November 29, 2023

Global Macro Trading for Idiots: Part Two

The Brain Damaging World of Foreign Exchange

GMTFI

Welcome back, idiots.

Note (August 12, 2024): This post was originally published on November 29th, 2024. I’ve removed the paywall and unlocked this post for all free subscribers given the prominence of the carry trade unwind in the Japanese Yen over the past week. I hope it contributes to your understanding!

In our last installment of “Global Macro Trading for Idiots”, we covered the riveting and edge-of-your-seat action that is trading the US yield curve.

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By the end of the article (if you were paying to see the trade below the paywall, which you really should have, it was a banger) I had explained how to understand the basics of trading the yield curve and how to implement (using futures) our recommended trade - selling 10s on 2s10s30s when it was -104bps risking 10bps of NAV DV01, expecting a steepening.

Over the next two months, 2s10s30s steepened nearly 80bps from our entry. I make no promises the trades in this one will be as good as that was, but there’s only one way to find out!

As we all know by now, the yield curve can’t predict anything so I don’t even know why we were talking about it! Now, we’re going to talk about why we’re all here, money.

Well, currency, at least.

Foreign Exchange (FX) is the most liquid market in the world, employing high leverage to take advantage of small moves. Currency markets tie the global economy together, making foreign exchange (FX) an essential consideration when analyzing cross-border capital flows and international trade and investment.

Just like with the first installment, there are hundreds if not thousands of FX primers out there that you can use to learn about every intricacy. That’s not what this article is for, this is focused on trading and learning the implications of FX rates across various markets. Even equity investors focused solely on stock picking cannot ignore the impact of FX moves on their portfolio's performance. This article will touch on the clear cut basics, and (below the paywall) I will expand on my own views for some FX trades over the next few months.

In today’s connected markets, every investor is essentially an FX trader, whether they realize it or not. Mastering some currency market basics allows you to understand important signals sent related to volatility, hedge more effectively, and construct unique trades for specific global macro outcomes. So let’s get started!

FX is important. For everyone.

Take recent currency developments in some inflation-plagued emerging markets.

Persistently high inflation - at one point nearing triple digits in Turkey and well past triple digits in Argentina, has driven aggressive interest rate hikes from central banks that have utterly failed to control these currency’s tailspins - local currencies like the Turkish Lira and Argentine Peso continue to lose purchasing power.

This fuels demand for hard assets as citizens rush to protect savings, bidding up equities, real estate, gold and cryptocurrencies denominated in the local currency.

This might seem like something you could be wholly unconcerned with as an equity investor, but you might be surprised at the opportunities in international stocks you’d miss by not paying attention to it. Turkish and Argentine stocks have soared even on a dollar-hedged basis.

The return of the MSCI Turkey ETF (TUR) in 2022 was > +100%. So if you did so well as an equity investor in 2022 that a relatively uncorrelated asset going up 100% in your portfolio that year wouldn’t have helped you, you can probably continue to stay unaware of FX moves.

For the rest of us, inflation and FX rates affect all asset classes. After all, you’re transacting in a globalized economy…with transactions denominated in - yep, you guessed it - currencies!

This is not just something that’s limited to having an impact on the stocks of emerging markets, FX reverberates through asset classes.

Historically (and currently, as well), escalating US trade tensions and devaluation of the Chinese yuan have caused ripple effects like surging gold prices and increased inflows to US stock indices and bonds as Chinese capital took flight. FX changes can be a determinant in foreign markets as much as they can be in local currency markets.

Perhaps the most recently stunning example of FX impacting equity returns has been during during Japan’s recent bull run - understanding how Japan’s economic rebound would affect equities might have gotten you to allocate to Japanese Equities (represented by the EWJ ETF), good for a cool 15% return YTD, but understanding the reaction of the BoJ in light of it and the effect that would have on the currency could have resulted in your Japanese equity allocation being USD Hedged (represented by the DXJ ETF) and therefore up 45%.

Triple the returns just by understanding how your thesis is impacted by FX.

Understanding FX seems not too big of an ask even for an equity focused investor/manager when it’s the difference between these FX-hedged (in blue) and unhedged returns in USD (in red) on a couple popular Japanese single name equities:

In the example above, the Bank of Japan’s dovish monetary policy contrasted with the hawkish Fed and weakened the Yen dramatically against the US Dollar. It was relatively straightforward and also not the hardest thing to predict (for me, at least, predicting the reversal is proving to be orders of magnitude more difficult). 

So, before we get into forwards and carry and geopolitics and elections and NDFs, I’d like to state the following: 95% of FX is policy rate and implied policy rate changes.

That’s going to encompass the rest of it (economic growth, inflation, etc) since it’s all packed in to how the market is pricing those implied rates. If your view on rate differentials is correct, you’re likely going to make money in FX (at least in G10 FX).

Some people will disagree here. What I say to that is:

So while it’s not all about relative central bank policy…this is Global Macro Trading for Idiots, as a fellow idiot, I’m here to tell you: yeah, it is pretty much all about interest rate differentials (and market expectations thereof).

In the example above, the Bank of Japan’s dovish monetary policy contrasted with the hawkish Fed and weakened the Yen dramatically against the US Dollar.

It was relatively straightforward and also not the hardest thing to predict (for me, at least, predicting the reversal is proving to be orders of magnitude more difficult but will be equally if not more rewarding once it occurs - more in this later).

Yes, there are a few other things - geopolitical and systemic risks manifest strongly in currency moves which reverberate across markets, relative valuation of currencies in terms of purchasing power parity and inflation, commodity and risk beta…still - it’s mostly interest rates.

Sorry, not sorry.

Let’s get into why…

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