2013: The return to normal in FX markets?

I was on a panel at FX Week North America. Here are my notes from my comments. 

              I.      The other panelist have provided some very interesting details:

a.       The Sharpe of FX style betas have shown a significant decline and just now returning to flat levels. 

                                                               i.      The Sharpe can move from positive to negative

b.      The dispersion of currencies have increased from low levels

                                                               i.      Moved back to normal  

c.       Carry  (interest differentials) has been driver not spot changes

d.       Trends have not been strong until the last six months

e.        Value trading has shown limited success

            II.      The key question to be addressed is in three parts:

a.       What is normal?

b.      Can normality of exchange markets explain Sharpe and currency dispersion?

c.       Where are we headed?

          III.      First, a framework-

a.    Exchange rates are a relative price based on differences in economic fundamentals; but FX is an expectations market where price is discounted future value of fundamentals

                                i.      Inflation differences

1.       The 2% inflation target framework around the world

                                ii.      Real and nominal rate differentials

1.       Global recession caused all rates to move lower with little differential

                                iii.      Growth differentials

1.       Recession and recovery has been in line after Great Recession but now differences are greater; Europe double dip,UK potential triple dip

                                iv.      Monetary differentials

1.       The QE world is starting to differ

2.        ECB, Fed, BOJ, BOE have all started to chart their own courses

                                v.      Debt/current account differentials

b.      Hence, exchange rate volatility should be a function of economic difference volatility

                                 i.      In reality, the numbers are only suggestive; volatility has declined with less fundamental differences but the connection is not strong.

c.       Dispersion in current fundamentals is slightly elevated based on 2000- present – inflation,   real GDP, deficit/GDP, unemployment, and nominal short-term interest rates

d.      Surprise index is cyclical but again only suggestive

                                  i.      Volatility of surprises for G10 is in a current down trend but has moved between positive and negative

e.      Common factor approach suggests that primary factor explains less and correlation has come down in the last year

                                   i.      Stock bond correlation suggests that world is behaving in two states

                                   ii.      The reason for RORO trading

1.       Will fall with reduction of common factor

f.        View of scapegoat theory of exchange rates – market moves between single driving factor  

          IV.      The mystery of currency volatility - excessively volatile?

a.       This has been an ongoing research issue since the 1980’s similar to Shiller’s excess stock volatility;

                                   i.      The need for overshooting models

                                   ii.      The disappointment of floating exchange rates

1.       The desire of policy-makers is to eliminate this excess volatility

a.       Policy-makers may actually be the cause

b.      Volatility is based on exogenous and endogenous risk  - exogenous risk may be increasing and endogenous risk may have hit a low (volume numbers)

            V.      Themes for 2013 – a world of growing contrast with a poor patient who has both psychological and physiological disorder

a.       Bipolar in policy  - a economy theory personality disorder

                                  i.      Coordinated divergence

1.       Monetary ease through QE

a.       Fed, ECB, BOE, BOJ, other who have stuck to 2% rule

b.      The issue is velocity forecasts

2.       Fiscal austerity for budgets

a.       Switching has caused uncertainty based on competing objectives

                                  ii.      Return of monetarism and the new reaction function – changing allergies

1.       Volcker in reverse

a.       The Taylor Rule with weight on unemployment

b.      Willing to accept inflation for more “growth”

2.       Cause monetary approach to exchange rates to ascend

                                  iii.      The savings imbalance story – a bad environment makes for sickness

1.       The heart disease of the global markets

a.       The lack of global financial order (Ger China – debtors US)

b.      Imbalance based on exchange rate view

                                  iv.      Financial Repression – capital controls Rogoff Reinhart

1.       The new currency wars                

a.       Not trade but capital

b.      Clogged arteries of capital

                                  v.      RORO trading – ADD

1.       Common factor

a.       “Commentary” market not “news” market

          VI.      Falling back to original piece

a.       Trend in fundamentals lead to trends in price

b.      Fundamentals will have an impact

c.       Carry will increase with rate differentials (watch real rates)

d.       Dispersion will increase