Ranking the minors

First, let’s take a look at the summary rankings. While the six majors examined last month were in trending states 60 percent of the time or more, only the Mexican peso qualified among the minors. The Indonesian rupiah, by contrast, was in a trending state only 10.9 percent of the time.

In addition, while all of the majors had average positive excess volatility, two of the minors, the MXN and the ZAR, had average negative excess volatility. Moreover, while the highest average positive excess volatility for the majors was the British pound’s (GBP) 1.0867, the INR had an average positive excess volatility of 1.3874, more than twice its underlying high low close volatility.

We can conclude from just these summary statistics the minor currencies are not smaller versions of their major cousins. They are materially different markets, and any one-size-fits all trading approach to them is unlikely to be successful.

While most of us would not regard the MXN as a trending currency, this is not your padre’s Mexican peso prone to sudden collapses followed by months of doing nothing, the August – November 2008 orderly sell-off not withstanding. After a long and persistent downtrend from early 2002 to early 2004, the currency rebounded, stabilized and then moved higher. Once the stabilization began in 2004, excess volatility for the MXN fell to consistently negative levels. The idea was simple and embarrassing from an American point of view: While Mexico did not have a policy of peso weakness, the U.S. had a policy of dollar weakness. And the MXN’s 2008 sell-off was not the result of a U.S. policy of dollar strength — the U.S. was busy lowering interest rates and creating all sorts of fiscal stimulus at the time — but rather of a global demand for dollars as risky assets were sold globally. This applies to the remaining currencies as well.

The South African rand collapsed with the prices of various minerals in 2000-2001, and then rebounded into a fairly narrow trading range under a combination of stronger export earnings and a more stable monetary policy. The ZAR held up relatively well during the commodity price collapse of late 2008 as the price of gold, one of South Africa’s principal exports, fell far less than did the prices of other metals.

The excess volatility pattern describes the market’s state of mind well. It was at high levels during the sell-off and at negative levels for most of the post-2002 era. The stabilization of the ZAR has great credibility in the eyes of global currency traders.

Anyone who looks at the larger picture of the Brazilian real can be forgiven for asking why it has not always been in a trending state. Its pattern looks like one of the majors’ in its broad, persistent moves both lower into the 2002 election and then in a strong upward trend between mid-2004 and mid-2008, followed by another strong trend lower in the second half of 2008. The answer is quite simple: Brazil always looks to outside investors as if their good luck is about to disappear in a flash. Each minor reversal prompts a quick run for the exits; here again, this is characteristic of how the major currencies annihilate trend-followers’ profits.

An active options market in the BRL did not develop until October 2003, but its pattern thereafter is telling: Excess volatility remained high during rallies until the credit crisis emerged in mid-2007. It was only then, when the market recognized the problem was not going to be a weak BRL but rather a weak U.S. dollar, that excess volatility fell. Excess volatility remained low during the downtrend of late 2008.

The Indian rupee (see “The rupee and emerging markets,” Currency Trader, December 2008) has had a large number of short-lived and strong trends, but their abrupt nature has made trading this market difficult for trend followers. Note how many of the strong trends move quickly to overbought or oversold levels and how excess volatility in the market has tended to remain high during both up and down markets. Indian policy has been to allow the INR to trade relatively freely, but until the nature of the market changes, which it probably will over time, it remains difficult to trade.

The Chilean peso presents an unusual outlook inasmuch as active trading in the CLP did not begin until 2004, marked with an orange vertical line in there. Once it did, the CLP entered a pattern of bursts higher and lower within trending states followed by interregnums of sideways consolidations. Prior to the late-2008 sell-off, excess volatility tended to move higher for CLP during rallies and fall during sell-offs. It appeared as if the market trusted the downtrends more, but the change in behavior during the second half of 2008 calls that supposition into question.

Finally, we come to the Indonesian rupiah, the least trendy currency examined. Its erratic nature, sparse trends, and exceptionally high excess volatility are a reminder of the bad, old days of emerging markets trading. What more — or less — can be said?

The laws of thermodynamics often are summed up by chemical engineers as “you can’t win, you can’t break even, and you have to play the game.” We have seen a similar conundrum for currencies: The minor currencies are grudging at granting the trends traders crave, but the major currencies snatch profits from trend-followers with wicked regularity.

The conclusion we reached in May 2007 (see “Why currency traders should be humbler”) was only the carry strategy really rewarded traders over time, and even then the strategy could backfire as it did for the British pound in September 1992. Carry traders play interest-rate spreads and convergences over time, which is a boring way for many Type-A traders to live. They want to win and they want to win now. This is a personality disorder, not a trading strategy, and we have more than two decades of data to support that nasty conclusion.