Copying and distributing are prohibited without permission of the publisher.


Picking the right game-plan in volatile markets

02 Jun 2008

The turmoil in the world’s credit markets since the summer of 2007 has proved how quickly conditions can change in the financial markets. Choosing the right FX strategy has never been more important. 

The sudden swings in the yen/dollar market highlight just how important it is to be fully informed. But predicting which way the yen will move next is no simple task.

The global credit crisis has reinforced the idea that the yen functions more as a proxy for international risk appetite than as an independent Japanese currency. As the dollar slides and global markets slump, the yen rallies, and that leaves Japanese investors exposed to forces outside their own market, and well outside their own control.

"Although the strong yen has contributed to lower import prices of raw materials and products, soaring raw material prices have a profound impact on our business and prime costs have been increasing as a whole," says a treasury official at Suntory, the Japanese brewer.

The popular opinion is that the yen will continue to gain ground against the dollar through 2008. But the key question is by how much?

"The yen has become an indicator of risk aversion in the global market," says Ashley Davies, senior foreign exchange strategist at UBS in Tokyo. "It has rallied against the dollar as people have become more concerned about the health of the US economy, and we think that process will continue. The dollar may gain some ground in the short term, but we are forecasting a yen/dollar of around 100 at the end of 2008."

Masafumi Yamamoto, head of FX strategy at Royal Bank of Scotland in Tokyo, predicts the yen will rise to ¥96 to the dollar by the end of this year.

"Risk appetite is the main focus," says Yamamoto. "The yen’s strength is a sign of the risk aversion of global investors, and we think that has some way left to run. The underlying problem is the US economy, and that worry is still there."

Eisuke Sakakibara, the former vice minister for international affairs and the man known as Mr Yen during his time in office, told EuroWeek’s sister publication Emerging
in April he believes the yen will break ¥90 to the dollar this year as Japanese investors unwind their overseas investments.

While that will hurt Japan’s exporters, one treasury manager at a big telecommunications firm welcomes the stronger yen.

"Basically, foreign currency assets and liabilities balance, so the impact has been neutral," he says. "However, because there is an import flow from abroad in the communications business, if anything there is a sense that an increase in the value of the yen works in our favour."

Junpei Yamamoto, head of FX sales at Barclays Bank Tokyo, says the outlook for the yen depends on whether subprime-linked disruptions get worse or subside. "Renewed investor appetites could lift the yen-dollar rate back to the ¥110 level over the coming year," he says.

Richard Yeatsenga, regional foreign exchange strategist at HSBC in Hong Kong, has a more optimistic view for the dollar.

"The yen-dollar will head back up as the dollar strengthens through 2008, and it is likely to reach ¥115 by the end of the year," he says.


Slowing economy

The tremendous demand for the yen as a safe haven investment — both for Japanese and international investors — has to some extent shielded it from the effects of domestic developments in early 2008. News that would otherwise have been detrimental to the yen has been lost in the fog of the global market turmoil.

Japan’s domestic economy, however, cannot be entirely ignored, and here analysts are in a dilemma.

Inflation data released at the start of April showed that prices rose by more than 1% on an annualised basis. That would ordinarily allow the Bank of Japan to consider raising interest rates above the paltry 0.5%, yet confidence in the economy is running low. The widely-followed Tankan index of business sentiment dropped sharply in the first quarter of 2008 to 11 points — a four year low — suggesting that policymakers may need to keep interest rates low to stimulate growth.

"Inflation is putting the BoJ under enormous pressure," says Yeatsenga at HSBC. "Price rises are unwelcome for Japan’s fundamentals but the idea of a rate cut is untenable."

Adding to the confusion is the fact that the Bank of Japan was embarrassingly without a governor for several weeks, leading to speculation that the position had been weakened by the leadership crisis. RBS’s Yamamoto, however, believes the new governor at the BOJ will be reluctant to change the current interest rate regime.

"Masaaki Shirakawa was involved in the big policy decisions taken under the leadership of former governor Fukui, so he is unlikely to change the previous policy," he says. "The economy may be slowing, but not to the extent that the BoJ will be cutting interest rates. We think rates will stay unchanged until the third quarter of 2009."

The major manufacturers who report for the Tankan survey are not confident about Japan’s economic outlook, and the index is expected to fall further in the next report in June.


Re-engineered economy

There is, however, some room for optimism in Japan’s shifting trade patterns. Manufacturers cannot compete on price with cheap Chinese goods, but instead Japan has developed bigger links with Europe and re-engineered its economy to benefit from China’s boom. A large proportion of Japanese exports goes to China, and though some of those exports eventually end up in the West, that leaves Japan less exposed than many of its Asian neighbours to a slowdown in the US.

Exports to China accounted for ¥12.8tr of the ¥40.4tr exported to all Asian countries in 2007, according to data from Japan’s Ministry of Finance. Asian buyers accounted for 48% of Japan’s total exports last year, and that will help protect Japan from a recession, says John Richards, head of Asian research at RBS in Tokyo.

"Intra-Asian trade is not just a matter of shipping raw materials for assembly before they end up in the US," he says. "Japanese cosmetics are very popular in Asia, and manufacturers export a lot of technologically advanced products to China and the rest of the region. Asia’s middle classes are growing and in good shape, while there is also a big need for a big infrastructure build-up."

What does an uncertain economic environment mean for the foreign exchange markets? In the short term, at least, market players will become more cautious. The crisis in the financial sector is also putting pressure on banks to control and reduce their risk-weighted assets. This trend could favour FX products as they are usually less risk-intensive, compared to other financial instruments.

"We have started a period of high volatility that will last through 2008 and possibly into 2009 as well," says Ivan Ferraroni, head of foreign exchange for Japan at RBS in Tokyo. "We just recently escaped a dollar crisis. In fact the risk is still quite high making it very hard to be optimistic about the US economy. As a result, a lot of Japanese investors are going into foreign investments fully hedged, which means they don’t trust the levels of the currencies at all."

Ferraroni believes another slide in the US dollar cannot be ruled out.

"Inflation is here to stay, so at some stage there will be a shift back to high interest rates across Asia. The main effect of this will be a big correction across a number of global equity and bond markets, which to some extent has already started to happen.

"In the US, equities are cheap but Treasuries at the long end will need to come off hard thereby leading to further weakening of the dollar. Diversification away from US Treasuries by sovereign reserve managers and petrodollar countries has thus far been extremely low but this could be the trigger."


Quant is coming

As demand for information grows, another growing area of research that can help investors pick the right long term strategy is the use of quantitative analysis, which depends on mathematical analysis of historical trends to predict trading patterns. Quant strategies vary from the rapid-fire world of high-frequency trading, where investors use models to spot short term anomalies and arbitrage opportunities, to long term risk management.

Quant methods can be used, for example, to determine the optimum amount of hedging on a portfolio of foreign currency assets, and that may apply to any large investor from banks and asset managers to insurance companies and hedge funds.

"In part, the Japanese market is already familiar with quantitative solutions, but the potential for growth is huge when you compare it to other markets around the world," says Pete Eggleston, global head of quantitative solutions at RBS in London. "Quantitative models can be combined with other research methodologies and that applies to a broad range of clients looking to either hedge exposure from foreign currency denominated assets, or to use the currency market as a source of additional return."

At the most sophisticated end of the scale are the funds who look to take advantage of short term opportunities through quantitative models, but many Asian clients are also interested in the medium to longer term investment horizons, Eggleston says.

"The conversations we are having now are very different compared to two or three years ago," says Eggleston. "Asian asset managers are diversifying outside of the G3 markets and into a broader array of foreign currency denominated assets. It’s only natural that they should be looking to do something with that currency exposure. That is a new trend, and more and more people are realising they can use their currency exposure to generate returns."


Does it work?

Quantitative models often don’t take into account the possibility of sharp market shifts, which can leave investors who rely on quant strategies facing big losses. That is a particular concern in Japan, where the currency has proven on numerous occasions that it is capable of sudden swings.

The big carry trade unwind following the near-collapse of Long-Term Capital Management, the US hedge fund, in 1998 sent the yen soaring 29% against the dollar in two months as investors sold dollars to buy yen and pay off yen loans — including a massive 16% gain in just one week (October 4-10).

Such periods of high volatility are notoriously bad for quant investors who are looking at short term momentum strategies.

RBS, however, has come up with a regime switching model, which aims to identify when a market is about to move from a period of low volatility to high volatility, giving investors the chance to amend their trading strategy.

"The model highlights when these periods are coming and effectively turns itself off," says Eggleston. "Investors might then decide to trade volatility rather than the currency trend."

The yen/dollar rate has fluctuated between 113 and 97 since the start of 2008, but Eggleston says his model performed reasonably well. Momentum investors would not have been so fortunate.

International research tools are finding a growing audience in Japan, where investors have come to realise that moves from the European Central Bank or US Federal Reserve have a bigger bearing on the Japanese currency markets than the slow-changing Japanese economy.

While risk aversion is running high around the globe, that focus is unlikely to change.
02 Jun 2008