The Lehman Brothers bankruptcy was a spectacular example of a variable outside the usual scope of the FX market that became internal to the FX market through the transmission mechanism of short-term interest rates. The perception of excessive riskiness in the interbank lending market morphed in to a perception of excessive riskiness in the euro/dollar currency market. Risk aversion is what they have in common – it’s a force through which price actions are produced.
As liquidity dried up and interbank lending tapered off to a trickle everywhere in the world, the US 4-week bank discount rate shifted from 1.92% at the beginning of June to 1.35% on 12 September – and 0.28% on 15 September, the date of the Lehman bankruptcy announcement. By year-end 2008, it was 0.11%. Yields fell all along the curve, too. The yield on the 10-year note was 4.324% on 13 June and dipped to 3.25% on 16 September. It bottomed near year-end at 2.038% on 18 December 2008. Around the same time, the euro fell from 1.5948 on 16 July 2008 to 1.2738 on 22 October 2008.
The drop in return reflects a massive safe-haven inflow to the dollar that violates the usual rule that currency follows yield. In other words, if all other things are equal, we expect a currency to fall if its yield is falling, especially the after-inflation, real yield. In 2008, investors were happy to get return of capital and never mind return on capital. The Treasury’s report on capital flows bears out this thesis. The net capital flow to the US, including Treasuries, Agencies and equities, rose from $14.76 billion in August 2008 to $59.10 billion in September. This is risk aversion in action.
It’s probably fair to say that risk appetite/risk aversion were known for decades under a different name: greed and fear. But whereas greed and fear arise from personal emotions that overcome rational cognition, risk aversion is entirely rational. The new flat world of international finance consists of players who recognise shocks and events outside their own securities’ factor set as capable of jumping barriers into their own factor set. In a sense, all factors, however exogenous-seeming, are potentially endogenous, and that’s not even counting unknown factors.
It’s not only the FX market that sees this effect. In US equities, after a 40-year delay, securities analysts started to acknowledge that multinational corporation earnings are influenced by FX rates; they were forced to start accounting for the FX effect of overseas earnings along with less difficult things like cash flow, EBITA and book value.
Information overload
Risk appetite and risk aversion are handy proxies for a broader and more thorough analysis, but if you want to follow FX and understand why prices are moving the way they are, you need to hold in your head a mix of economic data, institutional factors, and technical indicators on six or ten currencies, not to mention that ineffable thing called sentiment, which includes what the majority in the market are thinking and thus how they are positioned.
Each country has, at a minimum, ten variables you need to follow, including rate of growth of GDP, inflation, industrial production or some proxy for it like the purchasing managers index, unemployment, consumer sentiment, debt-to-GDP ratios, and so on, plus the viability of the banking system, political developments and the policy bias of the central banks and resulting interest rates. In addition, you want to know the technical condition of the currency – is it trending up or down, and with what robustness?
This is clearly impossible.
To make life more complicated, the foreign exchange market is driven by factors that constantly shift. One week, the market is focused on interest rate differentials, the next on the trade balance or fiscal deficit, and after that, an upcoming election. One minute, the market is risk-averse and clamouring for safe-haven US Treasuries, and the next minute it is willing to dive head-first into frontier markets.
How do you know whether a factor will dominate trading for months to come or is merely a one-day wonder? How do you make wise trading decisions when a driver is brand new and the market is trading in response to this driver for the first time? When has one trend run its course and another trend begun? More importantly, how do you know when to believe commentators and when to intuit they are talking through their hats?
A difficulty commentators and traders alike face is that the economics industry has failed to offer up a coherent theory of exchange rate determination (see Chapter 5). The FX industry has failed to give us basic information, so easily available in other asset classes, on positions and flows (see Chapter 6). Even the most accessible of explanations, relative interest rates (see Chapter 4), fails with great regularity. Conventional thinking would have it that the country with the highest real rate of return (real denoting after-inflation) will get the biggest capital inflows and thus a rising currency. But in 2009 and 2010, Australia was the first to start raising interest rates and had the highest real rate of return among all the developed countries, and yet the Australian dollar fell about 14% from the April peak to the May low in 2010 and again in the fall of 2011 as global risk aversion got all markets by the throat. Obviously the relative differential is not the only factor at work.
The effect of events on other asset classes, including equities and commodities like oil and gold, has a spotty record (see Chapter 7). When one big market, like equities, is in a tizzy, it tends to infect other markets. This is a variation of the falling tide lowers all boats market lore. But it takes falling stock markets in more than one market to affect currencies – usually.
And even if the fundamentals, relative interest rates and other markets all line up to point to a single conclusion, the FX market still may not obey – if the chart dictates otherwise. The chart is one of the few ways we have to get some idea of how a consensus of traders is positioned. Traders resist negative news when they are long and exaggerate the importance of negative news when they are short, and this can be seen on the chart. Unlike equity and other markets, FX embraces technical analysis with open arms – it pretty much has to, given the shortage of other information (see Chapter 8).
So, why bother to try to understand mountains of conflicting and contradictory data when a simple application of risk appetite/risk aversion will cut through the mess? The answer is that sometimes the most unlikely things can promote risk appetite and FX traders need to be like Boy Scouts – prepared. When Lehman failed, no one expected that the failure of one bank in the US would set off a global liquidity crisis, the failure of European banks, the drop in the price of oil from $146 to $36 in less than six months, or volatile gyrations in the EUR/USD as money flowed to safe haven US Treasuries.
Even when you can see risk appetite or risk aversion developing in the news day-by-day, you still want to be able to judge whether it has lasting power. As the sovereign debt crisis in Europe has evolved over several years and encompassed 19 summits (as of July 2012), the market has been mostly willing to give the European Monetary Union (EMU) the benefit of the doubt. But periodic euro rallies after summits have not been inspired by any measurable progress toward repairing problems, but rather by the extent the outcome was expected.
For example, the euro rally after the end-June 2012 summit was not set off by the seeming capitulation of Germany to a looser interpretation of Treaty conditionality, but rather because expectations of any progress at all were practically zero. A small change in conditions was seen as a breakthrough and worthy of a currency rally, even though, at the time, the euro zone was facing worsening recession and a central bank interest rate cut to boot. On the dire institutional conditions and bad economic data, the euro should have fallen. In this instance, though, risk appetite came roaring back to lift the euro on the triumph of hope over experience. In order to trade the euro correctly through this period, you had to be able to judge whether the risk appetite embodied in the euro rally was strong enough to overcome the economic data and interest rate outlook, for how long the sentiment might last, and what other institutional factor might jump up out of the shrubbery and bite the market.
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