FX models resurrected as markets emerge from crisis mode
LONDON (Reuters) - Computer-driven funds are seizing on signals suggesting the herd-like "risk-on/risk-off" investment behavior that has dominated currency trading since 2010 is fading.
The tight correlations that saw safe haven assets like the U.S. dollar, gold and German Bund futures move in parallel are breaking down, increasing opportunities for investors to make money by trading the arbitrage between them.
Many computer-driven quantitative, or "quant", funds struggled to make money during the euro zone debt crisis because their models failed to predict the near lock-step moves in asset classes or that currencies would react more to policymakers' comments than to data.
They suffered their second straight year of losses in 2012, with the average fund falling 3.4 percent according to the Newedge CTA Trend Sub-Index. While there are no figures available specifically for currency strategies, investors said foreign exchange was a big detractor.
An end to risk-on/risk-off trading - where economic factors play second fiddle to whether an asset is classed as a safe haven or risky - allows quant funds to resurrect models that fell from favor when the debt crisis was at its height.
"Last year, and to a lesser extent 2011, was characterized by people not caring about fundamentals. If you are trading like us, on fundamentals, in a systematic fashion, that makes it very difficult," said Anders Lindell, CIO and CEO of Stockholm-based systematic hedge fund IPM.
IPM, which has about $7 billion in assets, lost 1.4 percent in its Global Currency Fund last year, but Lindell expects more favorable trading conditions in 2013.
"People are reverting to looking at fundamentals this year. The primary driving factor is that people's excessive fears have started to move away... From our perspective, that is exactly what we are looking for," he said.
PSYCHOLOGICAL SCARS HEAL
Strategists blame the financial crisis and fears in 2012 of a euro zone break-up for the risk-on/risk-off phenomenon, in which a negative headline would send investors scrambling out of perceived riskier currencies like the Australian dollar and into safe havens like the U.S. dollar and yen.
When market sentiment swung into positive territory, assets would move in lockstep in the other direction.
"These mega-correlations grew out of an extraordinary level of fear and tension in the market," said Jane Foley, senior currency strategist at Rabobank.
With asset classes so highly correlated, currency investors had little opportunity to diversify. Choppy, directionless trading also left computer models with few trends to latch onto.
But Nick Beecroft, senior analyst at Saxo Capital Markets, says the "enormous psychological scars" of the global financial crisis are now starting to heal.
Investors' panic has been soothed by the European Central Bank's pledge to do "whatever it takes" to save the euro, the bond-buying program it unveiled, loose monetary policy in the world's major economies, and an improving U.S. growth outlook.
That has given investors enough confidence to refocus on fundamental factors, for example interest rate differentials and trade deficits.
"From a quant perspective it would be very welcome," said Pete Eggleston, head of quantitative solutions at Morgan Stanley, whose model suggests a shift is underway from the highly-correlated world of risk-on/risk-off.
These quant strategies include trading on the basis of momentum, carry and fair value.
Momentum strategies are aimed at exploiting existing trends in the market, while fair value assesses whether a currency should be bought or sold depending on its economic fundamentals.
Both struggled in a world where jittery markets were shunted around by wrangling between euro zone politicians.
Carry trades, where investors borrow a low-yielding currency to invest in high-yielding assets, also dwindled in profitability and popularity during the crisis when there was a mass market stampede to exit risky trades.
Even quants who are sceptical about whether the risk-on/risk-off trading pattern is truly breaking down are willing to acknowledge that changes are afoot.
The strong inverse relationship that used to see gold sliding at the same time that the Australian dollar rose against the Japanese yen has not held true since the second week of December, according to Morgan Stanley's model.
Some funds are already starting to see returns pick up as conditions improved late last year.
Winton Capital, one of Europe's biggest hedge funds, said in a December investor letter seen by Reuters that currencies added 1.54 percent to its returns, more than any other asset class, though overall the fund finished the year down 3.6 percent.
"If we are moving into an environment where the time horizon of market movements is less choppy and short-lived, there is potential for a broader range of quant investment styles to generate decent returns," Eggleston at Morgan Stanley said.
(Editing by Swaha Pattanaik and Janet McBride)
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