Sunday, 31 August 2014

You can't always get what you want in FX

15:53 Posted by The Thalesians (@thalesians) No comments

Mick Jagger and Keith Richards once wrote "you can't always get what you want". They later noted "but if you try sometime you find, you get what you need". I am too young to remember this song being released, although, perhaps for some of you reading, the year in question, 1969, represented the springtime of your life. I was instead a child in the era of Lionel Richie and his "Can't Slow Down" album. I came across an original vinyl version of it quite randomly several months ago outside an Amsterdam record store (see above). The reason why I bring up the Rolling Stones and Lionel Richie, which are perhaps the most unlikely musical combination you could ever conjecture, is that their lyrics might (just) help to describe currency markets recently.

Following currency markets for nearly a decade, I cannot remember a more despondent time amongst market participants. To paraphrase the Rolling Stones somewhat, currency traders have failed to get either what they want or need in terms of returns. Volatility has been so sapped from currency markets, that, for a time over the summer, EUR/USD and USD/JPY short dated vols were on a 4% handle, an indication of the severe lack of activity or interest in the market. Is it true that currency markets just "can't slow down" any more to use the words of Lionel Richie? In retrospect, the plethora of media articles earlier this summer on the lack of volatility was perhaps an indication that we had reached a low. Why should currency volatility matter for traders? Generally, currency market makers are more profitable when volatility (& volume) levels are higher. In terms of the buy side, broad based indices for currency funds show it has been a tough time for them as a group too. If we take for example the HFRX Currency Fund index, it is close to flat on the year as of end of July.

It has not simply been a lack of volatility that has adversely affected the currency markets. The furore over the 4pm FX fix has rumbled on for a year. Indeed, the first inklings of the subsequent controversy were sown in August 2013, by a Bloomberg article and it is now a focus of regulators. For those of you interested in reading more on the 4pm FX fix story, I have written an earlier blog article on the subject and some of my research on the topic was featured in the Wall Street Journal. A lot of the debate around the 4pm FX fix has revolved around the notion that currency markets are supposedly "rigged". The way I view it is that markets are never easy places to make money. You need to do a lot of work in order to be profitable. Even then, it is remains frighteningly difficult to be consistent in your profitability. This is something strikingly different to being "rigged". If you fail to spend the time and effort required, markets will appear even more unfavourable.

However, despite what might appears to be the glum message of the post so far, for currency traders there does seem to be some light ahead. In Mohamed El Erian's recent article (see FT: Rising risk of currency market volatility 26 Aug 2014), he noted that the conditions for a pick up in currency market volatility are here. Indeed, we have already seen some pick up in EUR/USD implied volatility in the second half of August. There have also been the return of trends within the market, notably seen in the decline in EUR/USD in recent weeks. Positioning data suggests a large amount of net short speculative positioning in EUR/USD, indicating that this is likely helping to buoy currency traders returns.

El Erian notes that the beginnings of monetary policy divergence, a factor which is crucial for driving currency markets, is likely to push up currency volatility. A pick up in volatility, is unlikely to be helpful for high beta trades (like currency carry trades). Indeed, for example in equities markets typically high levels of vol tend to be coincident with weaker equities markets.

However, rising currency volatility is likely to aid trend followers. Macro traders examining relative interest rates amongst currencies are also likely to welcome divergences in monetary policy, after a period of extraordinarily low rates. We also note that, from a seasonal viewpoint, historically currency volatility tends to pick up through the autumn as well (see Thalesians: Seas-onal the day - Understanding seasonality in market volatility - 2 May 2014).

Whilst, opportunities have been far between in currency markets for much of this year, it does appear that times are changing, if this pick up in currency volatility is sustained and we see a continued divergence in monetary policy. So whilst currency traders might not have got they wanted for most of 2014, perhaps it is time that they'll get what they need. The time is surely coming for some dancing on the ceiling...

To read more about vol seasonality, see my Thalesians quant paper listed below. My book Trading Thalesians also has some colour on market volatility (mixed in with a bit of ancient history). Pre-order on Amazon UK here and Amazon US here.

Thalesians - Seas-onal the day - Understanding seasonality in market volatility - 2 May 2014 (Available for Thalesians clients only. Ask me for subscriber details! Shortened versions are available for free)

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