David Bloom, Global Head, Foreign Exchange Strategy HSBC Global Markets FX winners and losers in a downturn April 2008 David Bloom, Global Head, Foreign Exchange Strategy HSBC Global Markets FX winners and losers in a downturn
How do we value currencies? • With equities we have different valuation techniques: dividend discount models, the PE, different multiples… • With bonds we have the real return, the risk premium, inflation expectations… • But for FX? It very much depends on the world we believe we are living in • We were living in a low volatility, low inflation world, so nominal interest rate differentials seemed to be the answer…and they were for a while • BUT not anymore
Yield differential has shifted against the USD……Many believe that is why the dollar is so weak
Fed sends in the cavalry, Lower rates, fiscal push and a weaker currencyWhatever it takes and the consequences be dammed
Total Return on Major Currency Carry Basket Jul 2003- Jun 2007 182 182 Annualised return = 14.66% 172 172 Annualised S.D.= 9.00% Sharpe Ratio = 1.63 162 162 152 152 142 142 132 132 122 122 Carry drawdowns 112 112 102 102 92 92 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 The most important chart to understanding the changeAbnormal carry returns mid 2003-mid 2007
Brutal rejection of the old world of low inflation and low volatility - Negative Carry returns
Paradigm shift from the nominal to the real • The return to higher FX volatility is negative for carry trades, and recent carry trade returns have been negative • However, this does not mean that relative yield has become a less important driver of currency performance • Yield rank remains a strong influence on short term currency performance as risk appetite ebbs and flows • However, perhaps we need to shift to a real concept
Buying higher inflation, selling lower inflation would have worked until recently in both South Africa...
Return on strategy Buy high inflation, Sell low 1.60% 1.60% 1.40% 1.40% 1.20% 1.20% 1.00% 1.00% 0.80% 0.80% Strategy fails on last 0.60% 0.60% two occasions 0.40% 0.40% 0.20% 0.20% 0.00% 0.00% -0.20% -0.20% -0.40% -0.40% Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 ...and in Turkey
…Current account surpluses are shrinking as the US deficit improves our interest rate reward should be higher, not lower
BRL and TRY offer good reward, unlike ZAR and USD Current Account (x-axis) versus real yield (y-axis) 10% y = -0.1602x + 0.0256 2 TRY 8% R = 0.368 BRL 6% AUD 4% GBP ZAR 2% 0% USD -2% -4% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35%
Points worth noting • The BRL stands out as offering very high real interest rates relative to its current account position, which by the way is in surplus • The TRY has high real interest rates but has a weaker current account profile. This relationship highlights that the TRY is not as high beta compared to the ZAR. • The USD also offers a relatively a relatively poor trade-off between real yields and its current account. Although the USD’s negative real yields look unattractive, the Fed is trying to reflate its asset markets. In this context the potential portfolio flows will dominate the yield play to support the USD going forward. • The ZAR offers a relatively poor trade-off between real yields and its current account. This has deteriorated sharply over the past year. This is largely because real interest rates have fallen sharply in the past year from over 4.0% to 1.2%. To us, this helps explain why the ZAR is weakening versus other high yielding currencies.
NOK and SEK offer good risk-reward on a real yield versus current account basis
Real yields will matter when macro dominates • The machines are being switched off as the carry model under-performs • Macro ideas are hard to hold on to given the volatility, so forward looking strategies are hard to trade • Until we settle into a new world the traders hold court… • Traders go with the news flow
G10 Performance against the USD over the last three months – Is it random?
The move to a “policy desire” framework... ...because nominal rates have broken down......we are between worlds…
Our other obsession is the pendulum that swings between decoupling and contagion
Eurozone data suddenly matters • Recent USD reaction to US data surprises has been relatively mild • Some positive data surprises from outside the US have brought very negative reactions by the USD • The pendulum swings from contagion to decoupling • We know the US is in a bad way but will it infect others • The latest German Ifo survey was surprisingly strong and EUR-USD moved higher, this response to European data is very unusual and trigger broad USD weakness rather than independent EUR strength
The relationship between US activity surprises and EUR-USD is loosening – since 2007
The relationship between Eurozone activity surprises and EUR-USD is increasing
Conclusion • We have moved from a low volatility, low inflation world, a world of certainty to an uncertain world • Nominal interest rates no longer the prime driver of currencies • Real concepts will come back into play • Once the decoupling contagion debate is settled • For the meanwhile traders and news flow will dominate
In the G10 world GBP has major problems • It’s not so much the improvement in the US but the deterioration elsewhere • GBP has further room to be de-rated • The ‘hot money’ flow from abroad is at risk of re-trenching as UK negative developments increase, including: • A deteriorating cyclical outlook for the UK economy • Net M&A flows for the UK are no longer favouring GBP • Harsh criticism of the current policy framework creates downside risk for GBP
UK policy framework – from friend to foe? • Perception of a safe, flexible and respected policy framework on a monetary and fiscal policy front • The UK was probably attracting money because of how London’s status as a major financial centre grew within this framework • We believe that any divisions within the MPC from now could show a divisive policy-setting framework and hurt GBP • If further problems beset either the BoE or policymakers in the UK, the situation could turn from mildly negative into something a lot more serious
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