Ranking FX risk


28 Oct 2020 - Oliver Brennan

Currencies move up or down because of a cross-border supply/demand imbalance. Unfortunately, BoP data are published with a long lag. So our scoreboard uses higher-frequency heuristics (all back-tested to identify signal quality) to build an aggregate ranking. All currency traders worth their salt are taught that carry is important. But is it? Take the example of sterling recently: last week, BoE MPC member Vlieghe suggested negative rates are a part of the central bank’s toolkit; today the currency is testing a one-week high. As a strategy, carry is actually far less important than you might think: the 1y Sharpe ratio of a carry strategy only spends brief periods above zero. This may change in the future, and the scoreboard will include a carry weight if its signal quality improves. But carry is a weak signal in the present environment and is currently not included. Momentum is a much more important signal than carry. Where the average Sharpe ratio of the carry strategy over the last five years is within a rounding error of zero, the average for a simple momentum strategy is +0.5, so this signal is included.

Current scoreboard signals: GBP is a buy, strong USD signals offset each other. Sterling is at the top of the current rankings – and has been for a few weeks – thanks to relative strong economic data, growth upgrades and positive momentum. Despite strong USD seasonals this month, other factors (the dollar is rich, its current account balance is deteriorating) offset the signal. CAD is ranked #3, but we reckon downside risk to the oil price from OPEC+ managing supply and a deterioration in demand mean it is not one of our preferred discretionary picks.

Just as with systematic trading, the scoreboard will get smarter over time: the relative weights of all these contributions may vary. If carry starts to perform we’ll increase its weight; if a momentum signal gets arbitraged away we’ll decrease its weight. As new driving forces emerge, so the scoreboard will evolve. The edge in using these data is not to create a dumb rules-based trading strategy. It’s in using systematic signals to inform a discretionary overlay: discretionary alpha is not arbitraged away over time and adding smart tools will make the alpha even better.

TS Lombard blog FX scoreboard chart

 


#USD #GBP #Fixed Income #Portfolio Management

 

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