Currency investors need political nous
Currency movers, from left: Brazilian real, South African rand, Mexican peso, British pound, Russian rouble and Turkish lira © FT montage; Dreamstime
This year’s most successful currency investors would have needed some remarkable political insight. They would have had to predict Brexit, the fall of president Dilma Rousseff, an attempted Turkish coup and the improbable polling success of Donald Trump.
Normally, the foreign exchange market is a slave to the humdrum cycle of jobs data, inflation, business confidence indices and yield curves. But politics — not just any old politics but a highly unpredictable, volatile version — has been the driver of the biggest shifts across currencies in 2016, and in all likelihood will continue to rattle investors into next year.
Three of the five biggest gainers against the dollar are the Brazilian real, the Russian rouble and the South African rand — all heavily influenced by dramatic political shifts. This year’s four biggest losses against the dollar have also been fuelled by politics: the British pound, the Argentine peso, the Mexican peso and the Turkish lira.
It has not helped investors that South African corruption investigations and Russian sanctions have all occurred against nearly unprecedented economic and monetary developments. Carmignac, the French fund, is worried about an environment of low rates and weak but sustainable growth which, alongside the unorthodox policies of central banks, has elevated fixed income and equity valuations to levels some say are unsustainable.
These asset classes are “vulnerable to external shocks”, says Carmignac, and it identifies three before the year is out. Two come from the political sphere: the US elections — whatever the outcome — and Italy’s December referendum on the constitution, which could see prime minister Matteo Renzi toppled. The third potential shock is the US Federal Reserve raising rates.
Nowhere is political risk more obvious to investors than in the UK, where “the pound is the purest expression of investors’ fears about political risk in developed markets,” says Nicholas Spiro of Lauressa Advisory, a macroeconomic consultancy.
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The Mexican peso has also felt the impact of political risk, laid low by the protectionist rhetoric of Mr Trump, he adds, but “it’s the pound that has become a proxy for politically driven volatility in markets”.
The pound gyrated this week on a series of political developments — the UK government’s about-turn on allowing parliament scrutiny of its Brexit plans, a leak on the cost to the UK of leaving the single market, the UK’s Brexit minister suggesting the UK would leave the single market.
The week’s decline comes in the slipstream of sterling’s calamitous slide during and after last week’s annual conference of the ruling Conservative party. That began with Theresa May, the prime minister, declaring a March deadline for triggering Article 50 to launch the formal EU exit process.
But traders say the real momentum behind the pound’s slump and Friday’s “flash crash” in which sterling dropped 6 per cent in two minutes of early Asian trading, was Mrs May’s second conference speech and her strong attack on capitalist forces, mixed in with the government’s policy to require companies to provide inventories of their foreign staff.
“What surprised a lot of people was the rhetoric coming out,” says Andrew Soper, head of FX options at Nomura.
Mr Spiro says: “Investors, who have wrongly viewed the UK through the narrow prism of cosmopolitan London, are having to come to terms with communitarian, parochial England.”
This UK political reality check is contributing to extreme short sterling positions as the pound has consolidated around $1.22 to the dollar and 90 pence to the euro. The market is too heavily one-way, according to Steven Saywell, global head of FX strategy at BNP Paribas. “The real risk for sterling could be a rebound. It has fallen so much and investors are so short that it could well rebound on positive news,” Mr Saywell says.
In emerging markets, political risk has spurred a dramatic influence on some currencies. President Jacob Zuma’s apparent attempt to undermine his finance minister is once more sending the rand lower. Russia’s rouble was weakening from Ukraine tensions, Brazil’s real dived earlier this year during repeated bouts of political instability and the Mexican peso has had to contend with Mr Trump.
When investors eye positive political developments, such as the ousting of Ms Rousseff in Brazil, currency rebounds can be significant. When more placid political conditions prevail, they allow EM currencies to surge, enabling risk appetite to flourish and investors to seek out bonds that trade at high yields.
In the case of the devaluation of Argentina’s peso, politics was its cause: president Mauricio Macri campaigned on a policy of free market reform, and he duly lifted currency controls.
Politics may be in vogue for investors, but it is far from the only driver of currencies.
According to Bilal Hafeez, Nomura FX strategist, investors should worry about five macro risks: deglobalisation, euro area debt, China growth, the Bank of Japan’s yield target and oil. Of these, only deglobalisation could be construed as a political risk.
“The underlying cyclical and structural factors are the main things to focus on,” he says. “Political risks are often an outcome of those.”
At various times, currencies are influenced by cyclical, structural and political developments, says David Bloom, FX strategist at HSBC. There was the yen, weakened by the political impact of prime minister Shinzo Abe’s election in 2012 and the structural change created by his Abenomics programme, strengthened this year by the failure of Japan’s cyclical recovery.
The US dollar was bolstered by the structural driver of expected rates normalisation in 2014, then shifted to become a data-dependent cyclical play. But that cycle is “going nowhere and neither is the dollar”, says Mr Bloom, although the US election could still alter matters.
The euro is in a stalemate, stuck between the structural driver of a big current account surplus and the politics of anti-EU sentiment. Political events such as the Italian referendum and the French and German elections will grab investors’ attention. Traders, however, view the euro as being relatively immune to political shifts, as last year’s Greek default stand-off proved, while quantitative easing will keep the threat of rising yields in check.
Returning to this year’s worst-performing major currency, the outlook for sterling appears to depend on a combination of political pressure and the structural problem of the UK balance of payments, overriding any good cyclical data.
“The experience of sterling in the run-up to the Brexit vote and the aftermath of the decision to leave demonstrates how swiftly and brutally a currency can succumb to the political driver,” says Mr Bloom.
Expect more volatility in sterling as political tension rises. “The market is very focused on political rhetoric coming out of the UK,” says Mr Saywell, especially whether Mrs May softens her stance on immigration and the EU, and the role of parliament in triggering of Article 50.
“These are going to be factors that could weigh on sterling or support it,” Mr Saywell says.
For investors, reading the political tea leaves on Mrs May is more important than reading the UK balance sheet.