dimanche 3 février 2008

Trading Forex Becomes Less Profitable

The return a hedge fund delivers is separated into alpha and beta; accordingly, the goal of of a good hedge fun manager is to deliver as much alpha as possible, whereby alphas is measured by the return generated in excess of beta, what is returned "naturally" by the market. In the case of forex, the beta is effectively zero, since one currency's gain is automatically another currency's loss. Thus, any and all return generated by forex investors is officially recorded as alpha. Historically, forex was a bonanza for hedge fund managers that speculated exclusively on currencies, who averaged annualized returns of 12%, controlling for differences in trading strategies.
That return has steadily dwindled, and in fact, the average professional forex trader lost 2.6% in 2006. The reasoning should be self-evident: increased competition. From the perspective of daily trading volume, participation in the forex market has tripled since 2001. Arbitrage (buying in one market and selling into another) has steadily eroded returns to the extent that one online forex brokerage now quotes the bid/ask spread to five decimal places! Fortunately, the evaporation of profits should drive many hedge funds out of forex in search of other investing opportunities, creating new opportunities in forex. The Financial Times reports:
Volatility was now back to historic norms, aiding managers. "The last three years have been really quite disappointing for the industry and it needs to produce some gains in the next couple of years to justify its existence."

Carry Trade Gains Favor

It's been rough sailing for the Yen carry trade of late; the technique had been sagging in popularity due to the credit crunch and the associated trend towards risk aversion. Over the last few weeks, however, the Yen has fallen, which is to say the Yen Carry Trade is making a comeback. First came the announcement that the world's leading Central Banks would be injecting hundreds of billions of dollars in the banking system, in order to ease growing liquidity concerns. Next, the Bank of Japan hinted that it would hold rates at .5%, the lowest in the industrialized world. Finally, a continued surge in commodity prices virtually ensures that countries rich in natural resources, such as Canada and Australia, remain viable "targets" for carry traders. Overall, the story remains focused around volatility. In fact, one investment bank discovered an inverse correlation between the S&P 500 and the Japanese Yen. In other words, the appetite for risk appears closely correlated with the strength of global capital markets and the popularity of the Yen carry trade. Bloomberg News reports:
Over the last fortnight, that odd correlation with equities has broken down...Instead the fundamental factors behind carry trades have come to the fore again. Investors are paying attention to Japan's economy.
Read More: The resources to carry on

China off the Hook...Again

hhSince even before the dawn of the Forex Blog, commentators have been speculating that the US Treasury Department would officially brand China as a "currency manipulator" in its semi-annual report to Congress. Such a label is important because it would enable the US to levy tariffs and other economic penalties against China. However, another report has been issued, and one more time the Treasury Department glossed over China's de facto control over the Yuan. The report did criticize China for failing to appreciate the RMB rapidly enough, since the 12% gains it has racked up over the last two years have been largely offset by inflation. The report also referred to China's widening trade surplus and accompanying growth in foreign exchange reserves. US politicians, however, are less than pleased, and are preparing to take matters into their own hands. The Associated Press reports:
"In refusing to brand China as a currency manipulator, which is so obvious, the Administration gives Congress no choice but to act on its own. This report is the strongest case possible for our legislation," said [one high-ranking Senator] Schumer.
Read More: US stops short of accusing China of currency manipulation
Continue reading "China off the Hook...Again"

Commentary: The Future of the Dollar

Despite its multi-year decline, the US Dollar remains the world’s undisputed reserve currency, claiming a 65% share of total Central Bank reserves. However, the chorus of soothsayers proclaiming the apocalypse for the Greenback is growing louder by the day. Every week seems to offer a new piece of news confirming that the Dollar’s reign is coming to an end. Analysts are drawing parallels between the British Pound of 50 years ago and the Dollar today. China is threatening to diversify its reserves into Euros. Iran and Venezuela are leading calls to price oil in terms of a basket of currencies, rather than in USD. The other members of OPEC are considering de-pegging their respective currencies from the Dollar. What does all of this mean? Is the Dollar truly in danger of being replaced as the world’s reserve currency?
The short answer is ‘no.’ The US twin deficits have expanded every year for the past decade and economic theory suggests that in order for a nation’s current account to rebalance itself, a decline in the value of its currency is required. At the same time, these deficits are sustainable for as long as foreign investors, sovereign and private, are willing to sustain them. And despite the looming threat of recession, economic data and anecdotal stories suggests that such investors remain willing to lend their financial support. For example, the announcement of record-breaking losses by American financial institutions has been met with solid commitments to invest by international investors.
In addition, while foreign exchange reserve diversification is certainly justifiable from a risk management standpoint, it hardly makes sense from a financial standpoint. The case could have been made for foreign Central Banks to exchange their Dollars for Euros and/or Pounds several years ago when both currencies were trading at relative bargains to the USD. Now that these currencies are more expensive, it seems harder for to justify buying assets and securities denominated in them. Furthermore, Central Banks must recognize that diversifying now would be counter-productive, by sending a wave of panic through the markets and undermining their efforts. As one analyst pointed out, Japan and China, the two largest holders of USD, both have a vested interest in an expensive Dollar.
However, the long answer to the question posed at the beginning of this article is closer to ‘maybe’ than ‘no.’ In the long-term, Central Banks will certainly move towards a more diversified portfolio of currencies. For countries like China and Japan, this will help minimize risk. For countries in the Middle East that peg their currencies to the Dollar, this will enable them to conduct monetary policy independent of the US. Ultimately, US capital markets are the most stable and liquid in the world, and regardless of the value of the USD, it will serve the interests of Central Banks to denominate a large portion of their portfolios in Dollars. Besides, analysts can be extremely fickle. It was only five years ago that the Euro was trading below parity with the USD and analysts were predicting its collapse. The fundamentals underlying both currencies have not changed much since then, yet commentators have reversed their positions. Who knows what such analysts will be preaching five years from now…

Interest Rate Story Hurts Pound

The British Pound has been reeling since the Bank of England cut rates at the beginning of this month, from 5.75% to 5.50%. Last week, the minutes for the meeting were released. They revealed that that members of the Bank were growing increasingly nervous about the state of the British economy and are worrying particularly about how fallout from the credit crunch will impact growth. British interest rates are still among the highest in the industrialized world, behind only Australia and New Zealand. Thus, it seems investors are punishing the Pound indirectly for the rate cuts, because of fears concerning the near-term prognosis for the British economy. At the same time, the minutes indicated that members of the Bank were adamant about not lowering rates further, so some of the concerns may be overblown.
Read More: Pound weakens after BoE minutes show concerns for growth

Yen Buoyed by Exporters

The Yen has received a nice boost from Japanese exporters, which moved en masse to exchange Dollars for Yen to meet certain year-end financial obligations. The logic is that exporters had owed money in arrears to domestic Japanese producers of the goods and services being exported and needed to be paid in Yen. Such logic could theoretically be applied to exporters in ever country, which would provide the same boost to their respective currencies. However, in addition to being the world's fourth-largest exporter, Japan's economy is unusually dependent on exports. Thus, it is understandable that Japanese exporters could exert such influence on forex markets when entering the market at the same time.
Read More: Yen Rises on Speculation Japanese Exporters Buying the Currency

Investment Banks Expand into Retail Forex

Forex is becoming hot! Average daily volume has surged past $3 Trillion, as the credit crunch has increased volatility and the Dollar has collapsed. In fact, Saxo Bank, one of the most prominent acts in retail forex trading, may record $500 million in revenue this year. As a result, several of the world's largest investment banks have announced plans to enter the burgeoning retail forex market. Citigroup is teaming up with a Danish bank to offer online currency trading. Deutsche Bank is stepping up marketing of its proprietary retail trading platform. Even Goldman Sachs is entering the fray, via a 10% investment stake in a British retail forex company. However, not everyone is optimistic, reports GulfNews:
Some think the reputational risks of enabling individual investors who may not be able to afford to lose substantial sums in what are notoriously volatile markets outweigh the possible revenue stream.
Read More: Global banks compete for growing forex business

The Record Rise of the Chinese Yuan

Earlier this week, the Chinese Yuan recorded its highest one-day increase in value in the two years since it was famously revalued against the Dollar. The currency rose nearly .4% and prompted renewed speculation that China's Central Bank will either widen the trading band to .8% or will generally allow the currency to appreciate faster. In fact, the political and economic consensus continues to maintain that the Yuan is not appreciating rapidly enough. While it rose over 6% against the Dollar, for example, it actually lost value to several of the world's major currencies. Furthermore, its decline against the Dollar is less impressive when China's skyrocketing inflation rate and burgeoning trade surplus are taken into account.

There are still a few analysts who are bucking the trend and arguing that the Yuan is fairly valued. This notion is supported by a recent World Bank analysis, which updated its calculation of China's purchasing power and reduced its PPP-equivalent GDP in the process. However, this opinion is echoed by only a small group of analysts, and an overwhelming majority continues to call for and anticipate a further appreciation of the Yuan. Bloomberg News reports:

Forward contracts show traders are betting on an 8.7 percent advance in the yuan to 6.7344 per dollar in the next 12 months. The median estimate of 28 analysts surveyed by Bloomberg News is for a rate of 6.88 by the end of 2008.

Read More: Yuan Rises Most Since End of Peg as China Seeks to Curb Prices