| Volatility likely to remain high |
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When the dust settles in the market, the banking landscape will be reshaped leaving a financial industry that is likely to be safer, but a lot less lucrative for shareholders, says Criona Fitzgerald.
Fitzgerald writes, 'The dollar has reverted to its traditional safe-haven status as investors continue to reduce exposure to assets facing an increasingly challenging environment. The dollar will benefit from repatriation flows so long as markets continue to operate on a least worst option basis.' |
Over a year has passed since the start of the credit crunch but this crisis is far from over. We have seen the collapse of large investment banks such as 158-year-old Lehman Brothers and the acquisition of 94-year-old Merril Lynch by Bank of America on the heels of the demise of Bear Stearns among many others. There is huge uncertainty still in the marketplace and strategists now feel that this credit crisis is the biggest financial shock in the banking industry since the Great Depression. | | Criona Fitzgerald |
The foreign exchange market is a dynamic environment that is constantly innovating and evolving. Research shows that taken over a long time period the volatility of major foreign exchange rates is historically low. In recent years, currency markets have been unusually stable, due in part to increased exchange rate flexibility among many countries and macroeconomic stability across countries reducing risk premia. An increase in risk aversion leads to a sudden widening of risk spreads and a spike in volatility. Credit crunch returns and the turmoil arising from the banking community has seen market volatility escalate.
Carry trades and forex volatility
Over the past year, we have seen heightened volatility in forex and other markets. Forex volatility is likely to remain high and forex markets will continue to pick up cues from global risk sentiment. Liquidity will remain severely constrained in the near-term amid continuing financial sector concerns. Due to uncertainty markets are nervous and risks of large swings in currency markets prevail. In the money markets, we have seen severe pressure on short-term funding and a sharp rise in short-term interest rates in the interbank market.
Traders react on economical or political events and as such provide liquidity to the markets. Broadly speaking a market can be considered to be liquid when large transactions can be executed with a small impact on prices. Following on from 9/11, we saw little movement in interest rates and also historical lows in forex volatility. Carry traders themselves used the low forex volatility environment for their positioning where they borrow low yielding currencies and invest in high yielding currencies. We saw investors appetite moving into the emerging markets. Now the tide is turning, carry trades are being unwound, volatility is increasing and investors prefer to have forex positions in the major currencies.
After the tech bubble burst in 2000, traders went from seeking the highest possible returns to focusing on capital preservation. As US interest rates were sub 2 per cent investors looking for higher yields went abroad to countries such as Australia with interest rates in excess of 5 per cent. And so carry trades became the name of the game. The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as Australian dollar and New Zealand Dollar against the
US dollar.
Risk aversion is an important driver of currency markets. Currency trades based on yields tend to be most successful in a risk-seeking environment, where investors reshuffle their portfolios and sell low-risk/high value assets and buy higher risk/low value assets.
However, in times when investors are more risk averse, the riskier currencies on which carry trades rely for their returns tend to depreciate. Typically, riskier currencies have current account deficits and when appetite for risk wanes, investors retreat to the safety of their home markets. It makes sense to unwind carry trades in times of rising risk aversion, since adverse currency moves tend to at least partly offset the interest rate advantage.
Carry trades underperform when volatility is high due to the threat of capital losses that may overwhelm carry income. A rise in volatility is unfavourable for the strategy. For many years, banks and money managers have utilised the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. While an aggressive unwinding is already underway, market conditions have been relatively constrained. The carry trade has been under constant pressures from looming risk considerations and quickly fading
rate expectations.
US impact
With the US heading for a possible recession, we see currencies like the euro, swiss franc, and Japanese yen being seen as safe haven currencies. The dollar has reverted to its traditional safe-haven status as investors continue to reduce exposure to assets facing an increasingly challenging environment. The dollar will benefit from repatriation flows so long as markets continue to operate on a least worst option basis. It is expected that European Central banks will follow the Central banks in Australia and New Zealand in the easing cycle and markets will continue to favour the dollar. Carry trading is no longer the name of the game and daily volatilities in currencies have jumped with daily fluctuations of over 5 per cent in some currencies, in particular emerging market currencies. With market liquidity worsening amid continuing financial sector concerns, forex spreads have widened. The interbank lending market is nearly non-existent and very little deals are going through in the swap market as the main focus is on cash. Even experienced traders comment that they have never seen anything like the current situation, in particular in the interest rate markets.
The outlook is gloomy for the US economy, with rising unemployment, high inflation, falling house prices and more restrictive lending practices which will lead to prolonged economic weakness. What impact will a US slowdown have elsewhere? And to what extent can the world economy continue to decouple from US weakness? Are there repercussions elsewhere? A recoupling with a US slowdown will be detrimental to commodity based currencies. At time of writing, crude oil has fallen over 40 per cent to date since its peak in July. In the UK, volatility is exptected to remain dominant especially considering the exposure of the UK economy to the fortunes of the financial services industry.
Emerging markets
Emerging market currencies remain under pressure from tightening global credit conditions and a sharp fall in risk appetite. When global liquidity conditions deteriorate emerging currencies tend to be singled out for depreciation, mainly because these areas tend to have large current account deficits, for example in South Africa and Turkey, or large external debt such as Hungary and Poland.
The fastest growing economies of Brazil, Russia, India and China have attracted the most attention. The Brazilian Real continues to be pressured by a de-leveraging process and high global risk aversion is likely to keep pressure on the Brazilian Real. In Russia, investors are concerned about GDP growth and external financing pressures. Elsewhere, some investors are wary of China’s disclosure-poor companies and India’s equity market. Investing in these markets poses unique challenges in that a lack of liquidity in them can be brutal to shareholders since investors in panic selling can send prices tumbling. Lately, we’ve seen equity and asset managers hedging out of their emerging market exposure, in particular selling of Brazilian Real, Russian Rouble, Polish Zloty and Mexican Peso. With the global slowdown and credit crunch turmoil, we’re likely to see the downward trend continue in these emerging markets.
Consequences of the credit crisis
When the dust settles, the banking landscape will be reshaped and we will be left with a financial industry that is likely to be safer but a lot less lucrative for shareholders. Over the last ten years, we saw the advent of globalisation, securitisation and derivative innovation and the current financial turmoil has certainly brought an end to this. We will see a banking business that will move away from the risks of heavy borrowings and complex securities back to the old business of chasing deposits and with this will come more restrictive lending practices. In the near-term, financial market conditions are likely to remain poor amid worries about the solvency of financial institutions. When confidence for the prospects for the financial system improves we will see a very different banking business. |
Criona Fitzgerald is head of corporate foreign exchange at Investec Capital Markets.
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