FX as Asset Class Under Attack

Stephen Harris

31 October 2005

Foreign exchange as an asset class faces a test in the next few months as market participants struggle to make returns from directional plays and increasingly look to interest rate driven trades. Trading in the major currency pairings has been more or less range bound this year making it difficult for hedge funds and CTAs to make money. Volatility in the market during 2003 and 2004, driven by a weak dollar led hedge funds to make extraordinary profits in the market. In a ranging market many trend following hedge funds buy the highs and sell the lows, or at best stay out of the market until a sustainable trend is identified. Paradoxically turnover in the forex market is on the rise but, according to market participants, this business is coming from central banks, especially the Russian and Chinese central banks and multi-national corporates, rather than the hedge funds which used to drive it. Those hedge funds still playing the forex markets are making less use of technical analysis, using charted historical price action to predict future prices movements, and are simply trading currencies to make money from relative interest rates, so-called carry trading. This is more of a passive wait and see strategy than the aggressive position taking that hedge funds had previously engaged in, and which some market participants say caused much of the exaggerated swings in the previous couple of years.