Taylor Rules Currencies, Not to Be Confused With the Other Guy

By Bo Nielsen

Aug. 22 (Bloomberg) -- Watching the fallout the U.S. subprime crisis has had on currency markets, John Taylor is thrilled. ``If you look at the best years we've ever had, it's when the market was completely haywire,'' he says.

Taylor's International Foreign Exchange Concepts Inc., the biggest currency hedge fund company in the world, is navigating through some of the wildest fluctuations the currency market has seen since the dot-com crash in 2002.

The average size of the dollar's swings against developed- market currencies in the past year has increased 46 percent compared with the prior year, and its moves against emerging-market currencies have increased by 23 percent, as measured by JPMorgan Chase & Co.'s indexes of implied option volatility.

Taylor has profited from the turmoil by using software that tracks trends. Three of FX Concepts' four biggest trading programs rose as much as 11.2 percent after fees this year through July 31, about eight times the returns of the Barclay Currency Trader Index of 145 programs tracked by Fairfield, Iowa-based Barclay Hedge Ltd. A program is a pool of money invested in one or more investment strategies.

The exception is the company's Developed Markets Currency program, which has returned an average of more than 10 percent since its inception in 1989. It declined 5 percent in the first seven months of this year as increasingly erratic price swings made it more difficult for the program's trend-spotting software to find profitable trades.

Randomness

That was especially the case in the so-called majors -- the currencies of the Group of Ten countries, which include the U.S., Japan, Germany and the U.K. ``It's become much harder to make money on the majors,'' Taylor says. ``They are not totally random, but it's damn near.''

Overall, assets under management at FX Concepts have almost tripled to $14.6 billion from $5 billion in 2002 and may swell to $25 billion in the next five years, Taylor says.

In offices seven stories above Manhattan's bustling 34th Street, analysts hunch over their computer screens or meet with customers in conference rooms dubbed Dollar, Euro, Yen and Cable, which is jargon for the British pound. They use software that tracks more than 500 exchange rates against their historical patterns to spot trading opportunities.

Every morning, Taylor's software crunches data going back to the 1970s -- everything from currency and commodity prices to real estate investments -- in order to forecast exchange rates. The predictions help Taylor's team select trades, most of which are made in the option, futures or forward markets.

`Rock 'n' Roll'

The traders are looking for imbalances, particularly among the major currencies, which account for about 90 percent of the world's foreign exchange trading.

``When you have some economies growing strongly and some economies encountering problems, that's when the currency markets rock 'n' roll,'' says Jonathan Clark, 52, vice chairman at FX Concepts.

Taylor's approach to the currency market is different from that of George Soros, who made an infamous wager in 1992 that the British government would withdraw its currency from the European Exchange Rate Mechanism.

Taylor bets only a fraction of his assets each time. His trades usually last a couple of weeks. His models flash when a currency's movements suggest it will continue on the same path and again when the move looks likely to reverse. (Taylor isn't to be confused with John B. Taylor of Stanford University, who invented the Taylor Rule, which central banks use to gauge interest rates vis-a- vis inflation and growth.)

Betting on the Euro

In the year ended in July, one of Taylor's most frequent bets has been on the euro against the dollar. Adjusting to the zigzagging market, he shifted from owning the euro to selling it, to owning it again, up to 15 times in his various funds as the European currency advanced 15.7 percent against the dollar, Taylor says. In trading Aug. 21, the euro stood at $1.4894, up 2 percent against the dollar this year.

Taylor says his models are telling him to continue to bet against the dollar. He predicts the dollar might lose about 40 percent of its value in the next three years against the Federal Reserve's trade-weighted currency index, which measures trade with 38 countries including Canada, China, Mexico and members of the European Union.

The prediction is partly based on his charts of the U.S. real estate cycle, which he says has a major impact on the dollar and will continue to point south for the next couple of years, dragging down the currency with it. He also says the price of a barrel of crude oil might reach $250 in 2011, further eroding the strength of the U.S. economy and the dollar.

Lever for Government

``When markets look ugly, currencies are the one lever that the government has that it can use to jerk its economy around without pissing off its own citizens,'' Taylor says. ``And the U.S. needs to do a lot of maneuvering.'' The government will try to keep the dollar weak, he says, to fuel growth in exports and deflate the value of its debt.

The dollar's fluctuations are especially welcome, Taylor says, because they create more opportunities for trades among the majors, a market that's been slowing in the past few years. Annual returns of Taylor's $4.1 billion Developed Markets Currency program, which was confined to the majors until June, averaged 5.1 percent annually since 2000 net of fees, down from an average of 14.8 percent a year in the 1990s. In July, Taylor added emerging market currencies like the Polish zloty and the Mexican peso to the mix.

Volatility Falls

Even including the turmoil in the past year, the average volatility among the major currencies has fallen 11 percent since the decade began compared with the prior eight years, according to JPMorgan.

That's partly because of the introduction of the euro in January 1999, which reduced the number of trades possible among the majors. Five of the Group of Ten countries -- Belgium, France, Germany, Italy and the Netherlands -- adopted the single currency.

Competition in the foreign exchange markets has also increased. The number of currency programs that are tracked in the Barclay Hedge index has tripled to 145 in the past decade. ``The competition is eroding profits,'' says Stephen Lewis, chief economist at brokerage Monument Securities Ltd. in London. He also says price swings have become more erratic. ``It has become easier to confuse noise with trends,'' he says.

At the same time, daily volume in international currency markets has tripled since 1992 to $3.2 trillion, according to the Bank for International Settlements in Basel, Switzerland.

That's about 11 times the value of the stocks changing hands in the world's equity markets and three times the trading volume of government bonds, according to the New York-based Securities Industry and Financial Markets Association.

George Soros

``It's a very, very liquid, very, very competitive market,'' says Kenneth Rogoff, a former chief economist at the International Monetary Fund in Washington and now professor of economics at Harvard University in Cambridge, Massachusetts.

``Taylor is up there with George Soros,'' says Maxime Tessier, head of foreign exchange at Caisse de Depot et Placement du Quebec, a pension fund that manages about $258 billion from Montreal and is not Taylor's client. ``He's a beautiful example of how someone can be a successful investor in the foreign exchange market.''

Taylor has made his mark without the benefit of a college degree in business or economics. A native of Locust Valley, on Long Island in New York, he attended the private Hill School in Pottstown, Pennsylvania, whose alumni include former Secretary of State James Baker III and Academy Award-winning film director Oliver Stone.

While Taylor graduated from high school at 16 with a perfect 800 score on the math section of the SAT college admissions test, he followed his father's advice not to rush into college. His father entered Massachusetts Institute of Technology at age 15, dropped out during World War II and then ran a small shipyard in Oyster Bay, Long Island, Taylor says.

Studied in Switzerland

The younger Taylor spent a year studying history and Italian at the American School in Switzerland in the village of Montagnola above Lake Lugano. In 1961, he returned to the U.S. and enrolled at Princeton University in Princeton, New Jersey. Between his junior and senior years, Taylor spent a year in Montagnola teaching modern European history at the American School.

He graduated from Princeton in 1966 with a bachelor's degree in romance languages and then began work on a Ph.D. in political science at the University of North Carolina in Chapel Hill.

Taylor's views of the currency markets are still influenced by his studies.

`Game of the World'

``One of the great things about foreign exchange, if you really try to understand what's going on, it's like the game of the world,'' Taylor says in his office, which is lined with books, including Bruce Chadwick's ``George Washington's War,'' a biography of Benjamin Franklin and treatises on the declining role of the U.S. in the world.

Taylor says he sees similarities between the current predicament of the U.S. economy and the French court in 1720, which was nearly bankrupted by John Law, a Scottish economist and notorious gambler who issued too much debt on its behalf.

``All through history, the world has borrowed and borrowed until it realized that it couldn't repay it,'' he says. ``There's nothing different from what we are doing now.''

Taylor got married in graduate school and abandoned his Ph.D. studies in 1969 to take a job at New York-based Chemical Bank, a predecessor to JPMorgan Chase, starting as a European political analyst. His knowledge of the region landed him a job in the foreign exchange department.

Learning About Currencies

He didn't know about currencies or economics when he started, but he was eager to learn, says Roderick Porter, who hired Taylor.

``John is an extremely intelligent, very intense guy,'' says Porter, 63, who served as president of FX Concepts from 1994 to '98. He now helps manage Southern National Bancorp of Virginia Inc. in Charlottesville.

Taylor started his career in currencies at a propitious time. The international foreign exchange market was just about to take off.

In 1971, when the Vietnam War was stretching U.S. finances, President Richard Nixon took the dollar off the gold standard. That led to the collapse of the Bretton Woods system of exchange rates that had tied currencies to the dollar and the price of gold since 1944. As currencies began to float freely against the dollar, demand for foreign exchange services from international companies exploded.

In 1973, Taylor joined First National Bank of Chicago, now part of JPMorgan Chase, then moved to Citibank, now part of Citigroup Inc., a year later. There he led the 100-person foreign exchange consulting group, helping companies protect overseas revenue from changes in exchange rates by creating so-called hedges.

Deutsche Mark Bet

He left in 1978 for GFTA Analytics, a Duesseldorf-based research company that used computer models of historic prices of currencies and commodities to forecast exchange rates. Taylor says he was impressed when the system predicted the dollar's 12 percent surge against the German mark that November.

A year later, Taylor struck out on his own. He hired Frank Mickey, now 56, a Princeton-educated programmer, to help him create a trading model. Taylor didn't know the first thing about computers, and Mickey, who was building satellite communication systems, had never worked with currencies.

Taylor did have experience with creative applications for software, though. While in graduate school, he had taken a University of Utah program designed to monitor patterns of heart rhythms and used it to analyze the ebb and flow of voter sentiment in Italy, he says.

Finding the 'Rhythms'

Applying the same software to the Canadian dollar and four European currencies including the deutsche mark, Taylor and Mickey were able to emulate the historical movements of the exchange rates.

``It was like a blind man feeling his way along the wall,'' Taylor says. ``But you can find the rhythms, the waves in a string of data.''

Taylor also drew on ideas from the 18th-century physicist Jean Fourier, who had invented the mathematics to describe the frequency of heat waves. Taylor used Fourier's formulas to calculate the distance between peaks and troughs of the currency prices, allowing him to forecast exchange rates. The first system they created ran on a computer in Mickey's garage in Bethesda, Maryland.

In 1980, Mickey left to become an independent software consultant and is now working for the National Institutes of Health in Bethesda.

In 1981, Taylor founded FX Concepts in New York to sell his currency forecasts to banks and pension funds. He rented a 300-square- foot (28-square-meter) office behind a marbled glass door in the old Standard Oil Building at 26 Broadway near Wall Street. A couple of desks, a refrigerator and a stool borrowed from Morgan Stanley packed the two small rooms.

Wooing Clark

In 1984, Taylor tried to woo Clark, then head of foreign exchange sales at what is today London-based HSBC Holdings Plc. Clark says he decided to accept an offer from Morgan Stanley instead. He met Taylor in the bar atop the World Trade Center to give him the news. After a couple of drinks, Taylor convinced Clark to join FX Concepts.

Clark, who's worked with Taylor for 24 years now, says he was impressed that Taylor seemed more interested in creating a group of equals at FX Concepts than in making money for himself.

``A lot of guys in our business are totally consumed with the next corporate jet or the next yacht, but that's not what John is about,'' says Clark, who's the second-biggest shareholder in FX Concepts today. ``He has developed an organization that will live beyond him.''

Later, Taylor lent Clark money to buy equity in the company, though Clark declines to say how much. Two-thirds of the company's 62 employees own a 54 percent stake, while Taylor's share has fallen to 31 percent. Taylor earned roughly $15 million last year.

Ship of Fools

When Taylor splurges, he takes five roommates from Princeton sailing on Chesapeake Bay in a chartered 50-foot (15-meter) sailboat they dub Ship of Fools, after a medieval story about a group of deranged passengers clueless of their own direction.

The group includes Charles Gibson, anchor of ABC's World News, and Karl D. Jackson, a professor of Southeast Asia studies at Johns Hopkins University in Washington.

Taylor's fund gained notoriety in 1985, when his models started to flash red on the dollar's five-year rally against the deutsche mark.

On Friday, Feb. 22, he recalls, he sent out a letter alerting his roughly 40 clients that the U.S. currency would peak the following week.

On Tuesday, the dollar started to fall. By April 19, it had dropped 14 percent against the mark.

Plaza Accord

The dollar's decline picked up steam after September 1985, when representatives from the U.S., U.K., Japan, Germany and France met at the Plaza Hotel overlooking New York's Central Park.

In what would be known as the Plaza Accord, they agreed to coordinated dollar selling to push the U.S. currency down. The dollar slid for the next three years, losing almost half of its value against the mark and the yen.

Taylor's correct prediction about the dollar helped attract more clients, so that by the start of 1987, he had 300 customers buying his research. The call also persuaded him that he could use his models to do more than hedge, he says.

He founded the Developed Markets Currency program in 1989 to invest in currency markets. His first big investor was Eastman Kodak Co.'s pension fund, which still has about $1 billion in his funds, he says.

Institutional investors now make up about 65 percent of FX Concepts' assets under management. Hedge funds account for about 25 percent. Taylor charges a management fee of about 1.5 percent and takes 20 percent of profits.

Hemophilia Research

While Taylor was seeking institutional investors, a blood test found that the baby his second wife, Joyce, was expecting would be born with hemophilia. Joyce's father had died from the genetic disorder, which prevents blood from clotting properly.

In 1990, Taylor founded the Coalition for Hemophilia B to provide information about the ailment and to pressure the U.S. Food and Drug Administration to allow new types of medicine into the market.

Frustrated with the lack of progress in Washington, Taylor also co-founded Inspiration Biopharmaceuticals Inc. in 2004 with Scott Martin, an oil executive and father of a hemophilia patient. The Laguna Niguel, California-based company has two drugs for hemophilia B in the pipeline and signed a $35 million agreement in January with Celtic Pharmaceuticals Holdings LP, a Hamilton, Bermuda-based private equity company, to market the drugs.

Taylor holds two patents for drug delivery methods in the company.

Taylor's son is now a 19-year-old sophomore at Princeton. Taylor also has a daughter from his first marriage, Louise, 30, who is a lobbyist in Washington.

Taylor's Best Year

Taylor's most successful year was 1992, when the maneuverings by George Soros rocked the markets by attacking the pound. The resulting turbulence played right into Taylor's models, pushing returns to 43 percent that year, he says.

In 1994, when coordinated central bank intervention almost cut currency fluctuations in half, the Developed Markets Currency program had its worst year ever, losing 19 percent. The program's annual returns averaged 14.5 percent until 1999, when the euro was introduced. Annual returns fell to 0.2 percent that year and in 2001.

Taylor responded to the declining returns by hiring more researchers, doubling the size of the company to 42 employees in 2000 from 20 in 1990. He also decided to change his strategy so that it didn't rely on trends alone.

The research department had been slow to adjust, arguing that returns would come back eventually, Clark says. At a meeting with researchers in December 2001, Taylor snapped. He banged his fist on the table, shouting that he wanted new models immediately, Clark remembers.

Brazilian Real

A couple of months later, researchers finished software to bet on the carry trade, so that FX Concepts could borrow low-interest- rate currencies such as the yen and use the money to buy high- interest-rate currencies like the Brazilian real.

The aim is to benefit from the difference in yields as well as potential currency gains. Taylor also began to trade options, which give the buyer the right to sell or buy a specific quantity of currency by a specific date at a specific price, taking advantage of inefficiencies in their pricing. The new strategies now account for up to 40 percent of trades on any given day, he says.

He also launched new funds in 2001 and '02, increasing his universe to more than 30 currencies -- including those in emerging markets like Brazil and Turkey that tend to fluctuate more than the majors -- and ventured into commodities, stocks and fixed-income securities.

The new funds are among his best performers. The $3.5 billion Multi-Strategy Program was up 10.7 percent in the first seven months and 13.1 percent annually since its inception in 2002.

`Shown in the Results'

The $3 billion Global Currency Program was up 11.3 percent through July and 15.3 percent annually since inception. The annual returns are ranked first and second since January 2002 among the programs holding more than $100 million, according to Barclay Hedge.

``The improvements they've made -- it has shown in the results,'' says Annette St. Urbain, chief executive officer of the $2.2 billion San Joaquin County Employees' Retirement Association in Stockton, California, which has invested $187.5 million with FX Concepts.

When it comes to trading the major currencies, making profits has been tougher. ``We're frustrated,'' says Ryan O'Grady, director of investment research and a 15-year veteran at FX Concepts. ``We're still struggling.'' If Taylor's bearish prediction about the dollar proves true, there may be enough turmoil to change that in the years ahead.

To contact the reporter on this story: Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net