Perhaps the FX traders should urge Prince to do a remake of the song more in sync with their current mindset. They may not be able to enjoy the volatility of their markets, but at least they can enjoy the ride? It’s been a ghastly August for the investment world. In one month alone, European markets are down 15%, S&P down 10%, and these are developed markets that apparently have stable to consistent growth and lower inflation. Emerging markets have been a different story altogether. They have been on a downward trajectory for most of the year, rightly so, given the need to rebalance their economies as growth slows and they undergo the de-leveraging process.
But what triggered the “Black Monday” of 2015?
The “carry trade!” Two words that are biblical to any FX trader; they only need one commandment, not ten to lead their lives by!” The extreme moves witnessed in all asset classes over the last few weeks have been the result of an unwind of core “consensual” positions across all investment portfolios. When a market is so stretched in one direction with the same bet depicted in various forms leveraged ten times over, any stress felt in one asset class can cause a domino effect across all asset classes. Risk is heightened and portfolios need to be unwound immediately. Statistical models start flashing as parameters are breached, alarm bells go off at senior management offices, trader’s phone rings commanding them to cut risk to stop the imminent bleeding. That is the circle of life in the investment world. The move yesterday was dissimilar to moves seen earlier this year because yesterday Global Equities saw indiscriminate selling across the board. Classic risk reduction 101.
What has been the most consensual trade this year? Long US and European markets, long the Dollar and Sterling vs. short Euro, Yen, and Emerging market currencies. Low and behold yesterday the Euro and Yen rallied nearly 3% and 4% respectively. In the FX world, that is a move beyond normal standard deviations. The bets have all been very logical given the growth outlook and monetary policy mapped out in these regions. But this episode does not have the same markings of the Asian Currency Crisis of 1997. Today the region has current account surpluses and has built up a sizeable reserve buffer. Emerging market currencies have already adjusted quite dramatically with greater reserve backstops in place. The Chinese Yuan devaluation may hint towards the start of global currency wars, but it was a necessary adjustment given its “peg” to the dollar, dragging it higher for most of the year even though the natural course of action should have been lower.
Earlier this year, European markets were up 22% and Euro was down 18%. Now European markets are flat on the year and Euro is down only 5%. That is what an unwind does. But one can’t paint all asset classes with the same brush. Commodities have been in a bear market for fundamental reasons. China is slowing down and there is excess supply over demand. Indiscriminate selling can cause exaggerated moves, but the direction makes sense. These episodes of natural “unwinds” give rise to great investment opportunities but one needs to be selective.
While the FX traders bring out their magic eight balls to get an idea of where the currency markets go next, maybe the hedge fund managers need to select Everything but the Girl on the juke box and sing along to “Wherever you go, I will follow you.”
