FX Markets 2010 – The Old Maid, Global Imbalances and Carry Trade

This piece was written before Christmas and will appear in the first 2010 edition of the Forex Journal. The data covers the market up until mid December.


Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall. In this way, and although one sometimes get the feeling that everyone believes that everybody may actually export their way out of their current misery, buying one country’s currency means selling another and thus, someone (be it an individual economy or a group/basket of economies) must end up holding Old Maid.

The discussion on global imbalances has many faces, but in the context of currency fluctuations and FX markets the focus tends, one way or the other, to gravitate towards the need for the US dollar to fall. This was evident before the crisis and still is. However, if this seems obvious to the most ardent dollar bears as well as to those who still see a structurally important role for the buck going forward, it has been far less evident who should pick up the slack if the dollar is to correct to the new global fundamentals. In this way, key emerging economies are still pegging their currency to the green back and in general; while most claim to see the benefit of a strong currency they just don’t want it to be their currency.

The interesting point here for economists and FX traders alike is then that whoever might appear to hold Old Maid today may not hold it tomorrow and in fact, this game, as it were, of Old Maid will ultimately have to give way for a structurally more lasting setup in which a so far unspecified group of economies will have to face the prospect of doing the heavy lifting in the context of global imbalances.

In this context, the important point to take home is that while intra-G3 currency moves may seem to suggest otherwise, rebalancing can never occur along this axis. This means that rebalancing must be narrated in relation to big emerging markets where the counterpart to dollar weakness has to come in the form of a basket of economies such as Brazil, India, China, Indonesia, Turkey etc. However, these economies are not happily assuming this role either and if they are not outright fixing their currency to the whims of the USD (and thus the Fed’s quantitative easing), they are busy contemplating how to slap on capital controls to control the flood of money coming in as a result of cheap funding opportunities in USD and/or JPY.

In short, they don’t  want the appreciation either and thus on we go into a market environment driven by the search for yield and where any signs that an economy may be able to sustainably offer a higher yield than elsewhere will trigger currency appreciation proxied by capital inflows to high yielding currencies funded by borrowing in low yielding currencies (carry trades).

The structural and theoretical factors that underpin such currency movements are important to emphasize even if they are, by now, an integral part of currency traders’ vocabulary. In a theoretical sense we are talking about the non-existence of the uncovered interest rate parity which has come to be known as so-called carry trade fundamentals.  These fundamentals as it were simply specify the well-known correlation between low yielding currencies and risky assets as well as market volatility. Concretely, this is the tendency for low yielding currencies to appreciate in conjunction with a fall in risky assets and increases in market volatility. Low yielders which traditionally have counted the CHF and the JPY have consequently been known to react on risk sentiment in the market where periods of low risk aversion saw these currencies used as funding currencies in carry trades that would subsequently unwind during periods of above average volatility. With respect to the market this means that above and beyond safe haven flows towards the G3 in periods of drama, interest differentials matter especially so, expectations of future interest differentials. Moreover, empirical evidence suggests (see e.g. Vistesen (2009)[1]) that periods in which the difference between low volatility and high volatility periods are large and significant, will also be the periods in which carry trade fundamentals are strongest (even if cross-asset correlations are always subject to notable time variation).

Beyond the concrete mechanics of the carry trade, this market feature also raises some fundamental questions about the effectiveness and transmission of global monetary policy Vistesen (2009) and Hugh (2009). To see this, consider first the question of where all the liquidity provided by the BOJ, the ECB and the Fed is actually going. Surely, the aim with such aggressive policies is to mend the domestic economies, but in a world where emerging economies continue to move along at +5% growth rates[2] low policy rates in the G3 act as a hugh sheet anchor for carry trading activity.

The flip side to this is then the receiving economies where, much to the chagrin of many central bankers, raising rates to quell the inflation that must come on the back of hot money inflows only serves to worsen the problem. Thus, and with a number of central banks stuck near the zero bound, raising rates only intensifies the pressure. This has been abundantly clear in economies such as Brazil, India, New Zealand, Australia, and most importantly in the CEE where many economies actually de-pegged back in 2008 with respect to the Euro because it was believed that the carry flows would lead to nominal appreciation that would choke off inflation. It initially did, but as risk aversion increased the CEE currencies plummeted.

This then is my view of global capital markets where the globalization of monetary policy drives carry trades to effectively weaken the control with which economies can deploy monetary policy to e.g. fight asset bubbles. It is important to keep this in mind in the points that follow.


The G3 in 2009 – A Recovery in the Works?

Even if economic activity in the first half of 2009 was heavily affected by the economic turmoil, the second half has seen the bulk of the developed world race back towards positive growth rates and thus, according to many, a recovery. Moreover, and in stark contrast to the complete seizure of credit markets and wholesale lending market that marked the height of the financial crisis in H02-2008, 2009 was the year, starting in Q2, that volatility and interbank rates declined to more soothing levels and where risky assets returned to their former buoyancy.

The question is whether this situation will continue into 2010 which seems to be a precondition for the hopes of a sustained V-shaped recovery. Additionally currency markets will take much of their direction from this too since the extent to which carry trades continue to fly will depend a lot on the effect and speed of ”normalization” by part of G3 central banks.

In this context, it is paramount to distinguish between between transitory and structural factors where the former seem to be the main drivers of the upbeat sentiment and recent pickup in economic activity. The main point is that with a very opaque economic outlook, markets may err strongly on the timing and actual moves by central bank as well as on the outlook itself. This is, in part, a natural function of the fact that central bank themselves are not certain of how to play the situation going into 2010.

Personally, I am skeptical when it comes to the idea of a sustained recovery. In particular, it is important to emphasize that while the global economy, in relation to the Lehman fallout, may have dodged the initial bullet that would have led to a catastrophe and an immediate cascade of company and sovereign defaults, the structural setup has not changed much. Events in Dubai, the ongoing difficulties in Spain, Eastern Europe and most recently the jitters of the Greek sovereign debt are all timely reminders that perhaps, the real crisis which policy makers will be unable to avert lies ahead of us and not behind us.

Moving on to major currencies, the big story with respect to G3 flows in 2009 was without a doubt the ongoing weakness of the USD versus the Euro and JPY that gathered pace as the recovery took hold and especially as financial markets normalized with risky assets shooting for the moon.

 In 2009 and using the average daily value between Jan 2008 and dec 2009 as index 100, the USD consequently weakened some 8.3% against the Euro and 3.4% against the JPY. One thing however is the relative measures of weakness and quite another is the levels observed. Consequently, a EUR/USD at +1.45 and a USD/JPY fluctuating in the 80s are levels where policy makers in Europe and Japan start to grow weary. Consider consequently the ECB’s continuing ”commitment” to the US authorities’ commitment to a strong dollar policy and the outright hints of intervention by part of the Japanese MOF and the BOJ and you get an impression of the kind of small but important skirmishes in an intra G3 context.

As ever, holding Old Maid is fiercely combated.

The G3 story of 2009 also highlights the big change observed with respect to the role as global carry trade funder. Thus and while the BOJ has been running  ZIRP/QE for the better part of the 21st century and thus also seemed secure as the global carry trade funder, something changed this time around. Consequently, we had the BOE, to a lesser extent the ECB, and most importantly the Fed who have all been forced committing to very low levels of interest rates in order to fight off deflation and to support the restoration of a financial system that has been mortally wounded during the evolving crisis. Especially the Fed’s frontloaded and aggressive policy response seems to have pushed the tables around in a G3 context. Thus, as risky assets began to fly in 2009 and volatility retraced to pre-crisis levels, it was the US economy that benefitted, so to speak, from a weak USD  to become the main funder of global carry trade flows and not the JPY much to the dissatisfaction, no doubt, of Japan who could no longer rely on continuing weak JPY to boost exports as the global economy left the intensive ward.

Going back to the idea of a global game of cards, we can then say 2009 saw the Euro and Japan jointly holding Old Maid relative to the US and the question then is; will this prevail into 2010?


G3 FX Themes for 2010 – Buy the Old Maid

The immediate answer to the question  above has to be no. After having scanned a vast array of 2010 predictions and analysis from the hands of some of the finest research shops I am convinced that the market believes that the USD will claw back some of its lost ground vis-a-vis the Euro and JPY in 2010.

Generally, the major theme for G3 FX markets in 2010 will be central bank policy and specifically the ease and speed with which unconventional monetary policies are withdrawn as well as the lag with which nominal interest rates follow. So far, the three big central banks are assuming their usual roles with the ECB rolling out a rather hawkish discourse on the removal of wholesale bank financing through its Enhanced Credit Support, over to the Fed promising low interest rates well into 2010 and only gradually speaking of removing QE and finally on to the BOJ who actually re-entered QE at an emergency meeting in the beginning of December and where we can expect the current rock bottom interest rate level to remain for as a far as the eye can see.

This sequential line-up is not consistent with the levels of the G3 crosses moving into 2010 and thus it would seem a sound call to expect the USD to take back some of its loss, most notably vis-à-vis the JPY which looks set to become, yet again, the funding currency of choice.

Essentially, the Japanese economy is not only highly dependent on exports to grow, it is also reeling under the yoke of a +2% deflation rate which means that the MOF will likely bully the BOJ into drastic measures in terms of buying government bonds as well as potential intervention. In a context where the US economy moves into whatever form of trend growth it may be able to generate and with the employment situation potentially improving into the first half of 2010, the Fed may have to change discourse and even the slightest hint from Bernanke that the Fed’s stance is about to change should favor the USD.

The EUR/USD also looks as a good sell, but the timing should be different according to e.g. Societe Generale who sees the EUR/USD gunning for 1.60 in H01 2010. Underpinning this view is a continued rally in risky assets and a cautious Fed relative to the ECB. So far the ECB is indeed looking more hawkish than the Fed which means that the EUR/USD may continue to enjoy support, but in my opinion this only goes to the unwinding of unconventional measurses. On the last ECB meeting it was worth noting the extent to which Trichet voiced the utmost sensitivity with respect to the economic outlook. In short, talk is preciously cheap in this context and the underlying economic fundamentals  strongly favor the US not so much because the US will now power ahead, but because major risks loom in Europe with the focus in particular on the fallout from Spain and Greece as well as the ongoing and unresolved mess in big parts of Eastern Europe. It will be very interesting to see whether the ECB maintains the discourse of ”normalization” which will have to entail a view on nominal interest rates sooner or later. Personally, I am very uncertain that we will see the ECB raising rates before the Fed since it would entail an unduly appreciation of the Euro not consistent with fundamentals.

In summary and mixing the market professionals’ call (e.g. Societe Générale) with my own I would emphasize the following; 

  • In an G3 context, 2010 clearly holds the potential for Dollar strength, but timing and intensity is going to differ. Most major research houses see the USD/JPY as a strong candidate for a correction that could move the pair back in the 100s. I concur. Whatever speed the US economy will have in 2010, Japan will be the laggard and the BOJ will be dragged kicking and screaming into a full out battery of QE measures.
  • In my book the EUR/USD looks way too high even in the 1.40s. However, we have seen before that this pair may continue to rally so it is worth treating this one with care. Societe Générale sees dollar weakness sustained (except versus the JPY) well into 2010 and thus the EUR/USD continuing to drift upwards. I only conditionally agree. Especially I would emphasize the fact that the risks to the Euro, by far, out match those to the USD at the current juncture. In this way, I am less sanguine when it comes to the continuation of the ”recovery” and thus the rally in risky assets.
  • Buy the Old Maid. If the rally in risky assets continue into 2010 and beyond, the Euro will be holding the Old Maid amongst the G3. If the recovery is stopped in its tracks it is very likely that it will be from an event conjured in Europe making the USD holder of Old Maid. The former looks the most plausible scenario at this point in time with the notable qualifier that the USD should strenghten against the JPY. In this way, the Old Maid will shift hands from the JPY to the Euro and potentially the USD with the outlook for the EUR/USD not easy to call.


[1] Vistesen, Claus (2009) - Carry Trade Fundamentals and the Financial Crisis 2007-2010, Journal of Applied Economic Sciences, vol. IV issue 2(8)

[2] And dragging commodity economies with them (e.g. Australian, New Zealand, Norway etc).