Forex Investment and Currency Trading

• Emerging financial markets frequently track swings in advanced economy stocks. However, the close relationship between Emerging Market (EM) currencies and the S&P 500 broke in October 2007 with virtually no sign of repair since.
• In 2H 2008, emerging market currency strategies will likely benefit from adhering to two main tenets
• 1) pursuit of relative value and 2) timing the Fed’s need to normalize its monetary stance.
• The EM trade recommendations have been skewed to relative value or an adherence in long positions, where central banks have the willingness, ability and need to reduce local inflation pressures.
• The second factor will likely appear at a later stage during the year, when market expectations shift toward a Fed needing to more actively neutralize its monetary stance. At that point, high yielding currencies will likely experience a temporary setback.

Clearly, the origin of the substantial and successive injections of liquidity followed concern surrounding the health of the US financial system – which ultimately weighed on stocks. Yet, the injection of liquidity by the Fed was supportive of EM currencies.

Despite a relatively strong performance in EM currencies to date, 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 5-day volatility of the EM High Yielding index was 8.8% between July 1, 2007 and June 30, 2008 relative to a scant 6.3% in the first half of 2007, 6.5% in 2006, and 5.5% in 2005. In fact, the identical measure for EM vol is now in excess of 10%. Thus, currency movements have been quite choppy, despite being range-bound.

Second, the seemingly uniform upswing in the Overall and High Yielding indexes masks a wide dispersion of individual currency performances. For example, CZK (+28.6%), PLN (+23.5%), and SKK (+22.7%) demonstrated the strongest gains relative to the USD during the recent period of financial turmoil. This reflects their high correlation with the EUR, as well as positive regional sentiment due to Slovakia’s pre-euro rally and Poland’s new government. Moreover, the region’s central banks proved relatively decisive inflation fighters, given well-established inflation targeting frameworks and relatively robust economic growth. Conversely, KRW (-13.4%), ZAR (-11.0%), and INR (-5.8%) logged the steepest declines against the USD during the same timeframe. ZAR, in particular, is a currency that has suffered from monetary policy being caught between the rock of inflation and the hard place of a rapidly weakening economy.

Russia will likely increasingly introduce currency flexibility as inflation drifts higher and the real exchange rate remains undervalued – despite the drift higher in energy. In fact, the move higher in energy prices bolsters the case for further currency flexibility. Likewise, CNY should benefit from large external account surpluses in China, which should provide the authorities with the ability to introduce enhanced currency flexibility.

It is still recommended to short USD/MYR as markets were pricing in substantially less MYR appreciation relative to other Asian nation counter-parts earlier in the year. The fundamentals remain relatively favorable for Malaysia with a sizable external account surpluses and the authorities’ ability to permit USD/MYR to drift lower. However, political uncertainty continues to push USD/MYR toward its 200-day MA of 3.2618.