Foreign Exchange Investing

Foreign exchange (forex or FX) markets form the core of the global financial market, a seamless twenty-four hour structure dominated by sophisticated professional players commercial banks, central banks, hedge funds and forex brokers and often extremely volatile. Many investors, particularly American ones, tend to ignore currency movements, and few financial analysts are trained to analyze the details of forex markets. But this is a mistake. As the 1997 Asian crisis and its aftermath vividly reveal, foreign exchange these days tends to lead economic activity. And the foreign exchange markets are huge, growing and increasingly powerful.

According to the Bank for International Settlements, the central bank for central banks, average daily turnover on the world's foreign exchange markets reached almost $1,500 billion ($1.5 trillion) in April 1998, 26% higher than when it last measured forex flows in 43 different countries three years earlier. Transactions in-volving dollars on one side of the trade accounted for 87% of that forex business. Almost a third of all forex trading takes place in London, by far the world's largest center, with New York and To-kyo second and third. Although London forex trading grew more slowly than New York over the three years to 1998, its average daily turnover remains greater than New York and Tokyo combined, having risen from $464 billion to $637 billion.

To put these figures in perspective, daily trading volume on the New York Stock Exchange (NYSE) is only about $20 billion; activity in short-term US government securities is around ten times that at $200 billion; and so at $1,500 billion, foreign exchange trading is seven and a half times the volume of trading in short-term US government securities and seventy-five times NYSE trading. This volume is far greater than the size of foreign currency reserves held by any single country. The forex markets cannot be ignored: for their size and forecasting ability; and for the potential that developments in these markets have for the future of the dollar as the world's dominant currency.

In the past, trading in the real economy controlled relative currency relationships. Since most currency flows were to settle trading patterns, there was a balance as goods and capital moved at about the same speed. But now the leads and lags are the other way around. While in name, forex markets exist to facilitate international trade, in practice, the bulk of turnover in these markets is attributable to speculation. Because financial flows are many times the size of trade flows and because financial flows are nearly instantaneous, currency market levels now tend to set trade: if a country's currency becomes low relative to others, domestic producers find it easier to export. The market sets the economy.

Where next on emerging market?

While it is true that fixed-income management is different from hedge funds, the issue of SEC registration is not really significant since it is more an issue of paperwork than a review of investment precepts. Hedge funds operating in bond markets have the same theories and practices as the most advanced fixed-income people, so there is a direct connection between the development of active bond management and LTCM. The latter is an extreme case but it comes with overconfidence in the models, and with a large segment of bond and derivative managers using the same models at the same time since they share the same education and same data-bases.

While historically stocks have provided substantially greater returns than bonds, there still may be good arguments for fixed-income investing. As the ads for investment products are all obliged to say, past performance is no guarantee of future performance, and many believe that bonds may outperform stocks over the next few years as stocks' recent strong performance makes them less attractive and as deflation becomes a more potent force than inflation.

Indeed, much of the recent interest on the plus side has been in the fixed-income market. While the stock market has been demonstrating volatility and generally crashing in emerging markets, the US bond market has been steadily strong. There have been two unusual circumstances: one is an inverted yield curve, where long-term rates are lower than short-term rates; the other is a flight to quality, with the quality preference spread widening dramatically. These previously occurred together in 1981, a highly inflationary period, and in 1990, when inflation was declining yet clearly positive. But to find a precedent for both happening for a sustained period, we need to look back to deflationary times almost a century ago.

It seems to be conventional wisdom that the US and European economies are in a healthy state of moderate inflation. But perhaps instead, they are mixed economies with some features still experiencing inflation, principally wages and salaries, and others experiencing deflation, principally those associated with materials and commodities. Today's forecasts are that there is likely to be even more competition from lower wages from the developing countries, which are experiencing extremely heavy deflationary pressures and that these pressures may spread to the developed world. With the reality of deflation plus relatively high real interest rates, bonds become very attractive.

The bond markets may also be boosted by the expansion of the eurobond market in Europe in the wake of the single currency. All new government debt in the eleven euroland countries will be issued in euros, market practices will be harmonized giving incentives for more corporate bond issues in euros, and the market may become more transparent, liquid and efficient. It seems likely that the euro fixed-income market will come to resemble the US bond market.

Finally, it is often valuable to challenge unchallenged precepts. One of the most widely accepted assumptions is that US govern ment short-term debt is the riskless base against which all other returns are measured. But is that always so? Not necessarily: since US debt is almost perpetual and refinanced, what happens when the debt holders, often non-US lenders today, have other uses for their funds? The largest holders of US Treasuries are Japanese and it is not difficult to imagine that they would have other uses for their funds than holding short-term US instruments. And if they and others withdraw from this market, the riskless security could become quite risky.

Critics on Andy Carter's Theory

One of the major disadvantages of investing in bonds is that they seem to underperform equities over the long term. This conventional wisdom is strongly expressed by Wharton finance professor Jeremy Siegel, who argues for the vast superiority of the equity markets as an investment vehicle. Siegel calculates that a dollar invested in a representative group of US stocks in 1802 would have grown to $559,000 in 1997 after adjustment for inflation (which reduced the value of the dollar to seven cents over that period). In contrast, a dollar invested in long-term government bonds, short-term bills or gold would have grown after inflation to $803, $275 and $0.84 respectively.

So while bonds are usually thought to be less risky than equities, in terms of inflation-adjusted returns, they have actually been more risky for most of the nineteenth and twentieth centuries. Siegel estimates that the real return on equities over almost two hundred years was 7% a year compounded, compared to 3.5% for bonds and 2.9% for bills. What is more, the superiority of stocks grows and their riskiness falls the longer they are held: they outperform bonds and bills 60% of the time over a single year, 70% over five years, 80% over ten years and 90% over twenty years.

The credit risk of bonds is a further downside, particularly during bull markets as investors become more willing to accept risk, which tends to reduce the spread or risk premium that poorer risks pay. When the market is jolted by bad news, the spread invariably widens again dramatically, causing the poorer risks to fail. Notorious recent examples include the aftermaths of the December 1994 Mexican devaluation and the August 1998 Russian default and devaluation. The latter led to the flight to quality and widening of spreads that was such a problem for LTCM.

The old argument in favor of investing in bonds is that they provide current income and some degree of stability of capital. It is generally agreed that the shorter your investment horizon and the lower your risk tolerance, the higher the percentage of bonds you should have in your portfolio. But should the bond portion of a portfolio really be actively managed? Research suggests that professional forecasters find it difficult to beat a simple approach that always predicts that future interest rates are equal to current rates, and that after accounting for management fees, bond funds tend to underperform simple passive investment strategies.

Is the whole of active fixed-income management a fraud perpetuated by managers to increase fee income more than the gains, even if achieved, that could result? Certainly, bond markets are thought to be very efficient and fees should be examined carefully and, ideally, avoided entirely if possible. For example, it is hard to see how management can increase returns when the yield spread between thirty-year corporate bonds and thirty-year Treasuries is under 1%.

Then again, for individual investors, trading in the bond markets can be difficult since in many cases, the markets are not very transparent. While the bid-ask spread on US Treasuries is small because of the very liquid market, the spreads on corporate and foreign bonds can be as high as 56%. This is because bonds are usually traded over the counter with no real marketplace. Investors must rely on brokers who have a big incentive to give the bond seller and buyer the worst possible price in both directions as they make the difference.