The fact that FX volatility has largely remained subdued despite plenty of geopolitical turmoil has implications regarding how firms think about currency hedging, said speakers at Profit & Loss Forex Network Chicago.
For example, Peter Azzinaro, managing director, global macro, portfolio management at Manulife Investment Management, explained that his firm foresaw at the end of 2018 that FX would be representative of a more tactical market in 2019, remaining range bound and only moving around macro events.
As a result of this, he explained: “This year we decided not to spend as much money in terms of premiums on optionality in order to avoid decay. This is because we were disappointed by the volatility we saw in 2018, we thought that this would continue in 2019, and we have indeed seen ranges shrink this year.”
However, Azzinaro said that he expects volatility to start to spike up in 2020 and Steven Englander, global head of G10 FX research and north America macro strategy at Standard Chartered, was inclined to agree with him on this point.
Englander argued that there has been a lack of volatility because inflation has been so low across the board, which has given policy makers and central banks the optionality to push back against shocks in the market. But he warned that if they lose this optionality, either because monetary policy stops working or because inflation picks up, then markets might start to be driven more by geopolitical factors than economic ones.
“We’ve all grown up in the era where politicians were focused on the economy, because that was the key to getting re-elected. But if you look at the emphasis that’s being put by policy makers in different areas — whether it’s President Xi Jinping in China and his balance between Communist Party dominance and the private sector, or some of the decisions we’re seeing in the UK around Brexit — I think that what we’re seeing is a set of shocks that can be attributed to politics, not economic policymaking. And I there’s a risk that that these geopolitical shocks grow in importance relative to the kind of economic shocks that we’ve all been brought up responding to. And if that is indeed the case then I think we’ll see a pick up in volatility, and it’s not going to be easy for the economic policy makers to offset that,” said Englander.
When Azzinaro was pressed on whether factors such as Brexit impact his firm’s decisions regarding currency hedging and trading, he said that the approach it has adopted is to wait for inflection points and opportunities in the market before trading in it.
“We’ve been a lot more patient and a lot more disciplined in waiting for the right inflection points to engage the market, and the macro view can be a big factor driving that,” Azzinaro added.
Having listened to this exchange, Jay Moore, the CEO of FX HedgePool, said that it’s clear that there’s a lot of complexity in the FX markets right now and this is why there’s been a growing demand for passive hedging products from the investment community.
“When there’s low volatility there’s not a lot of opportunities for trading and there’s a higher concern about shocks that might occur. So why not remain protected rather than picking up pennies in front of a steamroller?” he said.
However, Moore emphasised that the demand for passive hedging isn’t necessarily tied to volatility levels because in a high volatility market such an approach could be more prudent as it negates the need for firms to get their timing in the market correct.
“I think that currency risk is just becoming such a complex universe. We heard CTAs earlier at this event talking about how the opportunities to generate alpha in currencies has been gone for the last ten years. The alternative to such an active approach is to do nothing and leave your exposures unhedged on the basis that everything will even out in the long-run, but I don’t think that people have the patience to wait around for that to happen. So I think that the safe, simple approach is for firms to hedge the currency risk out and focus on the asset class that they’re investing in. And I think that the world is adapting to this reality,” he said.
Englander also highlighted that some corporates and investment firms preferred passive currency hedging because FX is not their core interest and they wanted any hedging program to be as vanilla as possible.
“For many investors, currency hedging is a nuisance. If you’re an expert in the bond markets then you’ve got to learn about FX because it’s part of the business if you’re investing internationally, but it’s not really your bread and butter. So you try to take out some of that FX risk if you can,” he said.
Englander continued: “Meanwhile, corporates know how to make mousetraps, but requiring them to also be experts in FX is unrealistic. They typically use hedging programmes that are pre-determined by some sort of formula, and although there might be some wiggle room there they’re aren’t going to override this formulaic approach because if they get the decision wrong then they have to explain themselves to shareholders or investors.”
Moore was quick to concur with these points, adding: “I also think there’s been a growth in the passive index market, which I think is in and of itself propagating more growth in the passive world proportionate to the active hedging space.”
On this issue of passive hedging Azzinaro made the interesting point that algorithmic trading, which is widely considered to be on the increase in the FX industry, is actually just another form of passive hedging. This is because firms utilising algos are essentially taking a view that a currency is within a certain range and then using an algos to capture this range on either side.
That being said, Azzinaro explained that Manulife’s approach to the currency markets is dictated by the broader market environment. Giving an example of this, he said that with a US election due to take place in 2020 his firm will probably reduce the amount of algorithmic trading that it does because they are expecting more volatility as a result of the election.
“We feel that what really gives us an advantage is our unique relationships with various counterparties in The Street and that we have different execution levers that we can pull. So what really drives our decisions more than anything else is liquidity,” said Azzinaro.
Concluding the discussion, Englander observed that he increasingly sees corporates, and even sometimes investors, engaging in what he termed “opportunistic hedging”, which he thinks is in some cases a byproduct of the flash crashes that have occured in the FX market recently.
“If a firm has to buy some USD/JPY at some point then they might leave an order in two or three big figures below spot, just in case something happens,” he explains. “It’s basically an effort to take advantage of any non-fundamental, non-permanent dislocation that might occur in the market. And it’s interesting, because we started talking to clients some time ago about this type of opportunistic hedging, and although there wasn’t much enthusiasm for this approach at first we’re now seeing some of them adopt it.”