Special Report:

Hopes for a return to fundamentals

Uncertainty about the single currency and a lack of volatility are keeping business slow, says Alice Ross

© Øivind Hovland

The foreign exchange market is having another difficult year. Volumes have fallen across the market, and volatility has hit its lowest level in five years. Many hedge funds have given up trying to profit from the euro and have moved into rates or equity markets instead.

Yet returns on currency investing are looking more positive this year, as investors wise up and work out how to make money in an environment of global central bank easing and dwindling interest rate differentials.

Investors and traders alike are hoping that the eurozone crisis will no longer dominate the foreign exchange market in the next few months, offering some respite to investors who have been foxed by the so-called “risk on, risk off” (ro-ro) effect that has made it hard to buy or sell currencies based on economic fundamentals.

“Forex has been a very difficult asset class this year because of the variables at play,” says Peter Taylor, managing director in forex trading at Barclays. “We’ve moved away from a lot of the normal drivers of forex – such as interest rate differentials – and moved into the realm of politics. It’s added to the uncertainty of the environment when you could have such big sentiment swings on comments from eurozone ministers.”

Trade in the forex market was particularly subdued over the summer as investors waited for central bankers in both the US and Europe to give markets some direction. August was a particularly quiet month as currency markets waited for the European Central Bank to outline its plans to buy government bonds in September, and the US Federal Reserve to decide whether it would announce further monetary easing.

“It’s a tiring market – a lot of people took the summer off, especially the buyside community,” says Fred Boillereau, head of foreign exchange at HSBC.

Yet returns in the currency market are showing some signs of improvement. A Parker index of currency managers shows that currency funds lost more than 6 per cent last year on average. Many of these losses came from investors trying to short the euro in the belief the single currency was bound to fall further, a trade that frequently went wrong as the euro stayed stubbornly strong.

This year, investors have shied away from trying to trade the single currency. Currency funds have made nearly 1 per cent on average in the year to date, but the trading environment remains difficult.

“It’s a mess out there in general in currency markets,” says Stephen Jen, founder of macro hedge fund SLJ Macro Partners.

“I’m concerned that, with the global economy having decelerated so much and QE3, the tensions are higher than any time I remember this year.”

In the end, the move by the US Federal Reserve to conduct more monetary easing in September did not spark a clear move in the forex market. Some had expected the dollar to weaken and risk appetite to soar. But that has not materialised because of concerns about limp global economic growth. That has left large currency pairs such as the euro-dollar yet again trapped in a range, which is frustrating investors.

“The last two years were about identifying volatility spikes. Now, volatility is lower and ranges are tighter, which a lot of investors have difficulty coping with. They have to maintain much shorter time horizons,” says John Normand, head of foreign exchange strategy at JPMorgan.

And investment banks are now in a race to stay competitive. While bigger banks including Deutsche Bank and HSBC say their volumes have increased this year, volumes across the industry have fallen. Daily forex volumes on the ICAP-owned EBS platform fell to their lowest-ever September levels this year, while August volumes were on a par with the traditionally quietest month of December.

Clive Ponsonby, a trader at JPMorgan, estimates that market-wide volumes have fallen 20 to 25 per cent in the past year. That is having implications for banks’ pricing in forex.

“Spreads have compressed massively in the past six months. The market response to falling volumes is to compete even harder. People are trying to cut costs,” says Mr Boillereau.

And Deutsche Bank, currently the largest trader of forex in the market, says that its volume growth has come mainly from companies rather than investors this year.

“For investors, the lower volatility hasn’t made it the most exciting year for the forex market,” says Kevin Rodgers, head of forex trading at Deutsche Bank.

“What the speculative side needs is a story and a trend, and we haven’t really seen that this year. Some of the major pairs have been pretty quiescent.”

While investors believe they are facing fewer tail risks thanks to central bank interventions, that comes at a cost. Volatility has fallen as major currencies have been trading in a range against each other, offering fewer opportunities for investors to place so-called momentum trades.

Many argue that the ECB has helped to reduce the ultimate tail risk: the prospect of nations leaving the eurozone. By promising to do “whatever it takes” to save the euro and introducing a plan to buy government bonds when sovereign states request aid, Mario Draghi, the ECB president, has created what traders call the “Draghi put”, reducing the likelihood of further steep falls for the euro.

“The Draghi plan has taken the extreme scenario risk off the table,” says Mr Rodgers. “Central banks across the world have been intervening to stabilise the currency markets, so we’re not seeing the massive swings we saw in 2011,” he adds.

The Draghi put has also helped shift focus from the eurozone on to other areas.

“Currency markets are becoming more multipolar among the eurozone, China and the US, and European shocks will be less acute,” says Mr Normand.

Traders are hoping that a shift in focus could lessen the ro-ro effect and enable them to focus on fundamental drivers in the forex market – such as interest rates and economic growth – once more.

“The biggest criticism you get from clients is that there’s only one trade: ro-ro. They would like to see more diversity,” says Steven Saywell, global head of forex strategy at BNP Paribas.

But some currency investors believe the ro-ro effect is starting to fade. Harmonic Capital, the London-based macro fund with nearly $1bn under management, has returned nearly 23 per cent to investors this year. The hedge fund has stuck mainly to trading emerging market currencies against each other, rather than trying to place bets among the major pairs, with central bank easing in the US, the UK, Japan and the eurozone reducing interest rate differentials and volatility.

Patrik Safvenblad, a partner in the firm, says that while major currencies have been stable or unpredictable, emerging market currencies have been responding more to fundamental drivers such as interest rates or economic growth prospects.

Many investors and traders see the US fiscal cliff, with a range of spending cuts and tax increases scheduled to come into effect in January, as the next big event risk. If that is satisfactorily resolved, the market is hoping that forex will finally be able to return to fundamentals.

Copyright The Financial Times Limited 2016. All rights reserved. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web.

More on this topic

Suggestions below based on Foreign Exchange