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As the FX World Turns - Global Exchanges

FICC Podcasts December 14, 2021
FICC Podcasts December 14, 2021

 

In this week's episode, we are joined by James Topham to discuss the phenomenon frequently referred to as "turn pressures" in the FX forwards market.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi. Welcome to episode 28 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson, in this week's episode, my co-host Steven Gallo and I will be joined by one of BMO's FX forward traders, James Topham from our London office. Together, we will discuss the phenomenon frequently referred to as turn pressures in the FX forwards market. The title for this episode is As the FX World Turns.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Audio:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Okay. It's December 14th, 2021. Welcome to episode 28 of Global Exchanges as noted in the intro by my colleague, Greg, we're joined today by James Topham from BMO's London FX trading desk. Specifically, James works for BMO in the capacity of a forwards trader, and this is a function which he has been performing for 15 years, both inside and outside of BMO. James, welcome to Global Exchanges.

James Topham:

Thank you, Steve. Thank you, Greg. Thanks for having me on the podcast today.

Greg Anderson:

Hi James, Greg here. Let me just reiterate the thank yous. We tend to get a lot of questions at this time of year from clients about turn pressures and we have a few of our own. So we're very excited to share your insights with our listeners and let's just get started. Go straight to questions.

Stephen Gallo:

Can you take our listeners through the various reasons for turn pressures?

James Topham:

Yes. Sure. In one line, it's regulation of the banking sector and window dressing of accounts in other sectors for the day of calendar year end, which leads to radical shifts in the supply and demand balance for collateral and cash instruments, relative to normal business days. Let's take one example. One of the most consequential regulations we think is the BASEL III GCIP charges regime, which applies to the biggest international banks. In simple terms, their balance sheets are measured. They're put into categories by size. The bigger you are, the bigger the capital buffer you have to hold. The more it costs you. So there is a direct financial incentive there to shrink balance sheet at the point of measurement, which is year end. So what you see is from the big banks is a big reluctance to take deposits, big reluctance to undertake repo type activity, real incentive, to shrink balance sheet.

James Topham:

So flows between different short end instruments, which would normally take place to clear imbalances between those markets don't occur. And that's why you see these huge spikes or, or chasms in implied yields. There are also some country specific factors, the design of the central bank commercial bank plumbing. The system there for keeping short end rates under control is a factor in the severity of turns. And there's also a couple of idiosyncratic domestic regulation type things like how insurance companies and other non-bank financial companies are regulated also impact behavior. It's worth noting that we used to think of the terms as being caused by a dollar shortage or more expensive dollars. But these days the dominant factor is unusually low yields on the non dollar currency, because there is so much excess liquidity and nowhere to park these balances without falling foul of costly regulatory charges. So that's why some of the yields are so low there.

Greg Anderson:

James, if I could ask the next question as a follow up. What you're talking about, sounds a front end interest rate curve phenomena on individual currencies, rather than something that spans across currencies and would impact spot foreign exchange. But my question to you is does this spill over into spot foreign exchange?

James Topham:

The short answer is no, not these days and not in G 10 currencies. There are common factors which can impact the spot rate and the severity of the year end turn. For example, the quantity of QE and excess liquidity in the system. But it wouldn't be correct to say that the turns are affecting spot. Although at times we are talking about implied annualized rates of 10% or more on balances. If those rates are only applying for a few days, which they are just over the year end specifically, then the net impact is a lot less. So in the bigger picture, it's unlikely to be worth the risk of taking a directional spot position to extricate yourself from turn costs. And we don't know exactly where the turn is going to trade in what week of the year and what level it will settle on, but because it is a known issue and is priced quite far in advance. I think people make their peace with it and I don't think people look to get out of it with a spot trade.

Stephen Gallo:

Well James, we're all aware of the fact that the global financial crisis of 2008 was a very important milestone in financial history. And many of us didn't even really pay attention to things like term pressure prior to the global financial crisis. So can you give us an idea of how things have evolved in the 10 plus years since the GFC, and then after that, are there any particular years, which you can pinpoint that stand out as being notable since 2008?

James Topham:

Sure. Yeah. The rough pattern is always the same. You know, it is volatile, it swings around on flows and rumors most of the time, it normalizes in the final week of the year, but not always. Things have evolved since, since the GFC, for sure. Two things that come to mind, the implied Euro term. You used to pay a premium for Euro pre pre 2012, I would say. And then it inverted into being Euro discount. So it was quite a meaningful change when that occurred.

James Topham:

Also, I think I'd like to highlight 2017 as being a year when there were a few types of dollar borrowing flows, all hitting the market at the same time around this mid-December time, actually. And really there was some huge moves in in turns, much bigger than previous years and much bigger than we've seen since. But I think that the people involved in that kind of in that mess, I think they altered their behavior. And I think people spread it around a little better now throughout the month of November and December, so that we haven't had such a squeeze.

Greg Anderson:

Very interesting stuff James. Could you compare this year, thus far, 2021 turn pressures that we've seen compared to the previous five years say?

James Topham:

It's been about average so far. I would say both in terms of ranges and the rough pattern of movement has been within the sort of five year average, I would say. But there are still two and a bit weeks to go.

Greg Anderson:

Just to tack on a follow up James. Have there been any currencies in particular that stand out with term pressures this year?

James Topham:

Yeah, sure. The Euro and European currencies, such as Swiss, Swedish and Sterling have been notably more stressed this year than others in G 10, like CAD and, and yen for example. That divergence has been more noteworthy this year, I think, than recent years. I do think we can see Sterling move across into that lower stress camp alongside CAD and yen later this year, perhaps after Christmas. But I'm less confident about Euro and Swiss and stocky, your sort of real QE negative slash zero interest rate currency are normalizing all the way back.

Stephen Gallo:

James, wondering if I could just jump in here and ask you specifically about Euro. Have there been any notable developments in the cross currency basis or term pressures related to the Euro this year? And if so, do you think this can be linked back in some way to the ECBs policy stance?

James Topham:

Yes, I have to think that the specific pressure in the Euro this year is related to the sheer volume of excess liquidity coming from QE. And there are other variously acronymed asset purchase programs. But there are also a few more specific plumbing issues within the Euro zone, which some specialists have commented on. I'm not a hundred percent on the details, but apparently another side effect of that, the asset purchase programs is a lack of good collateral in the market, which exacerbates the problems I've mentioned about swapping one short end instrument for another and equalizing the markets. So I think that's definitely something that's, that's driving Euro specifically. And I think it's then spilling over into the other currencies I mentioned like Swiss and stocky you have the sort of peripheral Eurozone currencies.

Greg Anderson:

James, big thanks for everything you've given us thus far. I think I have the honor of asking the last question and maybe I'll try to sneak in a double so to speak. So my question is this year, has there been a moment of peak or max stress, so to speak? And extend it, is it possible that that moment of max stress is still out there, like maybe tomorrow or somewhere between now and December 31st?

James Topham:

Yeah, sure. Thanks Greg. No problem. So far this cycle Max's stress occurred on Tuesday, the 30th of November. You'll note, that's a month end. So that's consistent with large month end roll flow, which comes from large institutional investors, mostly US investors, but also European and other institutions. So big flows where they roll one month at a time. So obviously at the end of November is where they conduct their role that'll go into January. So that's when those flows need to be digested by the market. So that was the moment of max stress thus far this cycle. I think that's probably established the top of the range for us so far and probably for the rest of the year. I think that we're going to trade within the existing range set by that until Christmas. And then after Christmas, we may see a break towards normalization.

James Topham:

The ECB special two week dollar operation is often viewed as a key turning point for opportunistic European banks to arbitrage the turn if they have the appetite and capacity to do so. This year that is taking place on the 22nd of December, I believe. So let's keep an eye on the uptake there. Four out of five times, I would say the turns do normalize in the run up to new year's Eve. Although there can be choppy two-way action when it comes to trading it as overnight on New Year's Eve itself, as liquidity, just totally evaporates. Anecdotally, we do still have one more category of dollar borrowers yet to come to the market this year with flows, large enough to easily push things around. So if they come tomorrow, then it could widen again tomorrow. But I think they may save it until last orders. So let's stay tuned.

Stephen Gallo:

Well, you know what, James, as Greg said, we've taken a lot of useful information in from you today. And I think our listeners will benefit from your insight. We certainly have. I know that. So I just want to say one more time. Thanks for joining us James. We'll be looking to get you on here again, probably in the new year, especially if we get some intrigue in funding markets over the course of the next 12 months.

James Topham:

Cool. Okay, Steve, thanks very much for having me. Thank you, Greg. And thank you, Steve. Thanks everyone.

Greg Anderson:

Thanks for listening to global exchanges, listen to past episodes and find transcripts bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcast, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC macro strategy group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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