Japan is actively devaluing its yen. Other nations threaten to retaliate, in kind, to stimulate their own economies through cheaper exports. A global currency war could wreak havoc on many smaller economies and stall out the budding recovery under way in larger ones … or not.
And it is that “or not” part that worries and delights some foreign exchange trading desks. They may be salivating about the increasing trading activity all this “currency war” talk is generating, but at the same time, they also have to deal with fretful currency investors.
“The phrase ‘currency war’ may be overblown, especially compared to the massive swings we saw in the currency markets in the 1980s and ’90s,” said Collin Crownover, senior managing director and global head of currency management at State Street Global Advisors, which has 16 portfolio managers dedicated to currencies, and about $100 billion in currency assets under management. “I think the term now means more political posturing by governments that don’t want to lose export market share to their neighbors.”
The term “currency war” has come to mean a competitive devaluation of currencies among several countries, each seeking to spark economic growth through increased exports goosed by their weakened currency. When one or two countries pursue these devaluation policies, it can work to benefit that country even though there are dangers of inflation and continued economic weakness. However, when the entire world is drawn into similar action, a free-fall of currencies and economies can occur that is often difficult to reverse.
The same is true, several currency traders said, in the FX market. If one or two countries send their currencies down, you have trading opportunities; if too many others follow suit, you can have a meltdown. And, should this playing-with-fire approach to global currency negotiations, which many world leaders seem eager to engage in, actually spread out of control and cause widespread economic catastrophe, even the most fleet-footed FX investors might not escape the carnage with their portfolios intact.
Pound Protection
Some trading desks are fielding desperate questions from investors as to which way to bet or hedge and on which currency. “And throwing terms like ‘currency war’ around only adds to the anxiety,” said Glenn Uniacke, head of options at FX specialist Moneycorp. “Anything with the word ‘war’ after it can’t be good to work with or to ease fears.”
Uniacke said that Moneycorp, a U.K. firm that provides foreign exchange services for individuals and corporate clients, is trying to calm its British clients who are seeing the pound take a beating in recent weeks and are worried the free-fall isn’t over yet.
Moneycorp, like trading desks all over the globe, is concocting complex FX trading strategies to help currency investors either hedge against further devaluation in home currencies they have to hold or engage in opportunistic trading to play the spreads between declining and strengthening currencies, Uniacke explained.
For example, his U.K. clients are not happy that the British pound sterling has fallen to multi-year lows against the U.S. dollar and euro. Many investors, who worry about locking in the pound at a bad price, are using “put” contracts to hedge, either alone or in tandem with regular forward contracts.
The way this trade works in practice is that a trader uses a “two-legged” price strategy, selling pounds at the current lower price, but then buying puts to sell the pounds later at a higher price. That engenders the right but not the obligation to sell. For example, the trader can buy the right-for 3 basis points on the value of the trade-to sell pounds for a strike price of $1.48 over the next 12 months, which locks in a floor price. This gives the buyer protection against further decline in the pound, and a bonus of unlimited upside if the pound rebounds and increases beyond $1.48. That would be because the put option would effectively allow the trader to buy U.S. dollars at that price, even if dollars were selling on the exchanges for much higher.
“It’s a ‘trade now or trade later’ mentality, depending on where you think the pound will go,” said Uniacke. “And this strategy provides a barrier to protect against those worst-case scenarios.”
In fact, Uniacke added, some investors have chosen to do this trade for free by using a collar on the put option, say, at the $1.63 level, which limits the upside potential, but eliminates the 3-basis-point cost. Then, even if the pound appreciates above $1.63, the price for the trader would stay at that collar level.
“There are so many connotations that investors are seeking out,” he noted. “And judging by the conversations we’ve had with our U.K. clients, they are very concerned about where the pound is going.”
Return of the Currency Carry Trade
Of course, not all currency-war-related trades are defensive ones. Philip Simotas, president and director of investment management at FX Concepts, a New York-based currency hedge fund with around $2.9 billion under management, said the FX market is seeing a return of a longtime favorite: the currency carry trade, which allows investors to play the interest rate differential among currencies.
In that trade, investors buy higher-yielding currencies-those with higher interest rates, like the Brazilian real-against those with lower rates, like the U.S. dollar or the yen, Simotas explained. Then, investors, via a FX futures contract, can gain on the difference between the two currencies’ interest rates over time, and can also gain on the spot trade if the higher-yielding currency actually strengthens.
“There is a great opportunity in the currency carry trade,” said Simotas. “Since December, these trades have worked well again.” There is, however, great downside risk if the higher-yielding currency involved in the trade continues to fall in value. The Brazilian real, for example, has fallen almost 15 percent since 2010. In fact, it was the continued devaluation of higher-interest-rate currencies that killed off this once popular trade over the past three years, Simotas noted.
Dancing with the U.S. Dollar
I think investors are always trading, no matter whether you call it a war or not,” said Kit Juckes, head of foreign exchange at Societe Generale in London. Since the financial crisis began in 2008, global currency investors have been doing a dance with the U.S. dollar, he explained. They would buy up dollars when they felt global risk was rising, and then abandon them for higher-yielding currencies when those concerns about risk waned.
Over the past few years, investors had been moving into higher-yielding currencies like those of Australia, Mexico, Brazil and even Canada, but then these currencies started getting too expensive. “It’s like going to three-star restaurant, but then realizing that the food quality has gone down and the prices have gone up,” Juckes joked.
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