October 2023
This was a guest article for Macro Hive
Summary
After a strong 2022, global macro investing is back in vogue.
One segment of the global macro industry that has particularly benefited from the changed environment is FX trading.
Dedicated FX managers are seeing a resurgence of performance and, for diversified macro managers and commodity trading advisors (CTAs), FX trading has become an important driver of returns.
For hedge fund allocators, FX managers are now one of the few strategies that may benefit both from higher and more volatile interest rates.
The Golden Age of FX Trading
FX markets and FX trading have long been at the heart of the opportunity set for global macro. After Nixon severed the dollar’s link with gold in 1971 , the Bretton Woods system of fixed exchange rates began to unravel and a new era of floating exchange rates began by 1973. Initially, capital controls limited the ability to capitalise on FX movements. However, as the decade progressed, more countries liberalised the capital account, enabling freer movement of capital.
The 1980s and 1990s were the heyday of global currency trading. Stronger capital flows (what became known as ‘hot money’) combined with macroeconomic imbalances to create major moves in FX markets. In the US, Volcker’s shift to tight monetary policy coupled with Reagan’s expansionary fiscal policy in the early 1980s spurred a major US dollar rally after its decade-long slump of the 1970s. It took the Plaza Accord of 1985 to halt the rally, but that set the stage for a multi-year US dollar decline.
Europe was also a hotbed of opportunity. Although monetary union was the ultimate goal, the path to a single currency was punctuated by periodic blow-ups in the European Monetary System. Rising German interest rates in the early 1990s in response to German unification were incompatible with economic conditions outside Germany and strained the system. The blow-ups (such as Sterling’s exit from the ERM in 1992), and the subsequent convergence trends, were great trades for bank prop desks, global macro funds and dedicated FX managers.
A Lost Decade
However, in the 2000s, the growing number of dedicated FX managers were met with a diminished opportunity set. The introduction of the euro in 1999 immediately eroded a whole set of currency crosses. Later in the decade, the Global Financial Crisis (GFC) generated volatility in FX markets, but the hangover from the crisis set the stage for a tough decade for FX trading.
Chart 1: Major Economy Interest Rates 1990-2023
Source: BIS
Synchronised but subdued economic growth with little variation in growth and inflation across the major economics caused interest rates to converge to zero through the 2010s (Chart 1). This translated into more subdued FX markets and meant that many FX trading models based on momentum, carry and yield curve dynamics were ineffective.
The introduction of Dodd-Frank after the GFC prompted a decline in the number of bank prop desks as a major force in FX trading. Equally, with fewer markets to trade and more muted macro conditions, many specialist currency traders shut down. The number of dedicated FX programs reporting performance numbers to BarclayHedge (and comprising the BarclayHedge FX traders Index) peaked at 145 in 2008 and has steadily declined to 31 in 2023 (Chart 2).
Chart 2: No. Programs in BarclayHedge FX Traders Index
Source: BarclayHedge
The Return of Currency and Carry
However, just as the number of dedicated currency traders declined, the opportunity set improved. Since 2020, we have seen greater volatility in growth and inflation, desynchronised cycles between the major blocs (such as weak growth in China versus strength in the US economy) and meaningful interest rate dispersion (Chart 3). In short, interest rates are back as a key driver of currencies.
Chart 3: Dispersion in Rates Across G8 Major Currencies
Source: BIS
Greater fluctuations in interest rates are key for currency moves in at least three ways:
1. Carry
Although in theory, spot and forward currency values are tied to interest rates via the no-arbitrage condition of covered interest rates parity, the ability to borrow more cheaply in one currency and invest at a higher interest rate in another (a carry trade) tends to heavily influence short-term capital flows. Such carry trades become particularly attractive when the fundamentals are perceived to be favourable for the higher-yielding currency (as with USD/JPY last year and again this year).
2. Value
Although interest rates often drive short-term moves, valuations matter over the long term. Carry-related moves tend to drive currencies away from fair value and create trading opportunities for more value-oriented investors.
3. Asset markets
As all assets are valued by discounting future cashflows, changes in interest rates influence domestic bond and equity markets and drive capital flows in and out of the country. Declining interest rates can be positive for a currency if they drive appreciation of local bond and equity markets and flows into the country. Quantitative macro currency traders often seek to capitalise on lead-lag relationships between interest rates, asset markets and currency markets.
From this perspective, it is telling that not only have interest rates risen and dispersion has increased, but the greater amplitude of the rates cycles since 2020 is also contributing to the improved opportunity set (Chart 4).
Chart 4: 1-Year Change in Official Interest Rates G8 Currencies 1990-2023
Source: BIS
Implications for Investors
The better environment for FX trading is reflected in hedge fund manager performance. 2022 was a strong year for both global macro and managed futures, and the BarclayHedge FX Traders Index posted its strongest annual return since 2003 (Chart 5). Diversified managers are also seeing FX trading move from being a drag on performance to a driver of returns. A recent paper from Aspect Capital, a large CTA, highlighted how simple carry and momentum models applied to FX markets are seeing their best performance recently since the 1990s.
Chart 5: Annual Performance of BarclayHedge
FX Traders Index 1990-2023
Source: BarclayHedge
For investors and allocators, stronger trends in interest rates and currencies are part of the more constructive outlook for global macro and CTAs more generally.
However, as interest rates have ratcheted up, an important question asset allocators are now asking is whether hedge fund allocations still make sense given significant competition from the higher yields in fixed income and credit. A corollary is which hedge fund strategies will benefit and which will struggle in a higher rate environment.
As currencies are traded on margin, currency funds tend to hold a lot of cash and benefit directly from the higher return on cash deposits as well as the potentially greater trading opportunity that comes with increased macro volatility.
Having been out in the cold for a decade, specialist currency managers may now offer a compelling option to hedge fund allocators.
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