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Trading Forex means that we are getting involved in a complex web of intertwined factors that to a lesser or greater degree will determine valuations in a particular currency. However, as we approach the month-end, a special element is at play.
What I am referring to is what’s called the ‘rebalancing flows phenomenon’, which is what we tend to see around the 4pm London fix in the very last few days of each month, with special relevance the very last day. That’s the time when these flows are felt the most.
Usually portfolio managers will either leave or give orders to dealing desks to be transacted at the fixing time and price. These flows can be very heavy at the end of the month and particularly heavy at the end of a quarter.
Therefore, this result, at times, in moves that don’t necessarily have neither a technical nor fundamental logic but rather is all about tweaks in currency risk exposure by global portfolio managers. That’s why a common perception is that portfolio rebalancing at month-end generates large and unpredictable market moves in FX.
So, as a rule of thumb, what you need to understand is that as part of a basic model to gauge these flows, we could be looking at the change in equity performance by market capitalisation for all G10 currencies and then adjust this for monthly FX spot moves.
This gives an indication of how the value of assets has changed over the course of the month and thus the extent of portfolio rebalancing flows that will likely take place.
Let’s say the US equity market, in this case the S&P 500, outperforms the European market, and here we can take the DAX as reference. Note, this example is very simplistic as we must account also for the NASDAQ in the US or the EUROSTOXX or other major benchmarks. But the pont remains. Keep reading…
Let’s say the US equity market did outperform Europe by 5%. That will make the portfolio 5% longer of USD than it was at the beginning of the month. So, that puts managers in a tricky position, especially those passive portfolios (like index funds)… Why? Because the currency exposure would have been altered. So if they want to maintain the same currency hedge ratios, they will have to sell the “extra” dollars and buy euros to bring the overall fund back into balance.
Now, these hedges are also going to depend on the geo-location of the portfolio manage. For instance, a U.S. Portfolio Manager that is invested in US and European stocks with a 50% in each geographic location and a monthly performance of 15% in US stocks and 10% in the European weight, will have by the end of the month a total portfolio value with the U.S. dollar denominated investments increasing by 5%. Therefore, to maintain its hedge 100 percent of your British pound currency risk, he would need to sell 5% more pounds while neutral on the USD as that’s its base currency since based in the US.
However, if under the same example, the manger is based in Europe, there will be a need to sell both the U.S. dollars and British pounds as both indexes increased, but to re-hedge the portfolio in order to maintain the same % currency risk into the new month, more dollars would need to be sold due to the fact that the U.S. dollar denominated investments has gone up.
After the above example, let me now share the main take aways.