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Capital flows by institutions are best described as ôpersistentö, he says, meaning that todayÆs visible flows will carry on tomorrow. And right now, the flow is one-way: retrenching from risk. State Street, which is a custodian to around $15 trillion of assets, one of the worldÆs big three along with JPMorgan and BNY Mellon, says cross-border appetite for equities is negligible.
ôInstitutional investors are not applying risk anywhere,ö Martin says, ôand that drives FX markets.ö
The reason is because US investors are the dominant factor, owning over 30% of stock marketsÆ global capitalisation. The past 10 weeks have been characterised by US investors selling offshore equities and repatriating back to US Treasuries and other domestic fixed-income or cash instruments.
Dollar strength is therefore easy to explain and will continue until US investors regain their risk appetite. The greenback will be given a further boost as more US investors consider hedging their remaining international-equity exposures; they have traditionally hedged overseas fixed-income portfolios, but not equities.
Martin says if market turbulence continues, keeping US assets in domestic bonds, the ôworst case scenarioö is that the dollar strengthens to parity against the euro. US investors owned over $5 trillion of global equities just two months ago so there is plenty of selling that can yet take place.
Forced selling by hedge funds and other investors in the wake of market volatility has also put an end to the yen carry trade. The yen has soared quickly against units such as the Australian and New Zealand dollars, greatly hurting both hedge funds and Japanese retail investors.
Such turbulence in FX markets has created unprecedented strains. ôIn 25 years in the markets, IÆve never seen such illiquidity in FX forwards,ö Martin observes. ôInvestors want to do big trades but they canÆt. Transaction costs are rising as a result of the big spreads institutions must pay.ö
Liquidity concerns become big problems for large institutions such as central banks because it hampers their mission of managing foreign reserves; their asset size is so huge, FX transaction costs pose a real threat.
Martin says the rest of the calendar year will see a large number of one-, three- and six-month forward contracts due. These are hedges used by global investors on their equity or bond exposures. Gyrations in FX markets are going to create cash-flow problems for some institutions that are fully hedged. Hedging is meant to provide protection but FX dislocations have been so extreme, with units such as the Korean won and the Aussie dollar falling so precipitously against the US dollar, that it will be very expensive to roll over forwards for investors in those markets. This in turn could force investors to dump other assets.
ôInvestors will have to realise these losses, as you canÆt roll a loss on a forward contract,ö Martin warns, noting that heÆs already seen investors forced into selling assets to pay for hedge-related losses. They are selling whatever is most liquid; until recently, the Australian dollar was first in line.
But Martin notes that G3 bond markets offer the biggest sources of liquidity. With redemption and repatriation supporting the US dollar, and forced selling driving up the yen, that leaves only one big market left where global investors still hold assets û and where thereÆs still enough liquidity.
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