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EUR/USD – it looks like we have 2-way risk again…

Last Friday’s employment report from the US was a lot weaker than market consensus with only 126,000 jobs created. Up till that point, it looked as though any rally in EUR/USD was a selling opportunity for the inevitable push towards parity – a level not seen for many years. The weak employment report caused EUR/USD to briefly spike above 1.10 and some market commentators appear to think that the Fed will now delay a rate hike until the back-end of the year, which may give a softer tone to the US Dollar.

Is the strong dollar causing a drag on US economic performance ? That’s difficult to say, but the main trading partners of the US are all still in easing mode and now that a US rate hike seems to have been kicked down the road, there should be good 2-way interest around the 1.10 level.

Transaction Cost Analysis – A microscopic analysis of the wrong thing ?

I attended a conference last week held at Bloomberg’s impressive building in the City. The subject was “TCA Best Practice” and the section on FX was very interesting. Bloomberg have a tool which, broadly speaking, allows fund managers to measure “slippage” when benchmark FX orders are executed. It can also measure, for example, how competitive are the various different quotes that a fund manager receives during this process. The information can be sliced and diced every which way and displayed graphically in glorious technicolour. Similar tools exist for Fixed Income and Equity markets. This functionality is very comprehensive, but I think there is more to the problem.

 For a domestic fund manager who is buying and selling foreign equities, the overall cost of the transaction is surely not just a few basis points of slippage on the equity transaction added to a pip or two of slippage against an FX benchmark. It seems to me that the equity fund manager has an FX exposure that arises the moment he buys or sells a foreign stock, which could have been many hours before the FX transaction is done. Perhaps the wrong thing is being measured ? Having said that, if your peers are all doing it the same way I don’t suppose there is much incentive to break ranks and do it any differently because fund management is a “relative performance” business.

 

“Last Look” pricing – invitatio ad offerendum ??

The debate continues around last look FX pricing and whether the distribution of information is skewed towards the dealers, and away from the customers. Well, yes – it undoubtedly is, and of course that’s the reason the systems are built in that way. I am not saying whether this practice is fair or not, but the contract term “an invitation to treat” is well established in law. It comes from the Latin invitatio ad offerendum and means “inviting an offer. The person (dealer) making that offer does not intend to be bound, as soon as it is accepted. Hence the trade rejections come thick and fast on some systems.

The important part is that users of systems with last look functionality need to know that it is being used, so that the apparent tight spreads and depth of liquidity are not just another mirage in the Foreign Exchange desert.

Now the rocket scientists are under the spotlight…..

It seems that the New York State Financial Services Superintendent, Benjamin Lawsky, has cast his net a little wider in the search for what really goes on under the hood of the FX pricing engines at several major banks. He has now issued subpoenas to Credit Suisse, Societe Generale, Goldman Sachs and BNP Paribas. This comes a few months after he had begun investigations at Barclays and Deutsche Bank.

It is one thing to accuse individual traders of colluding in order to “manipulate” the rates around benchmark fixings, but it is a whole new ball game if he suspects that the algorithms in the banks pricing engines may have been written in such as way that could disadvantage customers who are trading on the platform.

When you look at the CV’s of the brilliant minds that some of the major banks have hired to develop their e-trading capabilities, it would be naïve to think that they hadn’t written the alogorithms in favour of their employers. I expect they thought that’s what they were being paid to do  !! …………..Time will tell.

The flightless bird is soaring – but history shows it will eventually fall back down to earth….

Over the last 30 years the range for the New Zealand dollar versus the Australian dollar has been about 1.05 to about 1.40, give or take a little. This very broad range has traded up and down every 5 years or so.

The recent strength of the Kiwi has pushed the relationship almost over the edge, with the Aussie being talked down relentlessly and the RBA backing that up with rate cuts, and this morning the AUD/NZD touched 1.0350, it’s all time low.

The RBNZ do not have that interest rate tool at their disposal. Recent NZ retail sales data was strong, and even though the RBNZ governor says that his dollar should be 10% lower, he will not be cutting rates any time soon, having only just shifted to a neutral policy stance a few weeks ago.

Currency values are not just about interest rates though – There is really no good reason for this AUD/NZD relationship to break down completely. Economies go up and they go down, but these two countries are inextricably linked by their geography, so although short-term factors can push currency markets to extremes, I think it is time to take a longer term view by buying AUD and selling NZD around current levels.

Denmark – The more he shouts it….. the more you doubt it !!

Why is it that Central Bankers always feel the need to talk tough, instead of just quietly getting on with their business. Lars Rohde, the Danish CB governor keeps banging on about what he’s going to do and how much money he can spend, and how negative rates can go, in order to dissuade speculators from buying the Kroner – but they still keep buying it……After all, there are not many AAA Sovereigns left in Europe.

Denmark’s foreign reserves have been rising and now stand at over 30% of it’s GDP, but don’t worry because Rohde says “we can go on for ever” and he also reminds us that “we are the only supplier of Kroner”.

The CEO of the biggest Pension fund in Denmark (ATP) said that they haven’t bothered to hedge their EUR/DKK exposures because “We have full confidence in the Central Bank’s ability to maintain the peg”

Did I mention that Lars Rohde used to be the CEO of the ATP Pension fund……

Aussie Dollar – Mr Stevens is getting his wish.

Glenn Stevens, the Governor of the RBA, has been talking his currency down for a long time now, suggesting that 75 cents is an appropriate level for the Aussie dollar. In the last few months the currency has lost almost 20% versus the greenback, and tomorrow’s interest rate decision could bring further pressure.

The China economy is contracting, their steel mills are reducing output and the price of iron ore, Australia’s largest export, has halved in the last year. Stevens hopes that a weaker AUD will improve the domestic situation. One thing that he needs to be wary of is the house price bubble that continues to inflate – Sydney property prices are up over 12% in the last year alone.

The major trendline from the lows seen in 2001 and 2008 is around 71 cents. The 61.8% retracement of the big move from 60 cents in 2008 to just above 1.10 in 2011 has been convincingly broken, so an assault on the 70 cent level looks inevitable, even if rates (which have been on hold for almost a year and a half) do stay unchanged tomorrow.

Client confidentiality – 1990’s style…

When I was trading FX for Morgan Stanley about 20 years ago, we were doing business with a number of the larger Hedge Funds. At that time it was felt to be important that the trader knew who he was quoting when the Salesperson shouted for a price, but we were also conscious of client confidentiality. A bright spark on the Sales desk said, at the weekly meeting, that they should shout the clients name backwards. So Tiger would be “Regit” and Moore would be “Eroom” or “Nocab”. That’s a great idea, I said (with a hint of sarcasm in my voice), but what will you shout when Soros is on the phone asking for a price ? !

EUR/CHF positions – the problem with VaR…..

There are many talented, mathematical minds in the Risk function of banks and other financial institutions, and they are experts in devising models to manage risk by predicting possible market behaviour. It appears that a PhD in Astrophysics is much more useful in a Risk department than experience of how markets actually behave in the real world. The problem has always been that the models fail regularly, with spectacular consequences. No model can allow for the huge vacuum that existed after the SNB pulled their bid at 1.2000.

The most widely used risk measure is Value at Risk (VaR) and the amount of “value” (read potential loss) allocated to EUR/CHF positions (for example), when combined with some measure of historical volatility of that currency pair, will determine the maximum allowable position size that the trader can hold.

The problem with this approach is that as historical volatility falls (as it did all through 2014 in EUR/CHF) position sizes can be increased whilst still staying within the allocated VaR limit. In layman’s terms, the trader says to himself “this currency pair is not moving much, so I can take a bigger and bigger position and STILL stay within my VaR limits”.

Let’s hope that this mythical trader was long of Swiss francs last week……

Dual Currency Deposits – a layman’s guide

The Dual Currency Deposit (DCD) is a popular cash-management tool for companies that have multi currency cash flows. Let’s take a simple example of a UK-based company who are importing goods from the USA. They have an occasional need for Dollars, but they have spare cash balances in Sterling.

UK rates are low, and they are earning very little interest on their Sterling deposits. The DCD can offer a higher-than-market Sterling interest rate as long as the company accepts that their Sterling deposit may be repaid to them in US Dollars. They are effectively selling a Call option on their Sterling to the receiver of their deposit, and it is the premium generated from the sale of this option that provides the above-market deposit rate. The company must decide at which GBP/USD rate they are happy for the conversion to take place (the strike price of the option) and when this could happen (the maturity of the option)

For example, the current deposit rate for GBP for 3 months is only 0.50%. The current GBP/USD rate is 1.5200. A customer who places a DCD in Sterling with a maturity of 3 months and a “conversion” rate of 1.5500 will earn an annualised rate of approx 3.00% on their Sterling, which is significantly higher than 0.50%. After 3 months, if the GBP/USD rate is above 1.5500, the company will be repaid their deposit in Dollars.

FX Derivatives do not have to be complicated – they just need to be explained in plain and simple terms.