Central Banks Rattle Markets

Tuesday's contrasting moves by two major central banks—Japan zigged while Australia zagged—are just a few of the many jolts that policy makers will inflict on currency markets in the months to come.
For currency traders, predicting these moves and making the right trades to profit from them could make or break their year.

Some of the steps seem obvious. The Reserve Bank of Australia has been ahead of the pack in raising interest rates—making its latest move on Tuesday—which has pushed the Australian dollar higher. Others are proving less predictable. Japan surprised the market on Tuesday by announcing plans to inject more money into its financial system, causing the yen to weaken.

Most central banks are expected to follow Australia's lead by tightening policy at some point next year, either by raising rates or rolling back measures to pump money into their economies.
Getting policy moves right is "the most important thing next year," said George Papamarkakis of North Asset Management, a London hedge fund. There are likely to be "quite pronounced moves in currencies based on the differing exit strategies of central banks."
Collin Crownover, head of currency management for State Street Global Advisors, which oversees $100 billion in currency assets, expects the British pound to strengthen versus the euro, largely because he believes investors have misjudged the pace at which the two central banks will withdraw their measures to support their respective economies.

The Bank of England will move faster than investors think, he says, while the ECB will proceed more slowly.
The direction of interest rates can play a key role in demand for a currency. When a country's benchmark interest rate rises, money often flows into a country in pursuit of the higher yields, strengthening its currency.
Lisa Scott-Smith of Millennium Global Investments, a London currency manager, says she likes the Canadian dollar, the Norwegian krone and the Swedish krona, and is looking for the right timing to bet on these currencies.

"From this stage forward, there is a real potential for divergence in policy," she says. "There will be a time when people will break away because they have the strength to do so, and those currencies will appreciate."
Goldman Sachs also recently told clients that markets aren't anticipating enough tightening of monetary conditions in the U.K., Norway, Sweden, and Canada. The firm is looking to exploit that discrepancy through bets on currencies or on short-term interest rates, according to a note distributed by the firm. It is betting that the pound will appreciate versus the dollar.

The U.K. might be a surprising choice, acknowledges Francesco Garzarelli, an economist at Goldman in London. So far this year, the pound has gained about 14% against the dollar and 5% against the euro.
"A lot of people still see [the U.K.] as a basket case, but we have a more constructive view," he says. "We think [interest] rates are going to normalize a bit quicker than the market expects."
Of course, whether investors are feeling fearful or optimistic will continue to play a major role in currency moves. Dubai's attempt last week to postpone debt payments caused currencies to gyrate, benefiting those viewed as havens like the yen and the U.S. dollar.

Even as investors attempt to discern the next moves by central banks, they will have to watch the broader picture. For a currency to thrive when policy makers raise rates, investors must believe the economy is sturdy enough to withstand such a move.
Contracts that incorporate expectations about benchmark interest rates in Europe indicate a hike could come there in September, says Alan Ruskin of RBS Greenwich Capital, while in the U.K. and Japan such contracts suggest it is still more than a year away.
Meanwhile, investors are confident the Fed will have raised interest rates by 0.25 percentage points by next November, with a smaller chance it could happen as early as August, according to contracts connected to the federal-funds rate.
The earlier investors bet on such shifts, the more sizable the potential profits. Investors who anticipated that central banks in Australia and Norway would be among the first to raise interest rates reaped handsome rewards.

Australia started hiking rates early last month and Norway followed suit.
Since the start of August, the Australian dollar has gained over 10% on the U.S. dollar and the krone has jumped 9% against the greenback. Currency investors often use borrowed cash to pump up their bets, supercharging gains—and magnifying losses.

Those gains have presented new divisions among traders.
Mr. Papamarkakis of North Asset Management still favors the Australian dollar and the Norwegian krone in the ahead, despite the recent gains.
"People might be surprised at how things continue to move from here," he says.
But David Rolley, who manages a portfolio of global bonds at investment firm Loomis Sayles, says he is avoiding the Australian dollar, even though it could benefit from higher growth and interest rates.
"Everybody owns Australia and so do all of their relatives," he says. "If anybody ever decides to sell, it's going to be volatile."

WSJ - 31.12.09