FX managers switch dollar shorts to emerging markets crosses

With the dollar-versus-major-currencies story exhausted, some hedge fund managers are seeking profits in dollar plays against developing markets

For those in the market, the current trend in FX is trading the dollar imbalance against emerging market currencies, but some hedge fund managers are abandoning the strategy altogether, claiming that it makes no economic sense.

Jason Daw, senior G10 FX strategist at Merrill Lynch says: "The US dollar versus euro, and Canadian dollar story is pretty much played out. Emerging markets are the place to have money at the moment."

He sees strong plays in Asia in non-Japanese currencies such as the Taiwan dollar and Korean won. For example, on 24 November, Daw put on a short USD versus long equal-weighted basket of one year RMB NDFs, with an expiry on 28 November 2005, spot 8.2765, TWD, INR and SGD - a trade on a basket of Chinese, Taiwanese and Singaporean currencies.

Daw says: "We expect Asian currencies to outperform other currencies. For example, the Canadian dollar is up 40% against the US dollar and the euro is up 30%, but non-Japanese Asian currencies are only up 10% so far against the US dollar.

"They have a way to climb, and we expect them to continue to appreciate against the US dollar."

Daw is bearish on the Australian and New Zealand dollars and sterling, all of which he believes are overvalued.

He calculates that the Australian dollar is 23% overvalued and says Australia's central bank has raised interest rates at an inappropriate time. This sentiment may not yet have filtered through to hedge fund managers or the market. Merrill Lynch's automatic trading platform closed the short AUD-USD position it opened 25 February, but kept the long position as the 40-day moving average looked to be coming in above the 45-day moving average.

David Harding, manager of the Winton Futures Fund, is still long the Australian dollar because of the commodity boom. He says: "We will not back off until the trend has obviously reversed; and in early March the Australian dollar got another jolt."

Merrill Lynch thinks the euro, Canadian dollar and Swiss franc are trading at fair market value. In February, Daw put on a long six-month CAD-CHF trade with barriers of 0.91 and 1.01, with a 4 August expiry.

This trade highlights Merrill Lynch's conviction that both the Canadian dollar and Swiss franc are near fair value. Daw says: "This trade shows that, on the cyclical side, we think there will be no deviation of these two currencies from the broad US dollar path."

"We are selling volatility and betting that the Canadian dollar and Swiss franc will stay within the 0.91-1.01 ranges until 4 August. If the trade works out then it will pay out 4.5% to one," he adds.

The yen and Norwegian kroner are undervalued, according to Daw. He says: "Japan can not continue to run a current account surplus - the country has an aging population and needs to run a deficit and get money coming into the country."

However, Harding is maintaining his slightly short position on the Japanese yen because, he says, "the US is an important trading partner for Japan and it will keep its currency at a favourable rate for the time being."

The overvalued Australian dollar, which continues to rise, and the undervalued Japanese yen, which continues to fall, highlight the distance the FX market has travelled from logical economic thinking. These conflicting trends have driven some hedge fund managers out of the strategy.

Victor Niederhoffer, manager of the Matador fund says: "There is less proper thinking in the FX market than anywhere else in the world. I was active in FX trading for many years, but all the trades began to go against me at the margin."

"Current account deficits and other technical indicators that tell you when to trade do not apply to this market. It makes no economic sense," he continues.

Daniel Beharall, manager of Henderson's Global Fixed Income Absolute Return fund, has abandoned currency trading for the past six weeks, believing his investment style was ill matched to the foreign exchange market at the start of 2005.

KEY POINTS

Managers have moved to play the dollar against emerging market currencies, after the dollar/developed market crosses played themselves out.

Some former FX traders have abandoned FX altogether, noting "there is less proper thinking in the FX market than anywhere else in the world".