It’s worth putting into context the environment in which FX finds itself at the end of 2013. If there is one rule that works for FX, it is that no rule lasts forever (if that can be a rule!). FX is simply money, so the rate of return on money and hence central bank expectations remain integral. You only have to look at how tapering has entered the mainstream market lexicon to appreciate that; not only for FX but for pretty much every other market besides.
But within this, there has been a big shift that still prevails today. In the period 2002-2008 H1, trend and momentum dominated many FX pairs. For example, let’s take the dollar index in the first two years of that period. Seventy-five percent of the months saw the dollar depreciate in the first two years. The dollar was up only one year. In other words, it was a pretty strong bear market for the dollar. Consequently, for others it was a secular bull market, most notably for the Aussie, but also for the kiwi and euro.
Leaving aside the period in H2 2008 and 2009, we can contrast the pre-crisis period with the past four years. To do this for the majors, I looked at the change in the p-value for the ADF (Augmented Dickey-Fuller), which tests for the stationary (non-trended) or otherwise (upward or downward trend) over the period. Don’t worry about the numbers, just look at the change between the two periods, because this gives a measure of the degree to which the currency has moved from seeing a strong to weaker trend.
So the chart shows that this change is most stark for sterling. Having moved from 1.40 to above 2.10 in 2002-2007, it has held within a 1.42 to 1.68 range in the previous four years. In contrast, the sharp depreciation of the yen from late 2012 to mid-2013 means that on this measure at least, (there are alternatives) the yen has become a more trended currency in the post-crisis period.
This has not made life easy for those looking for big and sustained trends in FX markets, which is more the preserve of macro hedge funds rather than our average client. Again, taking the dollar index as a general but instructive proxy, it has not broken out of the range carved out in the second half of 2008 and the first half of 2009. So it’s pretty hard to say whether we’ve been in a bullish or bearish dollar market and those calling for a break higher on the back of Fed tapering (and ECB easing) have been left sorely disappointed by the price action in the second half of this year.
Overall, volatility has also been greater in this post-crisis period compared to levels prevailing in the pre-crisis period. The CVIX (from DB), measuring a basket of implied volatility on currencies similar to the VIX for equities, has been on average 25% higher in 2010 -2013 vs. the pre-crisis period.
This has meant two things for the bigger macro players. Firstly, trends have been shorter, so as soon as conviction rises, the trend can often reverse. Secondly, volatility can often stop-out trend followers, because intra-trend corrections tend to be larger.
The final issue that should be considered at the outset is the impact of central banks and QE on currencies. In the early days, it was pretty simple. QE pushed currencies lower, initially and principally the dollar, through a combination of cheap money and plenty of under-valued assets, especially beyond dollars. That interplay has become a lot weaker. Indeed, since QE3 started, the dollar is higher and its predecessor (operation ‘twist’) also prevailed over a strong currency.
I started noting this changing trend in the early part of 2013 (see “From RORO to MORO”). Changes in central bank balance sheets (as a proxy for QE) started to matter less for currencies, the magnitude of data ‘surprises’ (the degree to which data was above or below expectations) mattered more. This largely continued for most of the year, especially when Fed tapering speculation built from May to early September.
The question is whether we are going to break out of this post-crisis dynamic in 2014. In reality, my suspicion is that we will not. We saw 2013 as the year of divergence, which probably applied to the first half, but has been largely frustrated in the second half, principally those looking for a sustained move higher in the dollar. A sense of dollar frustration will still be a feature, even when tapering has started. The Fed has assured markets that tapering does not mean tightening, limiting the upward drift of market rates. The firmer dollar dynamics are likely more in the second half, once tapering is more complete. The Aussie will be the weakest on the majors and the euro will continue to surprise to the upside, more so in the early part of the year.