An interview with Axel Merk CEO of Merk Funds – Watch out for the human element
Axel manages four forex mutual funds in the US and is a frequent commentator to the media on topics such as macro-economics and the markets and sometimes airs controversial views. Axel very much uses his macro views as a basis for his currency trading. As such, and unusually in the forex markets, his trading style is not heavily driven by technical analysis.
Axel basically drifted into forex over a period of time. He first started out in the investment world in Switzerland in 1994 and mainly traded equities. He then took his business to the US in 2001. While forex was not his original focus he was attracted to the market due to a desire to diversify and to add uncorrelated assets to his portfolio.
Around the 2000 Axel started to take more interest in forex and gold, partly as a result of doing international cash management, which comes with a world wide investor client base and a focus on cross-border markets.
The firm also moved from running hedge funds towards mutual funds despite the stricter regulations and higher running costs. From Axel's point of view the extra regulatory costs were worth it as it Has it enabled him to have a higher public profile and to more easily market his funds.
To find out more about Axel please visit: merkfunds.com
JP: A lot of currency traders, even the longer term ones, see trading forex as being all about technical analysis. Why should people really care about fundamentals?
AM: A typical currency trader has an investment horizon that’s between a few milliseconds and a few days. My focus is often much longer.
If you have a longer-term vision of where the trend is going, you can still adjust to market movements. You can make money being on different sides of the same trade. I mean it’s just that whenever the currency moves your way, you adjust your holdings a little bit accordingly.
We do integrate technical analysis into our trading. But the core problem with technical analysis-driven investing and maybe with systematic investment strategies is that they haven’t worked well in recent years.
Now many blame the low interest rate environment where for example the carry trade doesn’t work particularly well.
But the way we see it is that when you have this very heavy-handed involvement of policy makers, regardless of how good your back testing is, those models break down. When policy makers change the rules you can’t expect that your back tested model will work.
So you have to account for the human element as well.
Also we look at a lot of things such as implied volatility and quantitative metrics. But we put it into the context of what is happening out there in the world. And so we think it is incredibly important that you don’t lose sight of reality, so to speak.
It is an interaction between the models and humans that we think is key to succeeding in the current environment.
One of the things we have been saying is that there was never a Euro zone crisis. There’s always been a global crisis. There’s too much debt in the world. And so we will continue to see this heavy-handed engagement by policy makers to try to deal with it.
To us what’s happening in the Ukraine is just a symptom of the environment we’re in of reduced political stability.
This is all part of a similar theme that we see globally and that sort of political instability is going to continue and investment ideas are going to be different from the environment where your favourite momentum strategy was ruling the day.
JP: Talking of heavy-handed policy makers, nobody wants a strong currency. So you can get a nice upward trend, say on AUD/USD, and very soon a central bankers says we can't have a strong currency and that intervention destroys your trading idea.
AM: Yes, but you can still add value as an investor. You can study each country individually because everybody is a hostage of their own political dynamics. For instance, I think the ECB is one of the most misunderstood central banks.
JP: Can you explain?
AM: Anglo-Saxon journalists always over interpret what Draghi (ECB President) says. He never says many of the things that he’s being quoted on.
Draghi's frame of reference is very different.
The Bank of Japan acts differently. Carney has revamped the Bank of England. Some of these things are more on the regulatory side and what not, but culturally things are different. On a simplistic level the ECB has a demand driven operation where banks can access liquidity as needed, whereas the Federal Reserve is imposing liquidity on the market and obviously it doesn’t work.
There are cultural differences in how these central banks operate.
Now clearly bankers do talk their currency down, but they do it differently and some bankers follow with action and some just with words. And so yes there’s a lot of noise created in the market.
But you can try and figure out they will do. How will they follow through? Very few go as far as the Swiss National Bank. They put a guarantee in there. Hey, leverage yourself; gear yourself up, because the Swiss Franc is never going to go up anymore with the Euro.
JP: That guarantee by the Swiss National Bank was amazing (In 2011 it dramatically capped the level of the CHF vowing to take drastic action to stop it soaring in value):
AM: And it’s an indication to short the Swiss Franc and that’s an extreme example.
Look at Japan. The policies are not as effective as they should be. Well what’s going to be the reaction of policy makers? Are they going to stop because they didn’t succeed or are they're going to double down?
Clearly we don’t know what’s going to happen, but we have a pretty strong opinion and we can put our money where our mouth is and then expect the currency to move accordingly at some point.
JP: Since 2007-2008 the world feels quite different. Uncertainty is almost perpetual now. But in terms of judging currencies, what fundamentals do you think people should be taking good notice of?
AM: Here's an example of what people can do. When the new politburo was announced in China we published a white paper looking at the bios (CVs) of the candidates along with the political dynamics in China and who might get the various posts within the politburo.
From that we had an opinion in early 2012 about the direction that China’s going to be taking in the coming years. In October 2012, that politburo was announced. Media headlines were full of interpretations about the direction the country is heading in.
Well, you can disagree with what the newspapers say and take a position based on that.
The Head of the State Agency of Foreign Exchange gave an interview where he laid out exactly what he’s planning to do and it is happening in the markets.
And yet the media’s full with all kinds of other stories about why this is happening, what the implications are, and whatnot. And then so based on fundamental analysis and looking at the actual policies and looking at how credible policy makers are, you can then make an investment choice.
JP: So would you say people would do well to actually go to various government websites?
AM: Go to the sources. We have a native Chinese speaker on our staff who can read the original documents.
To give you an example of what we do, in the spring of 2012, Draghi wrote an editorial in a German newspaper. Now the German public was very critical saying, “He’s meddling with our affairs,”
I told my office to get me the original. I can speak German. Well that German newspaper didn’t publish it online, so they gave me the English text. So I read the English text. Three hours later they got hold of the German published version and I read it.
The English and German versions didn’t match.
They were different in ways that I thought were very, very important.
And so I got in touch with the ECB for a clarification.
But the point is that you’ve got to go to the sources and make up your own mind about what’s happening because there are certain journalists who are very good covering this space. But they’re always going to add their own flavour and interpretation and you’ve got to have your own framework of thinking about the world and you’ve got to go to the sources. Rather than just chasing what everybody else is telling you what to do.
JP: How do you look at data? It sounds to me like you’re not the kind of guy who just looks at the headline number and does a trade on that But you do a lot more than that?
AM: And we’re certainly not interested in the second or the third decimal of whatever it may be.
The challenge, if you’re taking on non-farm payrolls and let’s talk about the Fed here for a few moments. Historically, the Federal Reserve is looking at forward looking indicators, which means they read the yield curve to get a gauge of the health of the economy. They can’t do that anymore because they are influencing the yield curve.
JP: In other words they're distorting the very indicators they use in their decision making?
AM: Exactly and so now they have to read the tea leaves like everybody else is doing.
So they’re looking at backward looking indicators and that means they’re confused. The Fed is transparently confused because they have no clue what they’re doing. They just don't have the data.
So then it becomes all the more important to try and understand the psychology of what’s going on in people’s heads.
Unfortunately Yellen (Fed Chairwoman) doesn’t have that much of a philosophy compared to Bernanke (former Fed Chairman). Bernanke was a student of the great depression. You knew exactly what he was going to do.
Janet Yellen is all excited talking about regulatory policy, about the competitive advantage and disadvantages of US versus European banks. When asked about how many hours are there in a work week, she doesn’t know. When she’s asked the percentage of mortgage-backed securities on a balance sheet, she doesn’t know the answer.
That means she’s much less engaged in those things.
Stanley Fischer (vice chairman of the Fed) is going to instil some discipline, some calm on the Fed. But if you combine that with a Janet Yellen who – the only thing she wants is for Main Street to be happy then we’re not going to get so much information.
JP: All this sounds like she’s a little bit unpredictable, maybe a little bit shallower than Fischer?
AM: In 2008 everybody knows that she warned about the financial crisis a little earlier than others did. But what many people don’t know is that in June of 2008 she called for an interest rate hike.
And because she has less of that deep philosophical rooting on how to approach monetary policy, she can change her mind.
And that’s going to have an impact. That’s going to make for different dynamics in the markets than under Bernanke.
JP: Any other important points you think are worth bringing out on fundamentals or that you look at in terms of positioning your funds?
AM: I think one area that’s very misunderstood is current account balances. It has been discredited many times over in terms of its ability to predict exchange rates.
Well we agree with that, but a current account balance speaks volumes about the sensitivity that a currency has towards the changes or the perception of changes in economic data.
If you look at Japan it used to have a current account surplus. When Japan had its earthquake (2011) the yen rose. New Zealand had a current account deficit and also had an earthquake (also 2011). The New Zealand dollar fell.
The Euro zone has a current account that’s roughly in balance, they have lacklustre growth, yet the currency is strong. To us that makes perfect sense and we do tie these things back to the current account balance.
Now do we care about the exact current account balance in that context? No, but we do care about the dynamics. And they change. One of the things, everybody in the forex world looks is the correlation between the yen and the 10-year note (JGB).
We happen to look more at the correlation between the yen and the VIX.
JP: Do you mean the VIX on the S&P 500 (a measure of volatility)?
AM: Exactly. After Abe (Shinzo Abe Prime Minister of Japan) had taken power, that correlation was deteriorating and was deteriorating just about in parallel with the deterioration of the current account balance. To us that meant that the current account is moving towards deficit. Deficits will matter and the yen is no longer going to be a safe haven.
Now in recent months that correlation has increased again. It may mean that the market foresees that Abenomics is not really effective.
It's this sort of thinking that helps us to understand what’s happening in the markets.
You can read more interveiws by MahiFX here.