Will Asian Currencies Forever Disappoint?
"Look how much faster these economies are growing! Just look at their favorable Balance of Payments! Look at the FDI (Foreign Direct Investment) pouring in! Look at their fiscal health!"
These are words I often heard when I arrived in Singapore to run an Asian currency trading business in 2010. The center of economic gravity was moving East - this was the unchallenged view three years ago. It wasn't about 'if,' but 'by how much' will Asian currencies appreciate versus their G-10 (Group of 10) counterparts in the coming years.
Let's take a quick look at the world of trading currencies according to macro-economic fundamentals.
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The first port of call for the macro currency trader has always been the Balance of Payments (BOP) - trends in trade, capital flows and FDI would be scrutinized religiously. If inflows were set to eclipse outflows then the currency in question was going to be a winner. Asian currencies (bar a few exceptions) have certainly ticked the right BOP boxes over the past three years. So why are we perennially disappointed by such a poor performance year after year. More pertinently, why are the forecasts of those clever economists continuously so wide of the mark?
Well, we know Asian central banks aren't shy when it comes to interfering with market forces - currency intervention to protect competitiveness has been a feature of the Asian forex landscape since one was wearing short trousers. But surely this should have been taken into account when the most erudite economists nailed their currency forecasts to the mast.
Looking back at the median forecast for each major Asian currency over the past three years one sees striking consistency in getting it very wrong. Take the two most liquid currencies in the region, the Indian Rupee and Korean Won – on average over the past three years median forecasts have missed the mark by a whopping 10 percent and 6 percent respectively. In the world of currencies those are big misses.
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Now - here is the point - rather than ridicule and rubbish our academic friends, one should genuinely cut them a lot of slack. Why so? You may ask.
Firstly we have clearly moved on very far from the old world where BOP was the major driver in a currency's performance. Currency intervention by Asia's central banks only part explains this shift.
Much of the reason lies in the very nature of the asset class itself. By definition foreign exchange is a 'relative value' product - you are actually trading two things at once - if you buy one currency, you are simultaneously selling another (hence 'exchange'). The reason Asia currencies have underperformed can largely be found looking at the currencies they are exchanged for in the forex transaction process.
Let's take the euro, for example. Surely Asian currencies should carve out strength versus a currency having to contend with crippling debt levels, horrendous growth prospects and a crisis of confidence in its future existence. Sell those euros and buy some Korean Wons those hardy economists cried! Of course this call, like many others, turned out to be wrong.
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Frankly no one considered the 2nd, 3rd or 4th derivative of the Southern European debt crisis as it started to unravel in 2010/11. European banks' balance sheets were pulverized as the value of the assets they held collapsed. No one expected Europe's banks to restore capital ratios by selling much of their Asian assets and repatriate the proceeds back home.
This is just one example among many where an economic crisis far from Asia can result in downward pressure on Asian currencies despite their sound structural fundamentals.
Then of course there is policy activism across the developed world. We all know the U.S., U.K., Europe and now Japan have undertaken to debase their currencies by printing money. These countries account for most of the world's gross domestic product (GDP) - naturally Asian central banks have responded by stepping up attempts to keep their currencies competitive themselves.
So, back to that unenviable recent track record of the currency forecaster - their job has been impossible. Analyzing underlying trends across a country's current account and capital account, as well as its conventional monetary policy is historically not so difficult. Second guessing the ramifications of the next G-10 economic crisis and the resulting unconventional policy response is very difficult.
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Sadly, for our scholarly forecasters this theme is not going away. Who can successfully predict, within a consistent analytical framework, the flow of public and private funds across boarders when many doubt if the world's second largest currency, the euro, will even exist in a few years' time. How does one fit the randomness of the world's quantitative easing policies into their currency forecasting models?
It's no coincidence that among the world's currency focused hedge funds the total amount of capital under management has radically shrunk in recent years.
Outside of the recent Japanese yen move, the reality is that the most successful currency traders since 2010 are the ones that simply trade the market's positioning. By that I refer to the busy intraday desk traders with an obsessive handle on how speculators are positioned.
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The randomness of the global economic backdrop and resulting unconventional policy measures has meant most currencies have found it impossible to carve out any sort of trend, regardless of a countries underlying fundamentals.
The result - mean reversion has been a common feature in the world of foreign exchange. Many desk traders will watch a currency move, wait for speculative positioning to become very crowded and then position themselves for the currency to revert back to where it started, knowing how hard it is for a currency to sustain a trend one way or another, and how likely it is crowded speculative positions will be unwound.
Perhaps the macro forecaster should get a little more micro and focus on the nuances around positioning and short-term extremes in sentiment.
Based in Singapore, Stuart Oakley runs the global Asian forex cash trading business at Nomura. He has worked in financial markets since 1995 and has spent most of his career trading Emerging Market currencies and interest rates, previously at Barclays Capital and Credit Suisse in London.