John Taylor became involved in the cash foreign exchange market near its beginning almost by default. He tapped into the technical trading revolution of the time and found that managing money in an absolute return strategy was much more appealing than hedging someone else’s risk. Taylor founded Chemical Bank’s Foreign Exchange Advisory Service in 1972 and developed the first computer models to assist multinationals in managing foreign exchange risk. Now his firm, FX Concepts, manages more than $8 billion in various programs, most of it concentrated in forex. He is a pioneer in the analysis of cyclicality of foreign exchange and was one of the first traders to apply technical trend-following models to forex markets. He did not stop there, however, expanding his programs by applying his analysis to carry and volatility strategies. We sat down with Taylor to discuss the history of the forex market and current market dynamics.
Futures Magazine: John you have been involved in the cash forex market for more than 40 years. How has it changed in that time?
John Taylor: People recognize that it exists now. It used to be that I would go to cocktail parties and would say what I did and everyone would walk away. Now they talk my ear off. It has changed a lot. Obviously the size of the market [is bigger] and participants are making more so it is harder to make money, perhaps because there are so many participants and fewer of the participants [are stupid participants], the stupid participants are still there but there are a lot of professional participants that are trying to make money which makes it harder.
FM: Stupid participants?
JT: The central banks, the governments, the General Motors, the Boeings; those people [entering the markets] for a different purpose so you could make a lot of money off of their needs. Nowadays their needs are far smaller relative to the size of the market. Most of the people in the market are trying to make money.
FM: You started in the 1970s managing foreign exchange exposure for banks. Explain the difference in approach between managing risk and trading as a CTA.
JT: Managing any hedging business is horribly unappealing because if you are making money it means the client is losing money on his investment; if you are losing money that means the client is making money on his investment and wonders what the hell you are doing there. There is never a time when both you and your client are happy. Therefore it is really difficult. You make a killing some years because the client makes a horrific investment. He owes you a lot of money and he is angry as hell because he had a rotten year and he owes you a lot of money. The next year he makes a ton of money and you lose money and he is like ‘why I am letting you lose some of my money?’ so I am happy to say our business is 99.5% absolute return business.
FM: Since launching your first system in 1987, you have continued to research and launch various different trading styles, but mostly restrict your trading to the foreign exchange sector. Why?
JT: Part of it is marketing, to show that you are really good at something; maybe we are not that good because we haven’t figured out to do other things very well. We have been looking at the interest rate market since 1985 and trading it since 2003. Despite that, out of our $8 billion plus under management only $112 million is in fixed income, which is part of our macro product so it is interesting that foreign exchange has taken a lot of time for us and we spend a lot of time working on it. We are working on shorter-term models and different kinds of mean reversion. Volatility has proven to be a spectacular business for us.
FM: Volatility traders usually focus on equity indexes; there are few who focus on currencies like you. Why is that?
JT: It is a hard business to do unless you are really good with your systems. By that I mean back office systems, pricing systems. You have to know what the options curve looks like and then you have to track it back through a lot of years to write the system. So when we started doing options in 2002, we found we had to build up from zero. There was no one doing systematic analysis of options and so we had to create the data; we found creating the data was horrific because all the old data was bad. The systems always would trade the mistakes: ‘Let’s trade there,’ but you really couldn’t trade there, because it was a mistake.
So it took until about 2005 before we had enough of our own data that didn’t have any mistakes in it where we were able to write stuff. Then we had to train an analytical staff. We [hired an expert] in 2008 from Hyman Beck who had been in the business since the 1980s and was an engineer. He was mechanically oriented so he worked well with our systematical people. Instead of having, say, three different ways to trade options we ended up with seven or eight. The last year we made 35% in options and that is a hell of a lot of money to make writing and buying options.
[Volatility] is an area where the foreign exchange market has been nearly untouched. We are the biggest factor in the options market now. It is interesting because we are [important to] liquidity, we’re making the type of money that the banks make in this stuff. It is a great business. It is not [only] a premium collection strategy, it is both. We work both sides and we just invested in more people to do this in fixed income and in equity indexes, and maybe commodities. We are trading over-the-counter options so there aren’t strikes that you have to work around. The options space is different when it doesn’t have strike prices or dates to work around. Options are already about 12% of our assets under management.
FM: Do you have less competition, particularly selling options in foreign exchange?
JT: Some of the stuff we are doing is based on price; also, we are competing more on the slopes and the wings. It is all price but there are a hell of a lot of prices in options. On top of that we are not a mean reversion outfit — you think that we would be trading gamma, owning a lot of options; but the fact that the spot business we have does look for trends. We also do cyclical forecasting and that cyclical forecasting will tell us, ‘the Japanese yen is grotesquely mispriced; instead of being ¥81 or ¥82 to the dollar, it ought to be 65 to the dollar. What can I do with that in the options space?’ Obviously I could do all kinds of gamma-related things that could take advantage of that without much risk and make a lot of money. Our knowledge in trading the spot market is really valuable when you put that together with the options.
FM: Is your study of cyclicality different than your trend-following approach?
JT: It is part of the trend following and it is part of the carry; it is part of [al]most everything. If, say, the trend is going and it has been going for X amount of time, the cycle says ‘that is it, it is going to end.’ We might not go short if we were long, but we might say we are long 100, now we should be long only 75. That is how it works. It is imbedded in all of the systems.
FM: Did the cycle research precede the trend-following model?
JT: My trend-following knowledge came late considering I worked in Chicago at the First National Bank and was involved with the first board of advisors at the Merc. The head of First Chicago was the guy who was supposed to do that. He didn’t want to do it so I got to go. I got to sit with all these unbelievable guys because First Chicago was being snooty and sending a junior guy there. That is when I began to learn trend following but I still didn’t believe it because I was more of a random walk guy. I went back to [New York to work at] Citibank and was running research and marketing in foreign exchange and guys were coming back from Chicago saying, ‘I made all this money on a four- vs. 19-day moving-average.’ I was like ‘get out of here, what do you know’ and after a bit some of these guys said ‘I got this great Ferrari,’ and [I thought] maybe I should pay attention to these guys.
So I started to do that. Then I went to work with a big cycle guy – very famous, very mysterious guy named George Herrdum. He learned his stuff in Chicago where he had been representing a German computer company and got involved with the Merc. He was a computer math guy so he said ‘this stuff ought to be figureoutable,’ so he did and I went to work for him. He was a difficult guy but I worked for him for a year-and-a-half and put cycles together with trend-following. That is how it came about. By the time I started my own company, a year-and-a-half later, my first client was Citibank because they wanted to know what sort of stuff they could put into this. So I wrote them a couple of models that they sold to people in the Middle East and made a ton of money. Typically, like any model, after two or three years it didn’t work anymore. They lost their reputation in the Middle East forever, but my name wasn’t associated with it. Thank God.
FM: Did you try to apply your trending models to a diversified group of markets?
JT: I never did. Now we are starting to because being in just currencies isn’t so good; we should be more macro managers. Therefore we are [expanding].
FM: What distinguishes the forex sector from all others?
JT: Tons and tons of liquidity; $3 trillion a day traded. There is [plenty] of liquidity; even in countries like Chili or Israel, there is still plenty of liquidity.
FM: Is there more of a balance between hedgers and speculators in the forex market than other sectors? If so, does that make it easier or harder to trade?
JT: It used to make the trade easier because the balance of hedgers was higher. Now the hedgers are totally overwhelmed by capital flows, although some of those capital flows can be defined as pretty dumb money. They are going overseas for other reasons than making money in currencies; they see the equity or real-estate markets as being very good, therefore the currency isn’t foremost in their mind. They don’t do a really good job analyzing the currency part of it so therefore they are a little bit of a weak hand that you can make money off of. That is why my options [strategy has been so successful]. Options are spectacular because all those options guys [that] banks are writing options for are dumb money because they are just in there to protect themselves. They are in there for some other business, that is why options are so good.
When I was at Citibank in the 1970s, our clients were IBM, Coca Cola, RJ Reynolds, Kodak; all these guys who where involved in the foreign exchange market all the time because they were making sales overseas, they were making dividend receivables, they had investments to make and so they were always saying ‘I want to get the best price.’ Now they call the bank and get a price on an option to lock it all in. That is the world’s [dumbest] decision and yet every single America company does that. They call three banks [and tell them] ‘I want option flow that says I am bringing back €200 million each of the last six months of the year, give me a price.’ They give them a price and they say ‘thank you very much, that is better than the other one I got. I will take it,’ and it is done. They say ‘I have no foreign exchange risk anymore.’ They just gave the bank a ton of money and the bank now has a position that it sold to them at a big profit — because the bank wouldn’t sell it to them if it didn’t have a profit in it — and they can go home and lock it in forever by going into the interbank market or they can trade it.
There are just tons of dumb money. I stood up in front of the International Association of American Treasurers about seven years ago and said ‘I feel like Alice in Wonderland. I know some of you guys from 15 years ago when we were fighting it out in the foreign exchange market trying to make money, and now you guys have gone and given all your money to the banks.’ That is what my speech was about. And you wonder why the banks are making so much money in their foreign exchange departments. It is because you guys are giving them the money by doing these options. Rather than actually going out there and saying ‘this is a good price, that is a good price,’ making that decision. Maybe they would make wrong decisions, maybe they would make right decisions, but net/net they tend to make [more correct] decisions than giving up big spreads to the banks. In options there is a lot of hedging money. And those hedgers are not showing up in the spot market but they are showing up in that market. Then it is converted into forward transactions by smart money; by Citibank, by JP Morgan, by Goldman Sachs who now have all the positions provided to them by American companies. They are smart money so they are hard to beat. [Therefore] the spot market is much more difficult than the options market.
FM: The carry trade has become more and more popular in recent years; please talk about it.
JT: Unbelievable. It is actually a dumb trade. Theoretically it is supposed to not work. There are thousands of people doing this, so all the rates [should] come out to be exactly tied in perfectly. The forward rate absolutely discounts the interest rate differential among currencies. So if it were the case it should come out even over time, so nobody should be able to go out and borrow the currency that has the cheapest interest rate and invest in the currency that has the highest interest rate. Those ought to balance out over time and you shouldn’t make any money. However, it doesn’t work that way. In fact, if you borrow the currency with the low interest rate and invest in the currency with a high interest rate it will go up. It is clear that unhedged money is going to that country with the higher interest rate and it makes the currency go up as well, and people are putting more money in there so it is going up. So the carry works very well except that every once in a while the country that has been going up with the high interest rate says, ‘My exporters are getting killed, the economy is doing terribly because my currency is getting too high,’ and it crashes.
But how often does it crash? It crashes once every 10 years, but the other nine years you make a lot of money being a carry trader. So all you have to do is avoid the crashes. That used to be the way carry was done all of the time but now it is done, even among the G10 currencies, where those crashes don’t happen the same way. It gets cratered every few years. It got cratered in ’92, it got cratered in ’94, it got cratered in ’98, it got cratered in 2001, 2007 and 2008, and it is not doing very well now.
FM: What are the most important factors — other than the obvious interest rate differentials — to consider before using this strategy?
JT: We are looking at trend, we are looking at carry, we are looking at cycles and we are looking at volatility. The higher the volatility in the carry trade the worse it is. If the trend is negative enough, it will hurt a carry trade. One of the most interesting carry trades right now is the Argentine peso. It is a crappy currency, you know it is going to blow up, historically it blows up. It has an interest rate differential rate over the U.S. dollar of 9.6%. So you can put your money in Argentina and get paid 9.6% and the currency goes down roughly 4.5%-5% a year so you are going to make almost 5% on it. They pay you 5%. They tease the money in there to get this extra 5%. So the trend isn’t always with you. Volatility in Argentina is 4% per year, which is extremely low, which means the system really likes it for that reason. The trend is bad, the system doesn’t like that; the pay is good, the system likes that. The cycle is still ok but it is getting close because if the rest of the world economy goes down they are being saved by the price of [soybeans] but if the commodity cycle ends, Argentina will be in trouble.
FM: Given your experience examining dozens of currencies, which currencies appear to be weakening in terms of stability as well as value? Which appear to be strengthening?
JT: The best currency in the world in a way is the Swiss franc because it is surrounded by the euro, which is really lousy. All the money is going to Switzerland and that makes Switzerland very strong, which of course the Swiss government doesn’t like. But it is not necessarily good against the dollar. It is good against Europe. Australia and New Zealand are unbelievable [in terms of] stability and value. Plus they have [billions of] people living north of them who need everything that they make. Those guys look good. Countries like Singapore [look great]. Asia is much better. [It’s] a three-stage world: Asia is first, the Americas are second and Europe is third.
FM: People have been predicting the end of the euro for years. What is your opinion on the viability of the euro?
JT: It can’t survive. They can change it dramatically but they have to turn it into a transfer unit. That means that the money comes from the rich states and goes to the poor states as a gift not as a loan; as a tax. That is what we do in the U.S., the rich states pay into the Federal government and the Federal government gives it out to [states like] Maine. Look at Greece; Greece is getting [subsidized] by Brussels, they are similar. People who live there, if they want to be equal to the Germans or they want to be equal to the people in New York, have got to have money transferred from New York to them every year. And Europe won’t do that but they have to do it. They have to totally reorganize Europe, shrink it; or they have to allow themselves to give money to these poor states. The euro is schizophrenic right now. If it is a German euro it is 1.7 to the dollar, if it is a Greek euro it is 0.7. I say the euro is going to go back to a buck. I can’t see it totally go but there is lots of agony coming as they try and figure out what to do with it. Certain countries are going to get thrown out; all sorts of difficult things are coming.
FM: We are hearing a lot of good things about Brazil. Is the real poised to become one of the major currencies?
JT: I don’t think so. We were just discussing how much money we want to put in Brazil. We don’t think that Brazil is that big. It is big looking but it still has [problems]. It is still not there yet. I like the government; it is certainly the leader of Latin America. They took some tough medicine but they are not there yet. They have to have extremely high interest rates to hold the money in the country. Every Brazilian worth anything wants to get their money out of the country.
FM: Will the Chinese eventually float the yuan?
JT: Yes. They will do it at their own pace, when they think it is the right thing to do. It is part of their taking-over-the-world strategy. [The yuan] is to become the currency that everybody trades. Because then they would have the control of printing money like the U.S. I am trying not to get too involved with China because they are planning on winning and I am planning on making them not win. So I am not going to let them take my money first.
FM: Some analysts say that the Chinese pegging the yuan to the dollar is beginning to hurt their own economy. Is now the time for them to float?
JT: I don’t think so. They still have a ways to go. For them it is of great value to have it be undervalued, to allow them to export because it weakens all the other countries too. I [believe] this is a world at battle issue rather than we are all out here being good guys together. For China it is really good to have a weak currency because it weakens the U.S. and everybody else’s manufacturing base.
FM: Are they winning the battle?
JT: Yeah, so far. We can’t make TVs, we can’t make ships, we can’t make anything because China is taking the business away from us. So we are weak. We might have big military things but we can’t work them unless we have equipment to make them work.
FM: There has been a lot of talk about the dollar being replaced as the reserve currency of the world. Is there any currency out there that can take the greenback’s place?
JT: Only the yuan and it is not going to do it for a long time because they are not letting it float; they are not ready. By the time we get to 2020 it is still going to be the dollar, that is as far as I can see. We might have an interregnum period where there are multiple reserve currencies, but it is probably going to end up being the yuan eventually because people will pick one. They always have picked one before.
FM: What would that mean for the dollar?
JT: If we lose it, it will be a big deal, but we are not about to lose it. The problem with being a reserve currency is whenever things are good in the world your currency is going down. [And] when the world is doing [poorly] and there is no liquidity out there because that is what happens when the world is doing lousy, then you are worth more. So when the world goes into recession the dollar goes up; when the world is doing great the dollar goes down. That is the most important thing to know about foreign exchange nowadays – it is kind of backwards.
It didn’t used to be that way but it is that way now. So in 2008 all of a sudden the dollar was strong as a moose. Then when we solved the thing, the Fed printed enough money, the dollar started to weaken in March 2009. Then it started to strengthen again last April/May because they were talking about raising interest rates and slowing down the U.S. growth of money. The dollar was strong then until August when Jackson Hole comes out and [Bernanke] says ‘I am going to print tons more dollars,’ and back down the hole we go and the world grows. Now the Republicans are in there and they don’t want to print any more bucks so guess what, the dollar is going to go up again and the world is going to go down, so 2011 is going to be a big recessionary year.
FM: What would it take for more normal fundamentals to be back in play?
JT: For there not to be so many dollars floating around the world. I don’t think that normal fundamentals are coming back.
FM: You talked a little bit about the manipulation of central banks. How does it affect your trading?
JT: It hurts it. Sometimes we can anticipate it, but most of the time it comes out of the blue. It is a problem for us, but sometimes it works out ok. One of the reasons the carry trade works so well is that the central bank of Indonesia, for instance, says ‘I don’t have enough capital in this country so I have a high interest rate. I don’t let my currency bounce around. I intervene, buying and selling to make sure it is nice and smooth.’ I love the central banks when they are doing that. But then all of a sudden they will say ‘it is much too high, I don’t need any capital, I don’t want it anymore, so I am going to drive it away.’ Then we get screwed. The carry trade is great often because all the emerging countries’ central banks are saying ‘I know how to get capital in here; I just have a high interest rate and I don’t let my currency [mess] around.’ So sometimes the central banks are ok.
FM: Is the level of manipulation more or less now?
JT: The same. It depends on what they want. Right now they have too much capital so it looks like they are intervening a lot because they are changing their mind. But if the world goes into a recession, they will flip to the other side. They are always there; it is just trying to win the game.
FM: Do you consider what the Fed is doing manipulation?
JT: It is but we do a poor job of it. It is very hard because we have so much money out there. We have to manipulate all of the money that is no longer in the United States. Our banking system is wide open, which makes it hard to do. It is much harder for the U.S. to manipulate its currency. You have to have a lot more controls than we have to get the job done.