Investors worldwide are running currency trades that are long sterling and the Australian and New Zealand dollars, and short the US dollar -- positions that seem to be based on optimistic views about prospects for the global economy to get out of recession.
Barclays Capital has completed a survey of 605 institutions, including hedge funds, real money managers, proprietary trading desks and corporations from the US, Europe, the Middle East and Asia.
The results raise what seems to be a contradiction. On the one hand, the survey shows the recent strong performance of risky assets is seen by investors as a 'bear market rally that is close to ending'. 37.5% of respondents say the trajectory of the global economy during 2009-2010 will be a W shape, a temporary recovery before renewed weakness sets in. Another 26.5% suggest we're in for the L shape, protracted weakness.
Together that's 64% of investors who are essentially bearish on the economy, versus only 36% who (mostly) expect a benign U-shaped recovery or (for a handful) a sharp V-shape recovery.
Moreover, following the recent rally in risky and cyclical assets, 37% of investors describe it as a bear market rally close to ending; and 23.5% describe it as a bear market rally but one with further to go. That means 60.5% of investors call this a bear market rally, and only 39.5% say the rally is sustainable.
Yet the most attractive currency positions that are on at present are long sterling versus the dollar (aka the cable trade) and long Aussie dollars, and short the US dollar. Such activity is also taking place in FX markets despite the fact that these trades are among the most crowded, meaning at some point the returns risk being squeezed away.
Surely, if most investors expect the economy to stay shaky or worsen, and for risk assets to take a tumble, then these FX trades will get them into trouble?
David Forrester, Singapore-based foreign exchange strategist at Barclays, says a distinction should be made between currency views that are currently being traded, versus future expectations. Going long Aussie dollar and cable and shorting the greenback offer the best risk-adjusted returns at present. If the activity in markets, primarily equities, turns out to be a bear-market rally, then clients would quickly throw their FX strategies in reverse.
Forrester points to another aspect of the survey that shows what is driving most currency investments: 'risk', according to 45.5% of respondents, versus things like monetary policy, fiscal policy, commodity markets or trade flows.
'Risk' in this case means FX markets are being driven by things like risk in equity markets, the Vix index, and so on. "Investor attitudes toward putting risk on or off will affect FX markets," Forrester says. For example, investors are now deciding what carry trades to chase or exit, and this matters more than, say, government budgets. And right now, investors are putting on risk, selling dollars to buy higher-yielding currencies, and trades in cable and Aussie/US and kiwi/US are experiencing the highest volatility.
The second-most important factor driving FX trades is monetary policy, or, rather, what Barclays terms 'unconventional monetary policy measures' which includes quantitative easing (QE) in America, Britain and elsewhere. 29% of the survey respondents cited this as the key theme for the FX market for the rest of 2009.
"In our view, QE has reduced the downside, the fat tail risk, of a big market sell-off," Forrester says. This has given comfort to traders, as it doesn't work against their putting on risk, and may limit the severity of a sell-off should risk assets lose steam. Moreover, Barclays' indicators suggest carry positions have eased, which reduces the damage should there be a sell-off in the next four weeks. Quantitative easing is providing a cushion for risk takers, and the 'green shoots' story of economic indicators showing many economies may stabilise are giving FX traders confidence.
This is a little strange, because QE should be awful for currencies, as it basically suggests governments are printing money. Barclays asked investors why they thought currencies weren't being impacted so much. The results show a dispersion of thought. Roughly similar percentages say the markets are rewarding government action to support the economy; that inflation is not a serious risk right now; that other factors outweigh the negative impact of QE; and that many other countries are engaged in QE or expected to go down that road.
Forrester takes this analysis to traders going long sterling and Australia against the US dollar. "QE can be good for one currency and bad for another," he says, noting that both the Federal Reserve and the Bank of England are following this policy. But the BoE has a credible inflation target and the market's perceived risk of the UK government inflating away its debts is much lower than in the case of the US. So that supports buying British pounds. Also, sterling took such a pounding since late 2008 that it became quite undervalued.
The euro is also favoured by surveyed investors but less so, and perhaps only against the dollar, whereas sterling and the Aussie dollar look strong against a basket of currencies. The euro was never sold off as much, the ECB is likely to further slash interest rates, and the economies of the European Union are not expected to recover soon. Sterling and the Aussie dollar were also hurt by a lack of liquidity, but QE is putting plenty of liquidity into global capital markets, allowing these units to perform well. Again, the euro never suffered liquidity problems so it has less force behind its rally.
Finally, Forrester says many investors like the Australian dollar because it is a commodity-related unit, commodity prices are expected to rise, the Australian economy is a China play, and commodities offer a hedge against inflation.
The last reason why investors favour Aussie dollar long, cable and dollar shorts despite some obvious contradictions involves the fact that these are also the most crowded trades. But Forrester qualifies this by noting 55% of investors report running 'light' positions in terms of their risk limits or capacity, and another 36% are running 'average' positions.
Overall, since December, FX activity has risen, but only to average levels, not the levels at which trading opportunities get arbitraged away, Forrester says.
The risk that most investors run is that stock markets do turn out to be in bear market rallies, economies are in W-shaped recoveries and green shoots disappear. In this case, all those dollar shorts will lose money, and carry trades will need to be rewound.
Forrester cites two areas in the markets that Barclays reckons offer attractive trades that haven't been exploited yet. One is the dollar/Asia trade. Investors say they like Asian units but many are short the yen and few are long the won. Going long Asian currencies against the dollar is one trade that more investors are expected to pursue in the coming weeks.
The second is within the emerging-markets world; right now, among EM currencies, most investors say they prefer Asia. But if a global recovery becomes more likely, Forrester expects currencies in Latin America and Easter Europe to perform well relative to Asian peers.
Over the medium term, he says long positions in Aussie dollars, kiwi dollars and sterling look attractive, but short-term bumps should be expected, particularly if commodity prices get a boost. If that leads investors to retrace support for the greenback, it might be a good time to load up on more carry trades.