The Economic Crisis & Foreign Exchange Trading Philip Brittan Bloomberg LP
U.S. Economy May Be Heading for Longest and Most Severe Economic Downturn in the post-war Period Number of Months in Recession 24 20 16 12 8 16 16 15 4 8 11 10 8 10 11 6 8 8 0 Feb '45 Nov '48 Jul '53 Aug '57 Apr '60 Dec '69 Nov '73 Jan '80 Jul '81 Jul '90 Mar '01 Dec '07 Recession Beginning
U.S. Unemployment Rate 1970-2009 9.0 % 1975 10.8 % 1982 7.8 % 1992 8.8% 2010 Forecast 6.1 % 1971 6.3 % 2003
Not Your Typical Business Cycle Real GDP Recession Expansion Recession Current Economic Downturn Time
ECRI Leading Economic Indicator of U.S. Economic Growth 1974-75 Recession 1980-82 Recession 1990-92 Recession 2001-02 Worldwide Recession 2007-08 Financial Crisis
Bloomberg s Financial Conditions Index 2 SD 4 SD Russia, LTCM Sept 11, 2001 10 SD!!!
Constructing a Financial Conditions Index Bloomberg's U.S. Financial Conditions Index Components and Weights Money Market Weight Ted Spread 11.1% Commerical Paper/T-Bill Spread 11.1% Libor-OIS Spread 11.1% Bond Market 33.3% Investment-Grade Corporate/Treasury Spread 6.7% Muni/Treasury Spread 6.7% Swaps/Treasury Spread 6.7% High Yield/Treasury Spread 6.7% Agency/Treasury Spread 6.7% Equity Market 33.3% S&P 500 Share Prices 16.7% VIX Index 16.7% 33.3% Total 100%
Bloomberg s Financial Conditions Index vs Bank Lending Conditions (Index) 2.0 1.0 Financial Conditions Index 0.0-1.0-2.0-3.0 Bank Lending Conditions -4.0-5.0 1992 1994 1996 1998 2000 2002 2004 2006 2008 U.S. Banks Willingness to Lend U.S. Financial Conditions (smoothed) Composite of Fed Senior Loan Officer Survey
U.S. Bank Lending Conditions and U.S. GDP Growth U.S. Bank Willingness to Loan (Index) 2.0 1.0 Bank Lending Conditions U.S. Real GDP Growth (qoq % saar) 6 5 0.0 4-1.0-2.0-3.0-4.0 U.S. GDP Growth 3 2 1 0-1 -5.0 1992 1994 1996 1998 2000 2002 2004 2006 2008-2 U.S. Banks Willingness to Lend U.S. GDP Growth (smoothed) Source: Bloomberg
Federal Reserve Policy Response to the Financial Crisis
Quantitative Easing U.S. Monetary Base since 2000
U-Shaped Downturn?
Extracting Alpha from FX
Long-Term Cycles in Exchange Rates Currency s Value Currency Overshoot Fundamentally Driven, Medium-Term Exchange-Rate Cycles Long-Run Equilibrium Path Economic Fundamentals Time
USD PPP Over-/Under-Valuation
Testing the Information Content of PPP Rank the G10 Currencies by PPP Long 3 most undervalued Short 3 most overvalued Test condition: currency must be over/under by a given % Test CPI and PPI Inflation Measures
PPP PPI Results with Over/Under Entry % 170 160 150 140 130 120 110 100 90 80 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 G10 PPI +/- G10 PPI +/-.05
PPP G10 PPI and CPI Dynamic Basket Trades with 0 and 5% Over/Under Entry Points Results for 1-Jan-99 to 31-Dec-08 Backtest Total Return Annual Return Volatility Sharpe Ratio G10 PPI +/- 21.1% 2.1% 8.1% 0.2650 G10 PPI +/-.05 41.0% 4.2% 8.6%.4855 G10 CPI +/- 33.1% 3.4% 7.5%.4498 G10 CPI +/-.05 38.6% 3.9% 7.8%.5067
FX Analyst Forecasts
G10 Forecast Currency Strategies Check FXFC Forecast for the end of quarter at the start of each quarter Long currencies forecasted to appreciate Short currencies forecasted to depreciate No Stops: Hold position until the end of each quarter
WCRS Forecasted Total Return
USDCHF Forecast Strategy Return Index with Spot Results for 3-Apr-06 to 15-Dec-08 Backtest (Spot Return) 135 1.35 130 1.3 125 1.25 120 1.2 115 1.15 110 1.1 105 1.05 100 1 95 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 0.95 CHF Forecast Index USDCHF
G10 Bloomberg Forecast Return Strategies Results for 3-Apr-06 to 15-Dec-08 Backtest (Spot Returns) Annual Return Volatility Info Ratio AUDUSD 6.4% 18.0% 0.3573 USDCAD 5.8% 11.5% 0.5034 USDCHF 8.9% 10.2% 0.8737 USDDKK 0.6% 9.5% 0.0643 EURUSD 2.8% 9.5% 0.2930 GBPUSD 15.4% 9.8% 1.5658 USDJPY -2.1% 11.9% -0.1734 USDNOK 3.0% 13.3% 0.2274 NZDUSD 8.0% 15.9% 0.5038 USDSEK 7.0% 12.4% 0.5601 Portfolio 5.6% 6.3% 0.8828
The Great Carry Trade Unwind
Carry Trade Problems Carry Trades exhibit long-term positive return Subject to periods of significant drawdown Drawdowns occur during periods of risk aversion and increased market volatility
Classic Carry Trade vs DOW Long: AUD, NZD Short: JPY, CHF
Term Structure of Implied Vol
AUDUSD Carry Return and 1M/1Y Implied Vol
Market Condition Implied Volatility Signal During normal conditions vols curves upward sloping Elevated vol levels create uncertainty in short term, curve inverts Use 1M/1Y implied vol ratio as a risk indicator Short carry trade when ratio crosses a threshold
G10 Forward Rate Bias w/ and w/o Vol Signal Backtest from 01-Jan-1999 until 16-Mar-2009
G10 Forward Rate Bias w/ and w/o Vol Signal Backtest from 01-Jan-1999 until 16-Mar-2009 Annualized Return Annualized Volatility Sharpe Ratio G10 FRB 3.1% 9.16% 0.3371 G10 FRB w/ Vol Mod 10.1% 9.14% 1.1098
Current Account Trade
Current Account over 3 Years
So What About the Dollar?
Long-Term Swings in the USD 5-Year Upswing 7-Year Downswing 10-Year Downswing 7-Year Upswing 6-Year Downswing
Beginning of New USD Upswing?
PPP Fair Value of USD
FX Options Market Sentiment
Risk Aversion and the USD $1 trillion in bailouts. USD negative after all Lehman bankruptcy. Merrill & BOA. Flight to quality? Fannie & Freddie USD positive?? $85 billion AIG bailout. Who s next?
EUR, JPY, GBP Forecasts vs USD
Forecast of USD Major Currency Index U.S. Dollar Major Currency Index 160 150 140 130 120 110 Analyst-Implied Forecasts 100 90 80 70 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
Forecasts of US and Euro Real GDP Growth
Dramatically Improving US Trade Balance
Improving US Current Account
Two Scenarios for the Dollar Flight to Quality: Risk aversion remains high, improving US current account makes USD a safe haven in a turbulent world Return to Normalcy: Risk aversion lowers, zero interest rates and quantitative easing make USD less attractive