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FX trading in doldrums due to muted volatility as Cass research paper highlights merits of momentum strategies

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Currency traders have got their backs to the walls in 2012. Amid low interest rates and low volatility (thanks to central bank intervention) G10 currencies have been largely range-bound. Trading volumes have slipped away, putting sell-side trading desks under pressure to meet revenue targets.

As Reuters reported earlier this month, one-month EUR/USD implied volatility was at its lowest level since Lehman’s collapsed. What makes this so extraordinary is that the euro has failed to capitulate – against the US dollar it strengthened to 1.34 at the end of February and has since weakened to 1.28 at the time of writing. However, YTD it’s barely changed despite the very threat of the euro’s existence being thrown into question.

Simon Jones (pictured), global head of FX e-trading, G10 and local markets at Citigroup, tells Hedgeweek: “There’s a lot of ‘not a lot going on’ in FX at the moment. Identifying the market drivers is the real challenge for currency traders right now.

“The range of the euro has been so quiet over the last six months that corporates aren’t the driving force here. There’s an element of reserve diversification still going on but activity is generally muted. Central banks are changing their dollars, which means there’s a consistent bid for euros and partly explains why we haven’t seen a collapse in the euro, despite the flow of bad news.”

Reinforcing the current lacklustre nature of FX markets, Jones’ boss, Jeff Feig, global head of G10 FX at Citigroup, was quoted in the Financial Times last week as saying: “I can’t remember a time when I’ve seen less interest in foreign exchange from hedge funds and real money investors.”

Against such an unfavourable backdrop, a new research paper entitled “Currency Momentum Strategies”, written by Professor Lucio Sarno of Cass Business School in conjunction with Lukas Menkhoff and Maik Schmeling of Leibniz University and Andreas Schrimpf from the Bank of International Settlements, has found that currency momentum strategies yield up to 10 per cent a year, based on analysing historical data from 1976 to 2010.

Speaking with Hedgeweek, Sarno explains: “We took a cross section of up to 48 currencies. We wanted to look back at different formation periods – one-month, three-months etc – and determine what the figures were if you bought currencies with the strongest momentum and sold those with the strongest negative momentum.”
One of the challenges when building momentum strategies is knowing how far back to look when ascertaining which currencies have the strongest positive/negative momentum.

“The answer is you don’t have to look far back at all because the strongest momentum appears to be in the last month. Unlike equities where you’d tend to skip the first month, in FX the most profitable strategies are where momentum is clearly short-term,” says Sarno.

To some this may just sound like a carry trade in disguise – carry trades involve borrowing money in a currency with a low interest rate and investing it in a currency with a higher interest rate, profiting the difference. That’s fine if exogenous conditions remain static; the reality is they never do. The low interest rate currency may unexpectedly rise, wiping out profits. But Sarno is quick to point out that the returns from carry trades appear to be uncorrelated to momentum strategies.

If that’s the case then what risks are you being compensated for in a momentum trade? According to Sarno, carry trades are a compensation for global macro risks. Cross-sectional momentum strategies, on the other hand, appear to be a compensation for country-specific risks. The most profitable portfolios are those that trade minor currencies rather than stable G10 currencies.

“Part of the compensation, therefore, is for incurring higher transaction costs because the liquidity within minor currencies is a lot lower; we found that transaction costs wipe out roughly one third of the profits. The other two thirds derives from country-specific risks: political risks, financial risks, macroeconomic risks, and idiosyncratic volatility,” explains Sarno.

Illiquid currencies are likely to generate up to 50 per cent of momentum returns and produce outsize returns despite their high transaction costs, though such momentum, as mentioned previously, tends to be strongest over the short-term. Consequently, turnover in these strategies is necessarily high; perhaps 60-70 per cent turnover each month.

“Over the last 10 years of our sample period if anyone was trading momentum strategies using just major currencies they would have lost money,” adds Sarno. He says that in recent times investors would have enjoyed phenomenal momentum from the Brazilian real in their long baskets whereas currencies like the Russian rouble would have been important in short baskets.

All well and good, but today’s macro conditions have washed out a lot of volatility, meaning momentum strategies are simply treading water. There’s nothing happening.

Olivier Rudez is the senior portfolio manager, FX strategies, THEAM Absolute Return team at BNP Paribas. He says the main problem in 2012 is the fact that everyone is focused on sovereign debt reduction. Only a few countries are actually enjoying a budget surplus and because a lot of money is flowing in, authorities are acting to prevent their currencies over-appreciating.

“The likes of the Australian dollar and Latin American currencies like the Mexican peso are crowded long positions nowadays. It’s less the case with the Brazilian real, which isn’t rising anymore because the authorities have placed a tax on inflows. Switzerland capped the Swiss franc at 1.20 against the euro so it’s useless now trying to trade EUR/CHF.

“As there are so few safe havens these currencies are over-valued. The AUD/USD is around parity but purchase power parity is somewhere between 0.75 and 0.80 which equates to a 20 to 25 per cent over-valuation,” says Rudez.

Sarno admits that over the 34-year sample period there were periods as long as two to three years “during which the strategy returns were meaningless”.

“To be honest we were surprised by this Cass research. We believe the returns on momentum strategies have been poor. Trend models haven’t done that well. It’s hard to explain how they could do well when you look at EUR/USD unchanged on the year,” says Jones.

Some analysts have described this year as an “ugly contest”: plenty of reasons to sell, few reasons to buy. “I can’t disagree with that quote,” says Jones. “It’s a case of it being the least ugly wins the contest at the moment.

“If you tell people that GBP/USD will be at 1.60 at the end of the year most will probably shrug their shoulders and say ‘sure’. With USD/JPY, the government is going to support it on the downside and export interest is consistent on the upside so there’s not a lot of interest there. In my opinion, within the G10 Canada and Norway are the two least ugly sisters, whilst in the G4 the UK is basically the least weak.”

Citigroup’s in-house research suggests that since November 2011, short-term traders have been net short high-yield currencies like the Brazilian real, which has fallen around 10 per against the greenback since early January. In today’s range-bound markets, traders have little choice but to be short-term.

Taking short-term tactical positions is precisely what Rudez says THEAM is doing: “This also means that we’re using smaller active positions than usual and using less of our risk budget. For the same purpose we’re using more vanilla options strategies to try to get an asymmetric return.”

“The most active funds in FX have been getting in and out quick; a good number have caught the recent move from say 134 to 128,” adds Jones, referring to EUR/USD.

Rudez says that one of the few significant moves seen this year was when the Japanese yen fell from 76 to 84 against the greenback in February: “Our systematic model isn’t identifying any value even by using a volatility-filtered carry model. The short-term shifts in volatility this year can quickly wipe out any profits made in a carry trade – say AUD/JPY – and that’s why the traditional carry trade hasn’t been profitable this year.”

AHL, the well-known systematic fund (part of Man Group), uses models that automatically scale back during these range-bound periods “to preserve capital while waiting for the next period of trending behaviour to emerge. A good example of this would be the current movements of the euro against sterling,” says portfolio manager Keith Balmer, adding: “Current trends that we are seeing are the selloff in the euro, Swiss franc and Brazilian real and strength of the pound and Norwegian krona.”

In Balmer’s view the biggest challenge for all hedge funds “is this phenomena of risk on/risk off over the last year or two”.  

Sarno admits that today’s period of low volatility does not favour momentum strategies but concludes by saying: “Volatility goes up and down and doesn’t stay low forever. You don’t want to build a momentum strategy once volatility has already gone back up; you want to do it beforehand.”   

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