Saturday, December 24, 2016

Foreign exchange trading - adding another dimension to alpha creation

The dollar and FX trading is back in hearts and minds of investors. For many, it never went away, but during the Post-Crisis period, there was a fall-out in performance and interest in trading currencies as an alpha source. With limited trends and carry that was squeezed down to zero there were limited opportunities for profit.  If all central banks are behaving the same and growth differentials small, there will just be limited trade opportunities except for periodic short-term dislocations. That dearth of opportunities has changed in 2016 and may continue in 2017 for a simple reason. Economic differentials across countries are back.

Start with carry. Short-term rates which tell us something about relative monetary policy are moving in different directions. The bond rate differential between the US and EU could not be greater. What has been a close relationship has strongly diverged. The dollar/yen carry trade is now seeing significant new money flows. The differentials between EM and developed market bonds also have increases in spread. Money can be made in carry without even touching the important issue of covered interest rate parity not holding with many currencies against the dollar.

Trends are back. Currencies can have long period of trundles behavior. This has not been the case for 2016. After falling for the first part of the year because of a delay in Fed action, the dollar has moved higher with clarity on Fed rate intentions. Classic trend-followers are seeing many opportunities. The simple chart of the dollar shows the strong movement.

Fundamentals are diverging. A currency is a relative price between two countries. When inflation, growth, and monetary differentials increase, there will be currency adjustments. If the fundamentals change, the currency will change. 

Volatility is back. Volatility has increased with the underlings increase in the volatility of fundamentals. The markets saw he large BREXIT reaction and spikes around policy announcements. While the overall trend is still not higher, there are more volatility opportunities.

If there are more opportunities, there will be more potential for alpha generation. Any one manager may not be a profit generator but when the markets are in divergence, gains can be made.

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