FX Traders, Take Heart: Even Keynes Lost His Shirt
It's a year since the Swiss National Bank toppled the currency markets into chaos by abandoning a pledge to stop the franc from appreciating against the euro. Talk to any trader in the currency markets and they'll tell you life has gotten harder in recent years. If it's any consolation, though, trading has been tough since the birth of the foreign-exchange market -- even for the greatest economist of his generation.
It seems that John Maynard Keynes was a pretty terrible currency trader at the start of his speculating career. Olivier Accominotti, associate professor of economic history at the London School of Economics, and David Chambers at the University of Cambridge Judge Business School, have been digging through the archive of King's College, Cambridge, where Keynes spent most of his career. They studied 354 currency bets Keynes made between 1919 and 1930, mostly trading dollars, French francs, Deutsche marks, Italian lire and Dutch guilders against the pound. Their conclusion, from a paper for the Journal of Economic History, is that speculating on currencies is so difficult that you probably should steer clear:
If someone as economically literate and well-connected as Keynes found it difficult to time currencies, then the rest of us should think twice before believing we can do any better.
After resigning from a job at the U.K. Treasury in 1919 at the age of 36, Keynes began to take advantage of the disappearance of the old system of fixed exchange rates. According to his biographer Donald Moggridge, currently professor emeritus of economics at the University of Toronto, Keynes got off to a roaring start with a profit of 6,154 pounds ($8,825) by the start of 1920 -- worth almost 221,000 pounds in today's money when adjusted for inflation. Moggridge notes a letter Keynes wrote to his mother at the time, which to my eyes smacks of hubris:
Money is a funny thing -- it seems impossible to believe that the present system will be allowed to continue much longer. As the fruit of a little extra knowledge and experience of a special kind, it simply (and undeservedly in any absolute sense) comes rolling in.
Emboldened, Keynes formed an investing club with friends and family called the Syndicate, and went on to make 9,000 pounds by the end of April 1920. It didn't last. In the next few months, "the Syndicate had lost money in every currency it had dealt in," according to Moggridge: Keynes closed the fund with losses of more than 22,000 pounds.
Undaunted, Keynes borrowed 5,000 pounds from Sir Ernest Cassel, a financier and philanthropist, and got back into the currency markets. Before the year was out, he'd repaid the loan, and by the end of 1922, he'd repaid his debts and accumulated more than 21,000 pounds.
(Full disclosure: I sit on the investment committee at King's College that oversees the money Keynes made for my alma mater. I've spent time in the archives sifting through some of his trading accounts; the volume of correspondence from his brokers making margin calls as trade after trade went wrong is kind of staggering.)
The following chart from Accominotti and Chambers shows how volatile Keynes's returns were in two decades of speculation (including a hiatus when he abandoned the foreign exchange markets):
The key takeaway for today's traders from Keynes's trading history, though, relates to liquidity rather than volatility. In today's currency markets, a combination of increased central bank interference and a post-crisis pullback by cash-constrained central banks is conspiring to kill liquidity in the securities markets. Here's a chart showing how currency trading has declined on the trading platforms operated by Thomson Reuters in the past couple of years.
Accominotti and Chambers sum up the difficulties Keynes had in timing his trades even when he was correct about currency directions:
It therefore sometimes requires both great conviction and adequate capital resources to maintain trading positions seeking to arbitrage a substantial misalignment of fundamentals. At times this creates a problem of there not being enough traders who can undertake such arbitrage activity.
The idea of there not being enough trading or time for so-called fundamentals to assert themselves will be familiar to anyone who has studied the "mean reversion" strategies that bankrupted Long-Term Capital Management in 1998. In the current environment, with investment banks paring the amount of capital they're willing to commit to the trading arena, it means foreign-exchange speculation will only get harder.
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