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Mean Reversion in Currency and Commodity Markets

 

Before we go into the intricacies of the financial markets, it may make sense to elaborate on the term 'mean reversion'. By definition, anything that does not go up or down in a straight line will revert at some point. The question is, where does it revert to? E.g. what mean? The mean being just an average of previous price points, but over what period we calculate this number makes all the difference. We have short term, medium term, and long term averages, and even moving averages. The point being that the definition of mean reversion in of itself is quite opaque. Having said that, here are our thoughts on the two markets:

 

In currencies, it really is all about the mighty US$. The reserve currency of the world, the one we all buy when things in the markets go dicey, and the one we all have to clear through a US bank, even when transferring money between our own accounts, at the same bank, in another country. By some measure, the US$ is involved in approximately 85% of all global currency trades, whereas the Euro accounts for about 35% and the Japanese Yen for 20%.

 

So what has the US$ done versus most other currencies? Not much, as it turns out from the chart below, which depicts the DXY Index that measures the performance of the US$ against a basket of other major currencies. We seem to be exactly in the middle of a 20-year price trend. That makes it quite clear that although things tend to mean revert in currencies, it would be very difficult to take a view on where it goes from here.

 

Source: Bloomberg

 

What about commodities? Well, there we get a very different picture depending on which commodity we look at. Oil seems to be stuck in the middle of a very large (100 point) range that started before the crisis of 2008. Gold, as well, is neither here nor there. Base metals and softs are at opposite ends of the spectrum, with one being nearer to their highs and the other nearer to the lows. Is there much mean reversion here or to be expected? Maybe, but no more so than in equities, where a stubborn upward trend has persisted for more than 9 years now, with very little mean reversion on offer. The other problem with investing in commodities is that you have to store them. The cost of doing so makes playing mean reversion a very dangerous game, if you don’t get your timing right.

 

For the moment, there certainly don’t seem to be any strong mean reversion signals, in either the currency or commodity markets. But never fear, with volatility back in play we may have to revisit this conclusion in the very near future.

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