Emerging Markets
CapturingAlphabyIdentifyingFXMarketExtremes
7 mins
Like many asset classes, emerging market currencies have historically relied on trend following as an important source of alpha. In recent years, however, extracting alpha from EMFX trends has been a frustrating endeavor. In this post, we illustrate our latest model designed to identify trend reversals in the FX market and enhance our ability to capture currency management alpha.
As evidenced by Figure 1, the total return index of an EMFX basket and the performance of our proprietary EMFX trend following return index, with the trend following index scaled to comparable realized long-term volatility as the total return gauge. In the past two decades, the trend-following strategy realized a Sharpe ratio of around 0.6, but since 2010, and particularly 2015, the performance has been largely flat.
We think such performance patterns reflect potential structural changes in the FX market. Sustained profits achieved by trend following (e.g., 2003 to 2007, 2008, 2009, 2014-2015) have become less common in recent years. Additionally, very steep reversals have occurred frequently in recent years (e.g., March 2022, December 2021, and March 2020), dealing another blow to trend following performance. Many argue such steep reversals may partly be the result of market makers reducing the amount of balance sheet dedicated to intermediating the FX market, contributing to the lack of market depth. Deteriorating liquidity often leads to outsized moves that are prone to steep reversals, presenting a persistent challenge to FX trend following.
Figure 1
EMFX Total Return and Trend Following Return
PGIM Fixed Income.
Sell-side researchers (such as those from JPMorgan and BNP Paribas) have attempted to model the more frequent reversals and published several related indices. Building on their work, we recently implemented our own EMFX Risk Appetite Index to quantify the magnitude of one-sided risk-taking in the EMFX market. We take a multi-faceted approach to capture market extremes through the following variables: short-term aggregate flows of FX trades, perceived investor positioning of various currencies, aggregate implied volatility indicators from the options market, and technical indicators reflecting the extent to which the market may be overbought or oversold.
Figure 2 shows the time series of our Risk Appetite Index and the thresholds for extreme FX positions. We use a simple, symmetric rule to enter into long or short EM currency positions when the oversold or overbought threshold (solid lines) of 1.6 standard deviations from the mean is reached, holding the position until the Appetite Index retreats to less than half of the threshold (dotted lines).
Figure 2
PGIM FX EMFX Risk Appetite Index
PGIM Fixed Income.
Figure 3 shows the performance of this contrarian strategy. Since 2016, the Appetite Index has breached the threshold 24 times, with 14 and 10 occurrences of extremely negative and positive risk appetite, respectively. We observe generally positive performance for this strategy, with a realized Sharpe ratio of 0.74.
Figure 3
Performance of contrarian strategy following the Appetite Index
PGIM Fixed Income.
Figure 4
Performance of the contrarian strategy performance in 2022
PGIM Fixed Income.
Amid the significant market swings witnessed in 2022, our Appetite Index identified four instances of extremes (Figure 4). In particular, the first two instances provide insight into our experience utilizing the index to drive contrarian strategy performance. From April 6 to April 15, the index flashed its first signal of the year, indicating an opportunity to short EM currencies. In late February, following Russia’s invasion of Ukraine, EM assets went into free fall as risk appetite vanished. The selloff didn’t last long, and flows into EM rebounded quickly, driving positive returns in EMFX as quickly as losses were incurred in the wake of the invasion. The quick recovery in EMFX led our Appetite Index to breach the overbought threshold in April and send short EM, long USD signals in anticipation of a reversion from the extremes.
Around this time, the macro environment was ripe for a reversal of the weak dollar trend, as persistent inflation in the U.S. prompted investors to price in significant Fed rate hikes in 2022, and a long list of tail risks engulfed emerging markets. Although the simple rule we set for profit-taking meant the timing of our position close was not perfect, it successfully captured the start of a significant change in sentiment.
From early April to mid-May, bullish dollar sentiment was in full swing. The tightening of global financial conditions continued, high inflation and supply constraints persisted, and a weak PMI report from China dealt another blow to EM growth expectations. However, in around mid-May, signs of overextended dollar sentiment began to brew as FX flows piled into long USD positions, dollar momentum was strong, and net dollar positioning became abnormally skewed in favor of the dollar. The Index sent its second signal this year, from May 17 to May 24, to enter into long EMFX position. Over the next few weeks, EMFX saw a relief rally amid signs of some re-opening in China and speculation about a pause in Fed hikes. In this instance, the timing of the long EMFX signal was exceptional, indicating an exit to the position near the rally's peak.
Our standard practice on any directional FX signals is to discount historical performances when forming our forward-looking expectation, largely due to limited data availability. After all, extreme moves are rare by definition, and we have observed only 24 instances of the extreme threshold being hit since 2016. Also, there is the likelihood that a sea change in the macro environment has created an FX regime friendlier to trend following, which may limit the potential of this contrarian strategy. As an example, developed-market currencies, such as the euro and the yen, have shown sustained trends of weakness versus the dollar this year. Despite these potential limitations, we believe the EMFX Risk Appetite Index is a valuable addition to our quantitative tools for delivering alpha, especially as a complement to the existing trend-following strategy in our framework.
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