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How I Stopped Worrying and Learned to Short the Euro


Meet Andrew Law and his fraternity of global currency traders. Are they shameless speculators, an essential oil in the gears of capitalism—or both?

In March, as his country teetered on the brink of insolvency, Greek Prime Minister George Papandreou blamed "unprincipled speculators" for exacerbating the crisis. Currency traders around the world were roiling markets, he said, and threatened to trigger a new global financial meltdown. He was talking about people like Andrew Law, chief investment officer of the $9 billion Caxton Associates, one of the best-performing hedge fund firms in the world.

What Papandreou saw as opportunistic speculation was all in a day's work for Law, 44. At the beginning of 2010, Law had a simple goal: to make money betting on global economic growth by shorting the euro and going long the rest of the world. He thought the Continent had problems that predated any impact he and his colleagues might have had. Currency traders make money betting on the movements of one currency against another. While other investors look at book value and price-to-earnings ratios, currency traders must stay abreast of political developments in every corner of the globe, translating tiny policy shifts or growth projections into profitable trading opportunities. At a time when many nations are in the midst of economic crises and concerns about sovereign debt are widespread, Law and other currency speculators can affect capital flows in and out of a country, driving up import prices and inflation, pushing stock and bond prices down, and causing a government's cost of borrowing to increase. The question is whether traders who bet on currencies are obstacles to a global economic recovery, as Papandreou suggests, or simply another set of actors making money—and making the market more efficient while they're at it.

Law believes that currency traders help resolve imbalances in the market. He simply wants to profit from his trades. "The driver of foreign exchange is having divergent outlooks for different countries," says Law, "and the fundamentals are pretty diverse at the moment."

Just as he was buying Canadian, Australian, and Asian currencies and pairing them against short positions in the euro, other traders were pairing those long investments with short bets against the U.S. dollar, which had weakened against the euro for much of the previous year. Law, however, was more concerned about Europe, after news that Greece's deficit was wider than previously reported. He wasn't sure how much higher the euro could go—it was then worth around $1.50, after climbing as much as 21 percent against the U.S. dollar in 2009. He saw the euro as the weakest link in the global currency market.

The 16 European Union countries that use the common currency had amassed too much debt. If investors began to view any of them as a default risk, the traders would start selling their bonds, stocks, and other assets, driving the currency lower. For the first five months of the year, foreign exchange trades were the largest bet in Caxton's main macro fund, and those trades were making the fund the most money. About half of Caxton's risk was from trading currencies, a higher-than-normal level for the firm that Bruce Kovner, who boasts one of the best track records in the hedge fund industry, formed 27 years ago. Law, who grew up in Cheshire, England, and is based in London, has been with Caxton for seven years. He was named Kovner's heir apparent in 2008.

Rarely have global economic conditions been so ripe for betting on currency fluctuations. Most traders agree they haven't seen such a difference between outlooks for different countries in at least a decade, and exploiting that gap is how currency speculators make money. Recovery prospects for the U.S. seem to be fading as employment fails to pick up, and Greece, Spain, and other European nations face massive deficits. At the same time growth prospects in Taiwan, Brazil, Malaysia, India, and Australia are so strong that policymakers have been raising interest rates to curb inflation. China has taken steps to deflate its real estate bubble and has let its currency drift higher for the first time in two years.

Currency traders are not overcaffeinated wild men barking orders on crowded trading floors; they're the self-contained types who have lunch with economics professors and carry the Financial Times tucked under their arms. The most famous of them all is the billionaire investor George Soros, who made headlines in 1992 for "breaking" the Bank of England when he shorted $10 billion worth of the British pound, which eventually led to the currency's devaluation. He and his lieutenant, Stanley Druckenmiller, earned $1 billion on the trade, but critics and politicians around the world who had seen their countries' currencies gyrating were not pleased. In 1997, Malaysian Prime Minister Mahathir Mohamad called Soros a "moron" who was out to destroy Asian economies. Soros' impact was so significant that in 1997 he made a point of refusing to speculate on the Russian ruble. "If I started to do some selling, the whole market would follow," he said in an interview at the time, "and it would have a bad effect on Russia."

On one level, what Soros, Law, and others like them do looks easy: A basic strategy is to buy into countries where interest rates are high and sell short those where interest rates are low, based on the expectation that capital will flow to countries where growth is strong and bond yields are high, thus pushing the currencies higher. In practice, though, the game is not so straightforward.

Like chess players, successful traders of currencies have to think several moves ahead—about what might prompt a central bank to raise or lower rates suddenly, for example. Decisions involve both political and economic variables, internal and external factors, and questions ranging from whether a rival political party might come into power to the possibility of a war erupting, which would cause investors to flee to the U.S. dollar—still seen as the safe currency. Currency traders don't deal with valuation in the same way that money managers who invest in stocks and bonds do. The value of a currency isn't absolute; it is always viewed in relation to one or more other currencies. "That's why listening to the market is so important," Law says. In addition to Caxton, Louis Bacon's Moore Capital, Paul Tudor Jones' Tudor Investment, and U.K.-based Alan Howard's Brevan Howard are major presences in the market. Law's boss, Kovner, who first made his name trading currencies in the 1980s, is seen as the grandfather of them all.

Most currency trades are done with forward contracts, essentially an agreement that a trader has made to buy one currency against another currency, generally one to three months in the future. Traders tend to construct their currency portfolios around a theme—a theory of where global markets are going and why—and hold their positions until the markets change. One peril of the field is high leverage: A hedge fund manager might put down as little as 2 percent for a forward contract, meaning that he has borrowed $49 for every one dollar in capital. If the market moves just 2 percent in the wrong direction, the trader's equity is wiped out. Risk has to be managed exceedingly carefully when a relatively small fluctuation can cause so much damage. As a result, profits can be elusive. Moore and Tudor both lost money in the first half of this year, while Brevan Howard is up about 0.2 percent. Caxton is doing the best, with a return of 4 percent, thanks in large part to Law and his bet against the euro.

The European currency started the year worth close to $1.50 but then tumbled below $1.20. Along the way politicians complained that hedge fund traders were driving the global economy into the gutter through their pursuit of short-term profits. Even the traders acknowledge that they've had some impact. "In the last six months, and for the next 24 to 36 months, what we do as a currency-focused macro fund is probably more relevant than it has been for at least a decade," says Howard Kurz, 53, who started Lily Pond Capital Management in 2001 and has been a foreign exchange trader since 1979. "The macro adjustments that are forthcoming are critical for rebalancing economies and allowing a transition from the vast accumulation of wealth in high-saving countries to increased savings in high-consuming countries." The result of that transition, he says, will be chronic slow growth around the globe.

Volatility in currency markets is partly due to the lack of certainty among traders about what will happen in the next six months. Law says he and other traders know they can no longer count on the so-called Greenspan put, referring to former U.S. Federal Reserve Chairman Alan Greenspan's practice of cutting short-term interest rates at any sign of trouble. With low rates, consumers borrowed money to buy houses, televisions, and cars (and investors borrowed to buy stocks), all of which kept economic growth humming and the price of assets rising. Without this safety net, investors are skittish and uncertain about central bankers' ability to regulate economic cycles. Law says he has been reminded this year of a lesson that Kovner has often repeated: "Markets can move further than anyone can rationally predict, because no one has perfect foresight."

Law's willingness to retreat when markets move in ways he can't explain helped Caxton's main fund make money in May, when most others hit trouble. Midway through the month, the confluence of factors that had helped everyone take in profits—rising equities, strengthening currencies in emerging markets and commodity producing countries, rising oil prices—reversed in a matter of days and sent traders scrambling. Law sensed the shift coming the week of May 17 when the euro, which had been sliding for most of the year, stopped going down and global equity markets tumbled. When a correlation that has been consistent for months suddenly breaks down, Law says it's time to get out of the trade.

Through the early part of the year, the euro had been trading between roughly $1.32 and $1.38. Then on May 10 the European central bank announced a $1 trillion rescue plan for Greece and other debt-laden governments, and the euro slid toward new lows. Shortly after that the euro's plunge came to an end, and so did Law's winning trade. Between May 18 and May 21, the Mexican peso, the Indian rupee, the Brazilian real, the Philippine peso, and the Malaysian ringgit all fell about 4 percent against the euro. The Australian dollar tumbled 6.5 percent and the South Korean won more than 7 percent. The Standard & Poor's 500 Index lost almost 6 percent in four days, beginning May 17. "We listened to the markets, and on that day the markets were saying that the rest of the world would have weakness, so we got out of the way," Law says. "We reduced our currency trade over the next 24 to 48 hours."

Law's focus has now shifted to the U.S., where he is more likely to express his pessimism about the economy by shorting stocks. His biggest question for the second half of the year is whether private-sector demand is strong enough to withstand the inevitable winding down of the government's fiscal stimulus programs. What became apparent to Law in May, when U.S. stocks took a dive, were signs that the domestic economic recovery was not as robust as advertised. The S&P 500 has jumped 7 percent since the beginning of July, but Law is sticking to his view: "The theme of slower U.S. growth will likely be seen in equities." The euro, meanwhile, has climbed more than 6 percent against the dollar since hitting a low on June 7, in part because the EU demonstrated it has the will and the resources to bail out any member countries at risk of default. Plus, Law believes, Germany, which is the strongest European economy, seems committed to stimulating growth throughout the region. "What we are watching very closely is the behavior of the government debt markets in Germany and in the U.S. and how they trade relative to equities," he says. If both stocks and bonds start falling in tandem, that would be bearish for the growth outlook and bearish for equities, he says, as it would signal that Germany might not be able to bail out its weaker neighbors.

While Law worries about the American economy, Kurz of Lily Pond Capital is "slightly bullish" on the greenback because of its status as a reserve currency. Even so, he says a strengthening dollar isn't one of his big currency themes this year. Both Kurz and Law agree that everything depends on what governments do. "The best trades historically have come out of policy mistakes," says Law. (He points to 2008, when the European Central Bank raised rates in July, only months before Lehman Brothers declared bankruptcy, and then had to reverse course abruptly. Law was betting, correctly, that the central bank would have to cut rates.)

Law is back to studying his charts, trying to find ways to squeeze out more profits. "The current period is not the same as anything we've seen in the last 25 years," he says. "What I've learned is that if you have a vision about where the world is going, and you manage to get into the trade at a good level, at the right size, and with the stop-loss in the right place, as long as the market continues to behave as I expected it to behave, then we keep the trade on." The smart speculator, however, knows his limits. "We can only point the ship in the right direction," Law says. "And then markets, fundamentals, policy will carry the trade on."


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