First there was carry, then there was risk-on, risk-off (sometimes called RORO) and now we’ve entered a new world order in FX, one which we’ll call MoRO (modified risk-on). Let’s take a look how this regime may work and what it will mean for FX trading.
Carry was easy, or as easy as these things get in FX. Between 2000 and 2008, a simple carry strategy (shorting low yielders, long high yielders) would have produced around 4.5% in excess returns. Volatility was also lower vs. the S&P 500. Since 2010, the returns from such a strategy have halved and volatility has doubled.
In its place came RORO. Asset classes and currencies became highly correlated, helped by central bank quantitative easing. For example, the 6 month rolling correlation between AUDJPY and equities (S&P 500) was just over 0.70. On the same basis, gold’s correlation with equities has been up at 0.50 on occasion and its’ inverse correlation with the dollar (DXY index) has been -0.66. Of course, such correlations in returns proved to be a nightmare for asset managers and for relative value plays within asset classes.
There are two major things to note so far this year. Firstly, these correlations that dominated the RORO period have been declining further (we were highlighting the changing dynamics towards the end of last year). Take another example, whereby the Aussie has become less dependent on global commodity prices. The 6 month correlation between the Aussie and the GSCI metals index has declined from 0.60 in August of last year to 0.34 currently.
Secondly, there has been a marked shift in sentiment towards the single currency, which has been mostly in evidence on EURCHF, but also on sterling. The flight of capital from the Eurozone and also from the periphery to the core is showing signs of at least stabilising and in some cases, partially reversing.
So whilst we may look at the underperformance of the yen and relative resilience of the Aussie as evidence that the RORO dynamic of old is very much alive, the moves of others show that it is breaking down. The Euro’s outperformance on the majors, the CAD’s more sluggish tone and the reverse safe haven flows discussed above.
The other way of looking at it is that capital is becoming more sensitive to domestic considerations, rather than the ebb and flow of risk. The change of government in Japan and anticipated adjustments to BoJ regime are the most notable reflection of this and a far more dominant force in weakening the yen than any perceived “risk-on” rationale.
Finally, related to this, the trends in the underlying balance sheets of the major central banks are diverging. On a 4 week rolling change basis, we’ve seen the Fed and BoJ central bank balance sheets expanding since early November, whilst the ECB and BoE are contracting. Of course, EURGBP performance shows that this does not have direct FX implications, but the divergence shows that central banks are taking different paths in their strategies, away from the more uniform expansion of the earlier QE period. On a broad perspective, this is going to make FX a lot more interesting in the coming weeks and by then, we could have moved into a new regime for FX. From MoRO to…?