. It is here that the frequently talked about ”global imbalances” really exist. If the yen stops serving as a funding currency for carry trades (which seems likely given recent events) then it is likely to start being driven by the more fundamental issues of trade. There are very good reasons why Mr Trichet keeps pointedly highlighting the performance of Asian currencies.
Would I buy gold? Until the recently the answer would have been no. However, now that it is reverting to its more traditional role as a safe-haven in times of trouble then the answer would be yes.
What is your forecast for the euro/dollar in the next three months?
Can the euro overshoot 1.40? Don’t you think that a rate cut by the Fed will improve the US economy and the dollar, while a strong euro will harm European economy?
Paul Khouri, Beirut, Lebanon
Simon Derrick: My forecast is, if anything, for the euro/dollar to go nowhere fast. On the one hand we have the ECB’s commendable insistence upon remaining focused upon the inflation threat. However, I suspect that a number of factors will offset this.
Firstly, although President Sarkozy remains somewhat out of favour at present, I can’t help feeling that he might suddenly find some political support for his views should the $1.40 level be breached, It is already noticeable that at least one employer’s body is complaining about the single currencies current strength.
Secondly, I also suspect that the process of FX reserve diversification that has driven the euro to its current levels may slow down as hot money flows into some emerging markets subside. Although it might mean nothing, I also note that some European government bond spreads have been widening out of late. Could this be another sign that official investors are becoming more cautious about the single currency?
What would be the most intelligent way for an individual investor to profit from the currency markets?
Michael Jenkins, Phoenix, AZ
Simon Derrick: The first thing to do would be to have an appropriate understanding of the risks involved. One of the most unnerving aspects of the currency markets until recently was the rise in popularity of the carry trade not just in the professional market but also amongst private investors. As I noted below, this is, by definition, a high risk trade given how volatile the currency markets can prove to be. I was therefore surprised to see articles being written during the summer (not in the FT I hasten to add) telling private investors how the trade worked and how to get involved. Subsequent events proved how dangerous a trade this can be.
The second thing to realise is that there is no failsafe way of consistently forecasting how currencies will perform that I am aware of. If there were then I would have retired a long time ago. However, this is not to say that there aren’t consistent approaches that you can take to capture trends when they emerge. There is plenty of literature out there on the use of technical rules to get you into and out of trends.
Thirdly, as long as you leave the appropriate stop losses, try not to screen watch. Set your targets, stick by your rules and try not to get caught up in the minute by minute fluctuations in a currencies fortunes.
Why is the New Zealand dollar lagging so far behind other currencies? Will it catch up with other foreign currencies like the Australian dollar on the back of resumption of the carry trade due to a weaker yen and weaker US dollar?
Paul Lee, Hong Kong
Simon Derrick: The New Zealand dollar really has had an appalling time of late, losing just under a quarter of its value against the Japanese currency in the space of just 18 trading days in July and August. However, its also worth remembering that these losses came at the end of an equally remarkable rally that had seen the Kiwi effectively double in value over a seven year period and had prompted the RBNZ to take the controversial decision to intervene in the markets during the summer. Even after the declines the currency is still trading around the kinds of levels seen in the first quarter of this year.
All of this goes to reflect two basic points. The first is that the New Zealand dollar was one of the most popular target currencies for the carry trade on the back of its huge interest rate differential over the Yen. The second point is that, relative to say sterling, the Kiwi can be a little more illiquid at times. The combination of these two factors goes a long way towards explaining both the extent of the rally and the subsequent severity of the declines.
Will the New Zealand dollar regain its favoured currency status in the near future? For choice I would have to say no. Although the yield differential still looks compelling, the markets have had a forceful reminder that the carry trade is a high risk proposition. With no sign of any imminent easing of tensions in financial markets generally, I suspect that investors will steer clear of this kind of trade for some while yet.
Some people are making projections that the US will fall into a recession, or at least find itself not being spend as much due to a de-leveraging effect the credit turmoil may have on US consumer spending. Because of this, are you bullish on the Yen and expecting the carry to unwind?
Tariq Ali, Texas
Simon Derrick: Given that the carry trade has been one of the defining trades for the currency markets in the past few years, this is possibly the key question at present. As the carry trade is, inherently, a high risk strategy, one of the basic conditions needed to make it work is that the markets need to be calm if investors are to feel comfortable chasing yield differentials.
A 610 basis point interest rate pick up for holding the Australian dollar and borrowing in yen for twelve months looks considerably less attractive when it is remembered that the Australian unit lost substantially more than this on just one day alone last month. When confidence in this type of trade is lost, it typically takes a number of years to recover. After the collapse of a very similar trend in October 1998 it took over two years for a sustained recovery to emerge.
Given that we are currently in the process of winding up a currency market bubble of substantially greater magnitude than that seen in 1998, it seems reasonable to suppose that the yen still has some way to appreciate.
What’s your view on euro replacing the dollar as the reserve currency? What events would trigger this move?
Chiunta Chen, London
Simon Derrick: This remains a hot topic of conversation in the markets with even Mr Greenspan commenting that its ”absolutely conceivable that the EUR will replace the USD as reserve currency, or will be traded as an equally important reserve currency.”
The key point here is that the euro already represents a substantial proportion of FX reserves globally. Although no exact numbers exist, it is generally assumed that the euro comprises a little over a quarter of official holdings. However, what is also interesting to note is that there has been little sign of this ratio changing dramatically in recent years.
In other words, although there is plenty of evidence to suggest that substantial amounts of euros have been purchased by reserve managers, it seems likely that this was done to diversify the fresh reserves being accumulated rather than anything else.
Can I imagine some of the “smaller” players deciding to diversify more actively into the EUR? Given the headlines over the past twelve months the answer is yes. Can I imagine the largest players (China most obviously) doing the same thing? No. Given the sheer scale of their FX reserves ($ 1.33 trillion and counting) even the slightest hint that they were to start selling some of their existing holdings of dollars for the euro would cause self defeating market turbulence and a potential political storm. Its also hard to imagine in the short term at least, reserve managers being prepared to start aggressively diversifying into the euro when the greenback is already trading close to an all time low.
Could the euro ultimately take on equal status to the dollar? Yes, it is possible but I suspect that it may take a long time to get there.