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The FX Game Just Got Complicated
By: Lior Alkalay
Last week ended with a positive tone. In fact, it is hard to remember such optimism since the crisis began. The Fed recently initiated an open-ended QE program insuring unlimited liquidity, the conservative BoJ has just followed suit and has announced more or less the same, and the ECB is on standby. China was able to avoid a hard landing and seems to be back on track with PMI figures surprising for the upside. Banks in Europe announced they will return in aggregate more than €150Bln in LTRO loans, signaling its back to normal for the EU banking system. Even the feared fiscal cliff was eventually averted and the expected fiscal cliff in March was elegantly postponed to May.
As the fugue over the global economy gradually evaporates, the sun begins to shine on equity investors. Equity investors suffered a prolonged period of uncertainty as risks of a Euro collapse, US fiscal cliff and Chinese hard landing lurked from every corner of the globe. And, while both bonds and equities performed well since 2009, bond investors enjoyed the coziness of the treasury market whereas equity investors were in for a roller-coaster ride, constantly walking on a thin thread between hopes of recovery and financial Armageddon. But as the big switch starts to materialize and intuitions get ready to exit their Treasury trenches and put their investments to work in equity, there is a sign that things are changing. Volatility in equities diminished sharply with the VIX (Volatility Index) falling close to pre-crisis era of 2007. Outlook for corporate profits continues to improve and, overall, investors are filled with the belief that equities’ valuation in multi-year lows, especially in terms of P/E, and even more so when considering the new QE-Nomics around the world. To put it simply, equities seem like the place to be at the moment. This creates a rather one-sided trend to equity investors (Indices and large caps) with big inflows of cash that has been parking in bonds for years and therefore could really take us into new highs.
FX Divergence Coming Your Way
Equity investors can now finally lay back and enjoy favorable conditions, just as FX investors had experienced a renaissance era over the past 5 years as the FX play divided into two simple modes: risk on and risk off.
Those two simplistic states more or less describe the FX mode for the past half-decade.It is either that the global economy is recovering and, therefore, it is worth taking risk across the board. Investors would react by buying into the classic risk currencies Euro, GBP, AUD,NZD and all other “high risk “ high yield economies. Then there was the risk-off trade when investors feared another financial catastrophe and sold all currencies that were associated with some risk and depended on high global growth for performance. Risk-off reaction was rather simple; investors were buying Dollar and Yen and selling everything else. But lately FX investors that have taken this approach have been burned and burned hard. Suddenly the old rules don’t apply.
With the recovery in sight, a new dynamic has emerged. With each advance we make towards the ultimate recovery, each economy reacts and behaves differently. The currencies, for that matter, broaden; thus, making FX projections more elusive with an entirely new set of rules to follow. Last week, in fact, was a classic example of the dramatic shift the FX arena is experiencing with each currency reacting to its own unique local matters.
While investors were expected to ignite a classic risk on play that would push EUR, GBP, AUD higher and the USD and JPY much lower, the reality was far more complex, leaving some FX investors in dismay. The Euro rose against the Dollar above 1.34 on to new highs for the year. The Sterling, on the other hand, which usually rises in tandem with the Euro, ended the week bleeding, shedding 400 pips in less than two weeks, falling below 1.61 and trading below 1.58. The Aussie, which used to be a classic gainer in risk appetite modes, slipped below its critical 1.05 support level and entered into a bearish pattern. And, the Yen, which usually fluctuates in opposite to the Aussie gaining inflows while the Aussie experiences outflows amid risk aversion trades, has actually weakened alongside the Aussie. FX investors have felt as if their world has turned upside down.
The risk on/ risk off mode era we got used to is dead, and it’s time to get used to a new era an era of diversity -- an era where interest rates could move in opposite direction rather than in correlation and an era where Dollar strength or weakness will not be cross board. Yen inflows will not be correlated to global risks and the Sterling will not not necessarily be correlated to its European peer across the channel. It is each currency on its own, a different game with different rules. How should we play this game? To be continued…