Forex Investment and Currency Trading

Emerging Market (EM) currencies have performed extremely well relative to other markets since the onset of turmoil originating in the US. Despite a strong performance, however, two issues surface.

First, returns from purely EM currency exposure remain relatively flat since November 2007. However, the volatility of returns is substantially higher in the recent period coincident with the financial stress originating in the US. For example, the actual volatility of the EM High Yielding index was 9.7% between July 1, 2007 and April 14 relative to a scant 6.1% in the first half of 2007, 6.7% in 2006, and 5.7% in 2005. So, movements have been quite choppy, despite being range-bound. This phenomenon is likely to persist as favorable forces such as strong commodity prices bolstering Emerging exporting nations and trade surpluses and intra-regional trade benefiting Emerging Asia compete with spikes in international risk aversion.

Second, the seemingly uniform upswing in the Overall and High Yielding indexes masks a wide dispersion of individual currency performances. For example, CZK (+25.7%), PLN (+22.0%), and ILS (+17.4%) demonstrated the strongest gains relative to the USD during the recent period of financial turmoil. Conversely, ZAR (-13.4%), KRW (-8.6%), and TRY (-2.9%) logged the steepest declines against the USD during the same timeframe.

The secret to future currency and asset performance should rest on local inflation trends and monetary policy responses. Countries with the desire and ability to tighten monetary policy will experience currency appreciation. A reasonable proxy for the ability to tighten is represented by projected GDP growth in ‘08 versus recent history. Likewise, the need to tighten is represented by the deviation from inflation targets.

A clustering of countries and currencies—which neatly fit into Starbucks’ coffee sizes— based on relative challenges for individual central banks as well as the capacity to tighten monetary conditions suggests that BRL, PLN, SKK, SGD, INR and RUB will outperform with underperformance in TRY and ZAR.