Foreign Exchange Gone Wild
Why life has gotten a lot more complicated—and potentially profitable—for currency traders.
By TOM LAURICELLA
So much for peace and quiet.
For the past decade, the foreign-exchange markets have been positively placid. Some of the credit goes to the euro, which gave Europe a single currency, simplifying the equation for investors. At the same time, a slew of emerging nations did some serious fiscal housekeeping, putting an end to the major ups and downs of their economies and markets.
Then came the financial collapse in 2008.
The euro has been battered back and forth as investors wrestle with diverging fortunes among Europe's economies and politically charged battles over how to potentially bail out struggling countries. Elsewhere, investors are contending with central banks that are undertaking massive efforts to slow the rise of their currencies. In the U.S., there remain worries that the Federal Reserve is on a mission to devalue the dollar.
The increased risks have made life a lot more complicated for foreign-exchange traders, or indeed for anyone who needs to change one currency into another—whether it's to buy foreign stocks or bonds, build a factory overseas or just plan a trip. It's harder to set investment strategies, manage holdings and avoid big losses. So, currency players are scrambling to adapt, trying to reduce risk and protect against short, sharp losses.
"Currencies are the ultimate sovereign or macro asset class," says Eric Stein, a portfolio manager at Eaton Vance Global Macro Absolute Return Fund, which holds $7.7 billion in assets. "What had been a private-sector debt crisis in both mortgage and bank finance has now morphed into problems with public-sector debt and that becomes a bigger issue for currencies."
But there's another side to the volatility story: the potential for tremendous profits in the choppy markets. As exchange rates swing wildly, currencies are making extreme moves, and many are flirting with all-time or multiyear highs, including the Swiss franc against the euro, and the Australian dollar and Japanese yen against the U.S. dollar.
So, with currency markets more volatile than they've been in years, investors have been pouring in to get a piece of the action. Daily market volume stands at $4 trillion, according to a survey of the industry by the Bank for International Settlements—and UBS recently forecast that the market would reach $10 trillion a day by 2020.
Look Both Ways
The big risks facing currency traders these days come from two directions: developed economies and emerging nations.
Randall Enos
Major central banks have been going to extremes with monetary policy to keep their economies afloat. In the U.S., the Federal Reserve has undertaken a second round of so-called quantitative easing, injecting dollars into the economy by buying U.S. Treasury bonds. The Bank of Japan last fall joined the Fed with a quantitative-easing program. Speculation persisted about similar steps from the European Central Bank and Bank of England—though now currency traders have been whipsawed in their thinking, and the focus in Europe is on higher rates.
Adding currency to an economy helps get money in the hands of cash-strapped citizens. But it makes the money already in circulation less valuable—so currency investors abandon it and seek out currencies that are less likely to fall in value.
Often, that means turning to the emerging economies that have become increasingly important actors on the global economic stage. The Singapore dollar and Thai baht, for instance, are both up 11% against the U.S. dollar over the past year.
This is where the second big policy risk starts to brew. Many of these emerging countries don't want so much attention from investors—and they're taking steps to keep them out. Exports are central to these countries, and a stronger currency makes their goods more expensive—especially compared with China, which has kept the yuan closely pegged to the U.S. dollar. Meanwhile, all the inflows of capital heat up their economies and threaten inflation.
Policy Dilemma
The situation poses a sharp policy dilemma for these countries' central bankers: Raising interest rates, the conventional economic response, just attracts more hot capital, further fueling potential asset-price bubbles.
So, financial authorities first tried turning to less-orthodox measures. In October, Brazil twice raised taxes on foreign investors and then in January imposed more penalties on short-term investments. Thailand, where capital controls imposed back in 2006 caused widespread anger among foreign investors, reinstated a withholding tax on outside bondholders. In November, South Korea said it would impose a tax on short-term investments in the country.
According to J.P. Morgan Chase & Co.'s emerging-markets currency analysts, capital controls constitute a major risk for investors in Asia. "While our base case is that control measures in Asia will be gradually implemented and modest, the risk is that policy makers may become increasingly emboldened and act more aggressively next year," they wrote in their 2011 strategy outlook.
But as this year has unfolded, building inflation pressures have forced the hands of many central banks. Both South Korea and Brazil raised rates in January.
Jeff Feig, global head of G-10 foreign-exchange trading at Citigroup Inc., says the environment has investors reassessing how they approach the currency markets. Most clearly, he says, more long-term investors are looking to shoulder the costs of hedging to protect against short-term losses on unwanted currency moves. "If you're running at 5% or 6% volatility in the market, and you're expecting to make 25% or 30%, you may not worry about it and not hedge," he says. "But if you've got 15% or 20% volatility your profits on an investment can be wiped out just by the move in the currency."
For example, with the euro, the longstanding assumption was that it would rise steadily against the U.S. dollar. "You saw a lot of complacency and then last year when the euro started to weaken, a lot of U.S.-based investors and corporations realized, 'We've got a risk here,' " says Mr. Feig.
At Barclays PLC, Michael Bagguley, global head of foreign-exchange trading, says investors making outright bets on currencies have also been looking to minimize the risks of the more volatile markets.
He says that's shown up in greater interest in owning baskets of currencies aimed at capturing certain trends. "Instead of positioning in a single currency pair, owning the basket reduces your risks," he says. One such popular trade in the past year has been to own a so-called BRIC basket—currencies from Brazil, Russia, India and China—while simultaneously betting that a basket of currencies from the big, developed countries will fall.
Playing Carefully
The more volatile environment also warrants a different tool set for the growing number of small investors trying their hands at currency trading, says Kathy Lien, director of currency research at Global Futures & Forex Ltd. For starters, it probably calls for using less leverage—borrowed money—when placing trades, she says. That's because leverage, by its nature, magnifies the gains and losses that are possible for a trade. In addition, in markets that are tending to bounce wildly, it may make sense to be a little quicker to take profits when they present themselves. In this environment, profits "can reverse in the blink of an eye, she says.
Lastly, Ms. Lien says, it calls for greater use of stop-loss orders, which are designed to automatically buy or sell at a certain price to prevent outsize losses. "If you don't use stop-loss orders, the currencies these days can be more likely to move farther against you than in a low-volatility environment," Ms. Lien says. "These are unprecedented times."
Mr. Lauricella is a staff reporter in The Wall Street Journal's New York bureau. He can be reached at tom.lauricella@wsj.com.
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