Forex Investment and Currency Trading

After the sell-off of risky assets last week, FX markets were much calmer this week. However, it feels as if market participants viewed this as a temporary lull in the conflict rather than a proper ceasefire, let alone the end of the war. Equities have recovered somewhat, though in a far from convincing way, but commodities have largely moved sideways and the macro data have remained dire, exemplified by today’s US numbers, all of which surprised the market to the downside. The relative calm was associated in G10 FX with some of the recent underperforming currencies doing well. The CAD and GBP appreciated about 3% against the USD and even more against the JPY over the past week. The NZD was an exception, but that was driven by New Zealand-specific events, most importantly, the 150bp cut by the RBNZ and suggestion that further easing is in the pipeline.

While volatility has abated to some extent, it remains high. In the near term, the huge uncertainties surrounding the global economy and financial markets make it highly likely that there will be further periods of thin liquidity, increased risk aversion and instability. During such periods, the JPY is likely to remain the star performer. But volatility is not the only factor likely to support the JPY in the near term. JPY further appreciation likely toward fiscal year end, hedging operations by Japanese exporters, demand for JPY from Japanese importers who hedged assuming stronger trade flows than are actually occurring, and repatriation of JPY by Japanese institutional investors are all likely to lead to further JPY appreciation in the months to come. Given the strength of the JPY (the TWI is at an all-time high in nominal terms) and the weakness of the Japanese economy, this will inevitably lead to discussion about the likelihood of intervention to weaken the JPY.

The extraordinary levels of volatility seen during the financial market turmoil have highlighted the need to have some sort of understanding of the evolution of volatility. Unfortunately, the most commonly used model of volatility, GARCH, has not proved a very effective forecasting tool.

A crucial feature of the collapse of markets in Q4 08 was the stress felt in EM money markets, as they did not escape the crisis that hit the global banking sector, severely impaired investor confidence and reduced growth prospects worldwide. This led to a broad sell-off of EM currencies but also had a big impact on G10 FX - it was a key factor behind the strength of the USD in Q4.