February 20, 2013

LONDON -- Rapid moves in foreign exchange markets have sent strategists scrambling to revise 2013 forecasts as resurgent currencies outpace price predictions, wrong-footing the experts that many rely on for hedging, budgeting and investment.

After two years of muted trading volumes and limited opportunity to make money as asset classes moved in lock-step, investors are piling back into currency trading.

The surge in trading has been fuelled by optimism the worst of the euro zone debt crisis is over and by talk of "currency wars", after Japan's readiness to talk down the yen drove other currencies sharply higher.

The change in pace has taken forecasters, many of whom earn six-figure salaries in return for their expertise, by surprise, and faulty forecasts can cost their clients dear.

Many new year forecasts were outdated within days; in some cases analysts also got the direction of a move wrong, predicting a currency would fall only to see it shoot higher.

In January, both the euro and yen ended the month well outside the range of all the forecasts in a Reuters poll of 53 banks. Strategists have not been so wrong on two currencies in the same month since October 2011.

Bank of England Governor Mervyn King once said only a fool would forecast exchange rates. Some strategists said the dramatic acceleration in FX moves highlighted the difficulty of making detailed forecasts in a $5 trillion-a-day market.

"You make a rod for your own back when you forecast," said Neil Mellor, currency strategist at Bank of New York Mellon.

"No one likes to admit getting things wrong. It affects your view if you start defending a position, when really you should be assessing what's affecting the market."

The yen has been the biggest mover as investors bet heavily that the Bank of Japan would aggressively ease monetary policy as part of efforts to revive the economy. The currency dropped far faster than the sedate pace envisaged at the start of 2013.

Reuters polling data shows the mean 12-month dollar/yen forecast from analysts surveyed in January was 87.8 yen. The dollar raced past that level four days into the new year.

By February analysts had raised the mean 12-month forecast up to 94.4 yen. That level was hit on Feb. 11.

Short-term forecasts were no better. Only a third of those polled in January correctly predicted the yen would fall against the dollar by month-end.

The euro, riding a wave of investor optimism, caused similar problems, ending January near $1.36, well outside the $1.27 to $1.3450 range in the poll.

POINT OF PRIDE

Unlike traders, who risk millions of dollars betting on market moves, only pride is at stake for analysts, though persistently bad calls might not be tolerated for long.

Those who miscalculate not just the pace but the direction of a move face a tricky conundrum: do they keep faith with forecasts even as markets race off in the opposite direction, or eat humble pie and hastily revise outlooks?

"When things are not going your way, it's not pleasant. If we change our forecast we get a bit of grief internally and externally," said Daragh Maher, currency strategist at HSBC.

HSBC strategists this month revised their dollar/yen 12-month forecast up to 80 from 74 yen, predicting the yen will rebound to levels not seen this year, just as many of their rivals see the currency falling towards 100 to the dollar.

For most analysts, getting the "story" right - a convincing argument for where a currency is headed - is more important than hitting a specific price.

"When someone changes their forecast, are they chasing spot, which I think is a mistake, or has their view changed? We're paid to try and help people make money, and so getting a story right and having an interesting story is part of that," Maher said.

There are no hard-and-fast rules for predicting currencies, but most analysts use a combination of economic fundamentals, "event risks" - the impact of any event, from an earthquake to a policymaker's speech - and positioning data, which looks at the weight of speculative bets on an exchange rate.

Many forecasting models include specific variables for each currency. The strategy team at Bank of Tokyo-Mitsubishi (BTMU)uses dairy prices to help predict the New Zealand dollar, reflecting agriculture's dominant role in the economy.

For the yen, the bank looks at the more traditional measure of the yield differential between U.S. and Japanese government bonds as an early warning signal of moves to come.

BTMU won top spot in the Reuters monthly FX polls in 2012, but was also caught out by the speed of the yen's tumble and lifted its 12-month dollar/yen forecast to 93 in February from 86 yen in January.

"These models break down; lots of variables did not signal this move. Spreads were very flat and still are," said Derek Halpenny, European Head of global currency research at BTMU.

Halpennny said although the models are not perfect, they are useful in assessing the outlook for a currency. The problems come when people expect too much of them.

"When you get requests from customers looking for five-year forecasts, that is laughable," he said.

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