Valuations at Extremes Making Winner of Losing Trade: CurrenciesNeal Armstrong
Foreign-exchange managers who sold currencies as they became overvalued beat both trend-seekers and traders analyzing interest-rate differentials this year, the first time they’ve won out against these strategies since 2005.
An unprecedented flood of cash from central banks in the U.S. and Europe to Japan has driven currency levels to extremes, pushing Deutsche Bank AG’s Valuation Excess Returns Index, which tracks tenders relative to purchasing power, up by 4.7 percent in 2013 as of yesterday. That compares with a 3.5 percent increase for the bank’s Momentum Index, which tracks currencies moving faster than average, and a 2.3 percent loss for its gauge of the interest-rate-driven carry trade.
“Anyone who followed valuation-based strategies would’ve done well this year,” Bilal Hafeez, the London-based global head of foreign-exchange strategy at Deutsche Bank, the largest currency trader, said in a phone interview. “Valuation has done really well, trend has been OK and carry has performed poorly.”
Choosing the right strategy has become more important for pension funds and other institutional investors this year. The surge in cash flowing through global markets has damped the price swings that many participants in the $5.3 trillion-a-day global currency market exploit, while central banks cutting rates to records slashed profit margins.
The yen has been the most profitable Group of 10 currency for valuation traders this year, according to purchasing-power parity data compiled by the Paris-based Organisation for Economic Cooperation & Development. Investors selling the currency benefited from a slide to about fair value versus the dollar, from 17 percent overvalued at the end of last year. The yen fell to a five-year low of 104.64 per dollar on Dec. 20 as Prime Minister Shinzo Abe eased policy to boost growth and end 15 years of deflation.
“Valuation trades have tended to work well this year,” Steve Barrow, the head of G-10 research in London at Standard Bank Plc, said in a Dec. 19 phone interview. “You’ve had to focus where the overvaluation is of specific importance to policy makers, such that they’ve responded in some way. What has happened to the yen was substantially down to Abenomics,” he said, citing a common term for Abe’s economic policy.
Deutsche Bank’s valuations index took off in April, when the Bank of Japan pledged to double the amount of bonds it buys each month to more than 7 trillion yen ($67 billion). The gauge, which last beat both the momentum and carry indexes in 2005, is now headed for its first annual gain in four years.
Even so, its returns are dwarfed by the stock market. The Standard & Poor’s 500 Index of U.S. equities has jumped 28 percent this year, on pace for its best annual performance since 1997, amid signs of sustained improvement in the world’s largest economy. Currency-valuation trading did outperform U.S. Treasuries, which lost investors an average 2.9 percent this year, data compiled by Bloomberg show.
The valuation strategy benefited from the Federal Reserve’s delay in reducing its $85 billion of monthly bond purchases until last week. The uncertainty this created made trends in the foreign-exchange market harder to call, hurting momentum trades.
The carry trade also suffered as low rates around the world made it unprofitable to borrow cheaply in one currency to invest in another with higher yields. Carry trades are the most common foreign-exchange trading strategy, with valuation the smallest of the three, according to the Basel, Switzerland-based Bank for International Settlements.
The Australian dollar was another winner for valuation traders, Standard Bank’s Barrow said, as the central bank’s repeated warnings that it may intervene to weaken the currency helped debase it 14 percent versus the greenback this year. The Aussie was 24 percent overvalued today, down from 35 percent last year, according to OECD purchasing-power calculations.
Deutsche Bank’s indexes measure returns of buy-and-hold investors with longer-term investments than banks. Still, authorities’ investigations of alleged collusion in setting foreign-exchange rates have dented confidence across the world’s largest financial market.
Regulators have started investigating traders including Goldman Sachs Group Inc. and Citigroup Inc. after Bloomberg News reported in June that traders pooled information about their positions with counterparts at other banks. Firms have said they’re cooperating with authorities, and no one has been accused of wrongdoing.
JPMorgan Chase & Co.’s Global FX Volatility Index has fallen 28 percent from a one-year high reached in June, making it harder for traders and investors to make money. Parker Global Strategies LLC’s Currency Manager Index, which measures returns from a number of strategies, dropped 4 percent this year and in October reached the lowest level since before the global crisis.
The U.S. central bank said Dec. 18 it will trim its monthly bond purchases to $75 billion, the first stage in a less accommodative monetary policy that may eventually lead policy makers to raise the main interest rate from near zero.
This also has hurt the carry trade, said Kevin Zhao, the London-based managing director and head of global sovereign and currency portfolios at UBS Global Asset Management Ltd.
“Any currency that benefited from lower U.S. interest rates, especially high-yielding ones like the Australian dollar, has weakened,” Zhao, whose firm manages the equivalent of $643 billion, said in a Dec. 18 phone interview.
Fed tapering will boost the dollar next year and help momentum trades to make money, said Deutsche Bank’s Hafeez.
The Bloomberg Dollar Spot Index, which measures the greenback against the euro, yen, pound and seven other currencies, has risen about 2 percent from an eight-month low reached in October, roughly halving its second-half losses.
“I think next year we’ll see a more protracted trend in the dollar, which will lead to better performance,” Hafeez said. The “trend” strategy “will probably be the one that picks up a lot.”