Blowing More Bubbles

This is my first blog of 2015. My father passed away in early March after a short illness that began before Christmas. Naturally, my family has been the most important consideration during this difficult time and some, less essential, parts of my workload have taken a back seat – and, unfortunately, this blog was one of them. But, it returns now and with renewed gusto – Dad intuitively knew a thing or two about financial decision making and I’m sure he’d approve.

In my last blog I wrote about central banks, asset prices and West Ham. After a three month break, I am still going to write about central banks, asset prices and West Ham.

Then I talked about central banks ‘blowing bubbles’ and noted that :

‘By historical measures both government bonds and equities are very expensive and although in the leading economies they are relatively stable there are signs of fissures elsewhere – especially in certain currencies and commodities.

I see the message repeated often in the world of financial advice that stability, as measured by volatility, means low risk – but that can change and change abruptly. And a general lack of understanding of the limitations of this methodology is partly why banks got in such a mess in the first place.’

Within a couple of weeks we had example of what can go wrong. And it specifically related to a financial dam bursting due to the actions of central banks.

The dam in this case was a commitment by the Swiss National Bank to peg the Swiss franc to the euro almost three years earlier. This was done to protect Swiss exporters from a rising Swiss franc that made their exports more expensive. But, in order to maintain such a peg, especially in the face of rising demand for the Swiss franc from within the Eurozone, the Swiss central bank had to do the opposite and sell their currency to buy euros.

And buy euros they did…and amassed a record pile of 495 billion Swiss francs worth of foreign currencies – almost 80% of Swiss national production. Which is simply enormous and when it became clear that the Eurozone was about to embark on its own program of quantitative easing, which would likely lead to another bout of demand for francs from Europe, the Swiss central bank decided they could not maintain the peg and removed it.

Following the announcement, the franc appreciated by 40% against the euro at one point, before settling at the end of the day with a 25% gain. What had been a stable relationship had shifted to a new plane in a move that traditional risk management implies is impossible.

While a central bank may temporarily ‘peg’ exchange rates, over the long term this is extremely difficult– especially if you are also attempting to fix interest rates with quatitative easing as many now are. It also explains how one country’s policies can be exported to other nations whether those nations want it or not.

Alpari lose their shirts.
Alpari lose their shirts.

Some of the fall out from the Swiss change of heart did not occur for a couple of days, when it then became clear that a couple of retail currency trading firms would fail – including West Ham’s shirt sponsor, Alpari.  They simply did not require of themselves or their clients enough of a financial buffer to cover such a move. They might argue that it was unprecedented, but in a world where governments are seeking to fix the rates at which they can borrow by printing money, one place where economic strain can show is in foreign exchange (fx) rates.

And these retail fx trading firms and their customers were highly leveraged. Lehman Bros, the epicentre of the financial crisis failed with leverage finally revealed as 30 times capital. These firms offered their clients leverage ratios over 100 – which is barely enough to handle daily trading noise and shines a very poor light on their business model.

So, my position remains the same – we need to be especially careful when managing risk at the moment. And I’ll keep a wary eye out for more signs of strain. I mentioned ‘fissures’ in currencies and commodities in my last blog and that remains my focus.

I also hope that I’ve given you an appreciation of how hard it is to trade currencies as a retail investor.

In the world of financial advice there is hardly any focus on currencies or commodities, but I mention both in our ‘product guide’. And I wrote the following regarding currencies –

‘please beware the glut of adverts out there from companies suggesting you can get rich quick trading currencies on a very short term basis. It’s very unlikely you’ll master the vagaries of short term foreign exchange movements, however seductive the marketing material may be.’

I can’t predict imminent movements in markets, but I can note elevated levels of risk that others either don’t see or choose to ignore. And part of that is discussing what is reasonable, and it is simply not likely that you’ll make a regular income from trading foreign exchange. I should know, I managed currency risk as part of other strategies for a long time and was paid in Yen for eight years.

If you are tempted by the hype, just ask the company seeking your business what percentage of their customers make money over a year? That should focus your mind a bit.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing;
  • this blog does not constitute financial advice and is provided for general information purposes only.