Addressing Key Market and Event Risks
There will be a persistent threat of currency-market volatility over the next few months, especially with funds increasingly viewing currencies as a separate asset class. There will be major concerns over the US economic direction and fears that the US external deficits are unsustainable. There is also the potential for radical changes in Asian exchange rate policies over the next year. In these circumstances, it is vital that risks are minimised and complacency needs to be avoided as periods of calm are liable to prove fleeting. Derivatives can certainly play a valuable role in improving corporate risk profiles, especially as it is possible to take advantage of speculative and unsustainable moves. It is, however, crucial that the use of derivatives is not used to increase risk.
The size of the foreign exchange market has continued to rise strongly. The latest Bank for International Settlements (BIS) survey reported that average daily market turnover had increased to $1,900bn from $1,200bn in the equivalent 2001 survey. There has also been a sharp increase in derivatives trading over the past few years. Daily options trading, for example, has increased to an estimated $117bn, close to double the 2001 level.
Although there has been an increase in commercial transactions, there has also been a sharp increase in fund involvement in the spot and derivatives markets. The flow of investment funds far outweighs trade flows and this will be a potential source of market instability.
The use of currency derivatives has increased sharply over the past three years. According to the BIS survey, daily trading in the over-the-counter currency options, FRA and interest rate swaps market had increased to $1,200bn from $575bn in 2001. The difficulty for markets is knowing whether the derivatives are being used to increase or lower risk. If there has been a general increase in risk-taking, and the overall suspicion is that there has been, it will be even more important for companies to pursue risk-reduction policies.
There will be concerns that market liquidity will be a problem despite rising trading volumes. In this context, the role of hedge funds will remain under close scrutiny. The latest figures from the BIS show that volumes from financial institutions rose to 33 per cent of total market volume compared with 28 per cent in the previous survey. This may not capture all of the move, especially as much of the hedge-fund volume is transacted through the prime-brokerage model which allows funds to trade under the bank’s name. The number of large foreign exchange banks has also declined over the past few years. There is an increased risk that the banks will not be able to meet trading orders in the event of hedge funds all trying to exit trades at the same time. The immediate risk has been increased by the number of hedge funds, especially as many of them have been using the same trading models. In the long term, risk should start to ease, with the variety of trading strategies likely to increase. It is, however, important to realise that it may not be possible to deal at sensible rates or even trade at all when the need for action is at its highest.
Just because market spot and option volatilities decline, it is not safe to assume that currency movements will be limited. Indeed, a prolonged period of low volatility is often a sign that a significant shift is on the cards. In particular, the underlying pressures are liable to build after a prolonged period of narrow range trading.
These dangers have been demonstrated over the past few weeks. In mid October, dollar/yen volatilities, for example, fell to an eight-month low. The spot rate had been stuck in a $109.0-111.5/Yen range and there was little market expectation of a significant shift. Within 10 days, however, volatilities had risen sharply back to a three-month high and the spot rate had fallen rapidly to a low of 105.8.
Similarly, volatilities on euro/dollar had fallen to annual lows in September and October as the Euro was stuck in a narrow Euro1.2250-1.2450/$ range. The Euro has now strengthened sharply to a peak above 1.28, less than 100 basis points from its record high seen in early 2004. From a medium-term perspective, the Euro/dollar rate has fluctuated in a Euro0.82-1.29/US$ range since the 1999 launch.
Traditionally, currency risk tended to be viewed as an aspect of trading in equities and bonds. It is, however, now increasingly common for currencies to be used as a separate asset class, especially in view of disappointing equity returns over the past few years and low bond yields. This trend towards seeing currencies as a separate class will result in a significant shift in investor attitudes as there will be pressure to generate returns from currency investments. The competitive pressures in the hedge-fund sector will also increase the risk that aggressive strategies will be employed. The easiest way of achieving this may be seen as taking advantage of strong currency movements. This will tend to increase volatility and may also lead to currencies overshooting fair value. If there are no major currency movements, there will be pressure for alternative strategies to make profits.
A significant feature of the past few months, for example, has been the use of no-touch or double no-touch options. The narrow market ranges this summer encouraged funds to buy double-no-touch options, for example, with 1.18 and 1.25 strike options in euro/dollar. The funds would make profits providing these barriers were not broken. There was also a clear incentive for funds to protect these barriers and prevent currency rates moving out of narrow ranges. There is a danger that underlying market pressures will not be able to find an escape route, increasing the risk that there will eventually be a sharp jump in exchange rates.
The market break above the Euro1.25/$ level will tend to increase volatility. After a prolonged period of narrow ranges, the markets will want to take advantage of the momentum trading and push currencies strongly in one direction. There is also likely to be a push to record euro highs.
To some extent, this is an impossible question to answer, especially as it is the unexpected events that cause most market stresses. It is, however, possible to see where the market stresses are likely to be and the potential implications.
One area of interest will be the US presidential election. US elections have often coincided with sharp moves for the US currency. The dollar, for example, started to rally strongly after the Reagan victory in 1980 and, historically, moves of up to 20 per cent in the months surrounding elections are common. The currency movements have often been triggered by sharp shifts in bonds or equities and these have had an important indirect impact on currency markets. The markets will be reassured by the prospects of continuity given that Bush appears certain to win the election to gain a second 4-year term while the Republicans have held congress with an increased Senate majority. Policy doubts will be a persistent theme over the next few months, especially if the market’s budget fears increase.
The risk of rapid dollar moves have been increased by the underlying US economic trends. The US is running a current account deficit of close to 6.0 per cent of GDP, with little prospect that the deficit will narrow significantly in 2005, and this makes the US more dependent on overseas capital inflows. If there is any decline in capital inflows, the US dollar will be vulnerable to a sharp retreat. There is the perennial threat that confidence in the US economy will suddenly falter, especially if growth is disappointing. This risk has been increased by the fact that the imbalances from the previous recession have not been corrected. In particular, consumer debt levels remain very high. There will also be the threat of trade protectionism from the US. The global economy has been relatively well synchronised over the past 2-3 years. The risks of volatility and sharp currency moves will increase sharply if they move out of phase.
In the context of global trends, the Asian exchange rate policies will remain under very close scrutiny. Over the past few years, the US trade deficit with Asia has risen strongly. US central banks and governments have, in turn, increased their holdings of US Treasury bonds, partly to prevent rapid Asian currency appreciation. These capital inflows have prevented rapid dollar depreciation. The amount of US debt held overseas has increased to over 50 per cent of the total US debt and the number of US bonds held in custody for overseas central banks has increased to over $1,000bn.
Asian governments have wanted to retain competitive currencies and this has encouraged substantial intervention to restrain Asian currencies. During the first quarter of 2004, for example, the Bank of Japan spent over $160bn in defending the US currency. There has also been a strong increase in reserves held by China and other Asian economies. To some extent, the Asian economies are stuck in this pattern as a change of policy now could lead to sharp dollar depreciation and heavy capital losses on existing US Treasury holdings. It is also the case that intervention has prevented market adjustment, increasing the risk of a disruptive breakdown. There will be a growing risk that there will be a policy shift and Asian currency gains against the dollar. The immediate risks of trade protectionism have been eased by Bush’s victory, but trade will still be a major issue and could result in major exchange rate pressures.
The periods of intense volatility have been associated with the ending of a currency peg. European currencies including Sterling, for example, fell very sharply when forced to abandon links to the Deutschemark. The risk of disruption has been eased given that most major currencies float. The Chinese yuan will, however, be a major focus of attention given that it is effectively tied to the dollar. China’s policies will remain crucial and domestic inflation will increase pressure for the yuan to be allowed to strengthen. The decision to increase official interest rates for the first time in 9 years could be seen as an alternative to a stronger currency, but it will still reinforce monetary policy stresses and contradictions caused by a fixed exchange rate. There will also be further international pressure for a stronger yuan.
A very popular trading strategy over the past year has been the use of carry trades. Investors have borrowed dollars at low short-term US interest rates and invested the funds in high-yielding overseas assets. Popular destinations of funds were Asian equities and commodity prices. There were market stresses in April and May when fears over an imminent increase in US interest rates caused a sudden reversal of these trends. There were, for example, substantial losses in the Australian dollar and other commodity currencies.
Although US interest rates have risen to 1.75 per cent from the low of 1.0 per cent, the market expectations over US rates have been lowered again due to fears over a slowdown in growth. Real rates are also still negative. This has encouraged a fresh interest in carry trades over the past few weeks. If there is a sharp increase in US rates or a downgrading of global growth expectations, there will again be a threat that positions will be reversed quickly.
The level of oil and wider commodity prices will remain an important focus. The prices of commodities have been pushed up in part by expectations of strong growth leading to supply shortages. Long-term interest rates have, however, been declining on fears that growth will slow. These inconsistencies will eventually have to be resolved and this will increase market risk. This should be offset by the benefits of increased central bank transparency.
There will inevitably be underlying fears over terrorism, especially as the 2001 attacks on the US caused sharp movements in currency values. The re-election of Bush may also spark increased activity by groups such as al-Qaeda. There is limited action that can be taken, although the most important factor is that it is vital to minimise risk levels.