Chapter 1
Foreign Exchange – The Fastest Growing Market of Our Time
The foreign exchange market is the largest and fastest growing market in the world. Traditionally, it is the platform through which governments, businesses, investors, travelers, and other interested parties convert or “exchange” currency. At its most fundamental level, the foreign exchange market is an over-the-counter (OTC) market with no central exchange and clearing house where orders are matched. FX dealers and market makers around the world are linked to each other around-the-clock via telephone, computer, and fax, creating one cohesive market. Through the years, this has changed with many institutions offering exchange traded FX instruments, but all of the prices are still derived from the underlying or spot forex market.
In the past two decades, foreign exchange, also known as forex or FX, became available to trade by individual retail investors, and this access caused the market to explode in popularity. In the early 2000s, the Bank of International Settlements reported a 57 % increase in volume between April 2001 and 2004. At the time more than $1.9 trillion were changing hands on a daily basis. After the financial crisis in 2008, the pace of growth eased to a still-respectable 32 % between 2010 and 2013, but the actual volume that changed hands was significantly larger at an average of $5.3 trillion per day. To put this into perspective, it is 50 times greater than the daily trading volume of the New York Stock Exchange and the NASDAQ combined.
While the growth of the retail foreign exchange market contributed to this surge in volume, an increase in volatility over the past few years also made investors more aware of how currency movements can impact the equity and bond markets. If stocks, bonds, and commodity traders want to make more educated trading decisions, it is important for them to also follow forex movements. What follows are some of the examples of how currency fluctuations impacted stock and bond market movements in past years.
For stock market traders, particularly those who invest in European corporations that export a tremendous amount of goods to the United States, monitoring exchange rates are essential to predicting earnings and corporate profitability. Throughout 2003 and 2004, European manufacturers complained extensively about the rapid rise in the euro and the weakness in the U.S. dollar. The main culprit for the dollar's selloff at the time was the country's rapidly growing trade and budget deficits. This caused the EURUSD exchange rate to surge, which took a significant toll on the profitability of European corporations because a higher exchange rate makes the goods of European exporters more expensive to U.S. consumers. In 2003, inadequate hedging shaved approximately EUR$1 billion euros from Volkswagen's profits, while DSM, a Dutch chemicals group, warned that a 1 % move in the EURUSD rate would reduce profits by EUR$7 million to EUR$11 million. Unfortunately, inadequate hedging is still a reality in Europe, which makes monitoring the EURUSD exchange rate even more important in forecasting the earnings and profitability of European exporters.
Traders exposed to Japanese equities also need to be aware of the developments that are occurring in the U.S. dollar and how that affects the Nikkei rally. Japan recently came out of 10 years of stagnation. During this time, mutual funds and hedge funds were grossly underweight Japanese equities. When the economy began to turn around, global macro funds rushed to make changes to their portfolios in fear of missing out on a great opportunity to take advantage of Japan's recovery. Hedge funds borrowed significant amount of dollars to pay for increased exposure, but the problem was that their borrowings were very sensitive to U.S. interest rates and the Fed's monetary policy tightening cycle. Increased borrowing costs for the dollar could derail the Nikkei's rally because higher rates will raise the dollar's financing costs. Yet with the huge current account deficit, the Fed might need to continue raising rates to increase the attractiveness of dollar-denominated assets. Therefore, continual rate hikes, coupled with slowing growth in Japan, may make it less profitable for funds to be overleveraged and overly exposed to Japanese stocks. As a result, how the U.S. dollar moves also plays a role on the future direction of the Nikkei.
Known as “the man who broke the Bank of England,” George Soros is one of the most well-known traders in the FX market. We discuss his adventures in more detail in Chapter 2, but in a nutshell, in 1990, England decided to join the Exchange Rate Mechanism (ERM) system because it wanted to take part in the stable and low-inflation environment created by the Bundesbank, the central bank of Germany. This alliance tied the pound to the deutschmark, which meant that the United Kingdom was subject to the monetary policies enforced by the Bundesbank. In the early 1990s, Germany aggressively increased interest rates to avoid the inflationary effects related to German reunification. However, national pride and the commitment of fixing exchange rates within the ERM prevented England from devaluing the pound. On Wednesday, September 16, also known as Black Wednesday, George Soros leveraged the entire value of his fund ($1 billion) and sold $10 billion worth of pounds to bet against the ERM. This essentially “broke” the Bank of England and forced it to devalue the pound. In a matter of 24 hours, the British pound fell approximately 5 %, or 5000 pips. The Bank of England promised to raise rates in order to tempt speculators to buy pounds. As a result, this caused tremendous volatility in the bond markets, with 1-month UK LIBOR rates rising 1 % and then retracing those gains over the next 24 hours. If bond traders were completed oblivious to what was going on in the currency markets, they would have probably found themselves dumbstruck in face of such rapid gyration in yields.
For Treasury traders, there's another currency-related issue that is important to follow and that is the gradual revaluation of the Chinese yuan. For most of its history, the yuan or renminbi (RMB) was pegged to the U.S. dollar. In the 1980s, the RMB was devalued to promote growth in China's economy, and between 1997 and 2005 the People's Bank of China artificially maintained a USDRMB rate of 8.27. At the time, it received significant criticism because keeping the peg meant that the Chinese government would artificially weaken its currency to make Chinese goods more competitive. To maintain the band, the Chinese government had to sell the yuan and buy U.S. dollars each time their currency appreciated above the band's upper limit. These dollars were then used to purchase U.S. Treasuries, and this practice turned China into the world's largest holder of U.S. Treasuries. In 2005, however, China ended its dollar peg and linked the value of the yuan to a basket of currencies and allowed it to fluctuate within a narrow band that was reset every day. While the exact percentage of the basket is unknown, it is largely dominated by the U.S. dollar and includes other currencies such as the euro, Japanese yen, South Korean won, British pound, Thai baht, Russian ruble, and Australian, Canadian, and Singapore dollar.
Through the years China has gradually widened the band that the yuan can trade in, but if China were to end the float and allow the RMB to trade freely on the global foreign exchange market, the impact on the fixed-income markets would be significant because it would reduce the government's need to purchase Treasuries and other fixed-income securities. An announcement of this sort would send yields soaring and prices tumbling. While it could be years before this happens, it will be important for bond investors to follow these developments if they want to effectively manage the risk.
The foreign exchange market has not always been a popular market to trade because for many decades, it was restricted to hedge funds, commodity trading advisers who manage large amounts of capital, major corporations, and institutional investors due to regulation, capital requirements, and technology. Yet it was the market of choice for many of these large players because the risk was fully customizable. Trader A could use a 50 times leverage, and Trader B could trade cash on cash. When the market opened up to retail traders, many brokerage firms swept in to provide leveraged trading along with free instantaneous execution platforms, charts, and real-time news. This access to low-cost information helped foreign exchange trading surge in popularity, increasing its attractiveness as an alternative asset class to trade.
Many equity and futures traders also turned to currencies, adding the asset class to their trading portfolios. Before you choose to do so, however, it is important to understand some of the key differences between