Once upon a time, the foreign exchange (FX) markets enjoyed a clear framework for trading and were seen as a reflection of the health of global economies. But as central bank programs of quantitative easing have been introduced, currency market trades are not so clear cut, according to analysts at HSBC.
The latest report from HSBC’s global research department heralds “a new era for FX” as currency carry trading, a popular strategy of currency trading that exploits global interest rate differentials, struggles in an era of central bank intervention and low interest rates.
“In the glory days of carry, the FX market had the luxury of a clear framework for understanding and trading currencies,” the report, led by David BloomGlobal Head of FXStrategy atHSBC , begins.
“Life for FX market was simple. Get your interest rate calls correct, and you could both understand and trade the FX markets….In the low inflation environment, higher short rates meant a stronger currency and vice-versa…FX was beautiful.”
“It was clear, liquid and transparent,” the report surmises.
Fast forward through five years of global economic crisis and central banks ranging from the Federal Reserve to the Bank of Japan have introduced near-zero interest rates and quantitative easing (explain this) in an attempt to stimulate economic growth creating “a problem for markets,” the report says.
Indeed, central bank intervention has made the currency trading world a risk on – risk-off place, according to HSBC’s report. Investors are now flocking to emerging market currencies and safe havens alike, which makes currency trading much more volatile and harder for investors to interpret.
“Today carry’s hold on FX has waned as global rates gravitate towards zero, forcing the FX market to react instead to the far more ambiguous implication of quantitative easing,” the report states.
“We now live in a world dominated by risk-on/risk-off, and prospects for unconventional monetary easing have become the key element of [that] dynamic."
HSBC notes that not all easing has had negative effects for currencies. Indeed, in the euro zone it has been positive as “non-conventional easing” European Central Bank easing has lowered “the possibility of eurodefault and disintegration” and has attracted investors.
In sum though, central bank policies have created an uncertain environment for currency traders as it becomes harder to identify economic trends. As global economic data points to an uncertain future in the euro zone and events such as the U.S. fiscal cliff approach, the world of FX becomes opaque, HSBC states.
“This lack of clarity is creating a puzzling outlook for many currencies…The world of FX has become one of perception rather than concrete links,” HSBC says.
In the U.S., for instance, easing has been dollar negative as “the resultant 'risk on' mood takes us to higher yielding more risky currencies.” This was indeed exemplified by the dollar falling to a four-month low after the Fed announced “QE3” in September that led to emerging market governments such as Brazil fearing a new era of “currency wars”.
HSBC’s view on currency market volatility is reflected by other FX strategists too.
Sebastien Galy, Senior Currency Strategist at Societe Generale told CNBC on Wednesday that the robust Australian dollar was an example of how investors flocking to a safe-haven asset had inflated a currency that should “be massively lower”.
“It should be massively lower…in a normal environment. But everyone is looking for yields which leads to over-shoot,” Galy said, “that overshoot has been happening for years.”
Indeed, HSBC concludes, as the carry trade dies a bit of the currency market could go with it.
“The demise of carry has brought “onion skin” layers of uncertainty into the FX market, tears and all.”