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ETFs versus forwards: Which are best to play currency dislocations?

by Robert St George on Oct 03, 2013 at 11:01

ETFs versus forwards: Which are best to play currency dislocations?

Congressional deadlock is bad for equities and equally bad for bonds, but may spell good news for the US dollar. As a safe haven currency with unparalleled liquidity, it thrives on fear and should strengthen on market uncertainty.

Wrangling over the US debt ceiling and deficit in the weeks ahead should therefore be supportive. But then again, the mess on Capitol Hill could weigh on economic growth, delay any tapering of quantitative easing and depress the dollar.

Stuck between these two forces, of course, the chances are that the dollar will not move significantly. That is what happened during the previous crisis, in the summer of 2011. There was week-to-week volatility, but it started the period – and the year – pretty much where it ended.

Sterling is also caught amid countervailing winds. Over the past few months it has been one of the best performing major currencies, gaining 7% against the US dollar and 5% against the euro, thanks to expectations of a Bank of England interest rate hike, contrasting with more dovish talk from the Federal Reserve and the European Central Bank. Yet this has prompted analysts to roll out phrases such as ‘extremely overbought’, ‘stretched to the upside’, and ‘a pullback may be on the cards’.

For emerging market currencies, the language is bleaker still. ‘For countries with large current account deficits, the possibility of a currency crisis has started to raise its ugly head,’ says Sara Yates, global head of foreign exchange strategy at JP Morgan Private Bank.

Central banks, including those of Brazil, Indonesia and India, have been compelled to defend their currencies by raising interest rates, dampening the growth outlook. The accompanying potential for higher returns from developed economies has aggravated the problem.

The countries mentioned above also face general elections next year, meaning current account deficits are likely to persist as incumbents try to spend their way back into office. In addition to this trio, Yates expresses caution over the prospects for the Turkish and South African currencies.

She is more positive about the Malaysian ringgit, though. It too has been hit by the broader flight from emerging currencies, which she attributes to its liquidity and the high proportion of its bonds owned by foreigners.

‘However, its other fundamentals are healthy,’ she says. ‘Growth is decent, rate hikes may be on the way, and the economy has a current account surplus.’

Sharp movements creating such putative mispricings have enticed many into exchange-traded currency products. ETF Securities, which runs 80 currency vehicles with some £280 million under management, reported flows worth £31 million in September and £76 million so far this year.

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