forex trading: Forex Blog

Forex is a Global Game

One of the advantages of trading currencies (compared to other types of securities) is that forex markets operate continuously from 6PM (US Eastern time) Sunday to 4PM Friday. However, some traders may find this overwhelming. After all, if the markets never close, how should one decide when to trade? Let's begin with a quick overview. London dominates worldwide forex trading, with New York in second place, followed by Tokyo and Sydney. Investopedia points out that the best time(s) to trade are when these markets overlap, due to a surge in liquidity, and hence, volatility. The best such overlap is between London and New York, due to the popularity of the Euro/USD pair. During these times, the "Pip" spread can widen from 30 to 70. However, since Tokyo dominates trading in Asian currencies, its overlap with Sydney is also a prime time to trade. Forbes reports:

When more than one of the four markets are open simultaneously, there will be a heightened trading atmosphere, which means there will be greater fluctuation in currency pairs.

The Bailout Irony

As the US Congress puts the finishing touches on a $700 Billion plan intended to resuscitate the ailing financial sector, analysts remain hard at work assessing the potential implications. The consensus- unchanged from when the plan was first unveiled- is strongly negative, especially as far as the Dollar is concerned. When combined with the government's other initiatives, the bailout will add nearly $1 Trillion to America's national debt. Additionally, the Federal Reserve Bank would have to print money to bridge a shortfall in the government's borrowings, thereby stoking the fires of inflation. Ironically, the Dollar's best chance to avoid a continued decline is if the bailout plan fails in its stated aim, and the American economy implodes, pulling the global economy down with it. The Wall Street Journal reports:

Investors have already begun to cut their exposure to emerging-market and other higher-yielding currencies, and this trend could continue even if the dollar is no longer the bedrock of safety it once was.

Monetary Policy: US versus EU

US political and economic officials are now operating in panic mode, as the credit crisis enters a new stage of direness. Politicians are hard at work trying to hammer out a bill that would funnel as much as $700 Billion into mortgage securities in a last-ditch effort to raise investor confidence. Ben Bernanke, Chairman of the Fed, has warned that failure to pass the bill could send the US economy into a prolonged recession and asset prices into a deflationary tailspin. Accordingly, the Fed may continue to act unilaterally if the US government can't be persuaded to come on board.

Contrast this frenzy with the relative air of calm across the Atlantic: although the European Central Bank has toned down its hawkish rhetoric, its focus remains on inflation, instead than the state of the economy. Accordingly, a change in the current monetary environment (whether rate hikes or rate cuts) still seems somewhat unlikely. However, a moderation in inflation combined with an economic contraction could force them to re-think their strategy, especially if EU member states step up their rhetorical attacks. In short, as the Fed ponders yet another interest rate cut, it looks like the EU-US interest rate gap could conceivably widen before it narrows, reports the The Wall Street Journal:

Interest-rate futures suggest investors believe the Fed is likely to cut its key rate soon, perhaps even before its next meeting on Oct. 28 and 29.

Korean Won Continues to Slide

This week, the Korean Won continued its downward slide, as a new round of volatility in global capital markets crimped a slight rally that had begun to build in the previous week. The currency has already fallen nearly 20% in 2008, as skittish investors have fled emerging markets en masse as the credit crisis has flared with renewed vigor. Last week, the government intimated with only a modicum of vagueness that it is prepared to use its $250 Billion in reserve to defend the Won, in order to forestall the kind of currency crisis that crippled its economy in 1997-1998. Bloomber News reports:

Finance Minister Kang said policy makers will manage monetary and fiscal policy in a "stable'' manner to strike a balance between curbing inflation and supporting the economy, which grew 4.8 percent last quarter, the slowest in more than a year.

How will Bailout Impact Inflation?

In day 2 of our bailout coverage, let's look at the potential impact on inflation. On one hand, the government is proposing spending $700 Billion to buy faltering mortgages. Combined with the funds that have already been spent to deal with the credit crisis, this brings the total expenditure $1 Trillion, which amounts to more than 10% of the current liquid money supply. On the other hand, global food and commodity prices have eased over the last few months, causing a similar abatement in record rates of inflation. As a result of the economic recession and consequent depressed demand, prices don't appear likely to return to the stratospheric levels of early 2008. In the end, the risk of inflation is probably most closely connected to the willingness of foreign institutional investors and Central Banks to continue financing American borrowing. If they hesitate, this would send the government running to the Federal Reserve Bank, which would be forced to print money, thereby stoking inflation. The Wall Street Journal reports:

If the Fed has to print money to pay this debt, "the more dollars put into the system, the more you dilute the value of the dollars out there," said Chuck Butler, at EverBank World Markets.

Bailout Plan Seen as Dollar-Negative

Congress remains deadlocked over the proposed $700 Billion plan to bail-out the American mortgage industry and alleviate the financial crisis, but that hasn't stopped forex traders from weighing the implications. Suffice it to say that the Dollar fell 2.5% against the Euro-its worst-ever single session performance- in the first day of trading since a loose outline of the proposal was made available to the public. The consensus, thus, is that the plan is unambiguously bad for the Dollar. Investors expect the US national debt will balloon, and it isn't clear whether foreign institutions and Central Banks are willing to play along, as they have in the past. In fact, treasury bond prices mirrored the performance of the Dollar, recording the sharpest fall in nearly two decades. Ironically, the potentiality that is more disconcerting for Dollar bulls is that the proposal won't be passed at all, and the global financial system will collapse as a result. Damned if you do, damned if you don't. Marketwatch reports:

"Investors [will] favor currencies where the central banks retain an anti-inflationary stance and where there is a well-developed government bond market where they can leave their capital. The euro would seem the most likely home for such investment flows."

Unpacking the Credit Crisis

In case you were asleep, US and global capital markets last week experienced unprecedented turmoil, followed by an unprecedented rebound. US stock market indices, for example, declined nearly 10% over the course of two days as it was revealed that three financial institutions (AIG, Merril Lynch, Lehman Brothers) were in deep trouble. Granted, the three scenarios managed to resolve themselves (government purchase, shotgun merger, bankruptcy), but the unthinkable had transpired. The following day, the markets promptly recouped their losses, as the earliest details of a sprawling US government bailout were announced. However, investors remain wary as they attempt to sort out the details. According to one piece of analysis, the forex implications are as follows:

First, the carry trade has officially fallen out of favor. Look for funding currencies (Japanese yen, Swiss Franc) to benefit and recipient currencies (Australia, New Zealand, etc.) to continue suffering. Next, while the US remains a safe haven because of perceived stability/liquidity, the monetary situation could still ignite a sharp decline in the Dollar, as the Federal Reserve performs an about-face and cuts interest rates in order to avert a complete financial meltdown. Instead, economies that have performed relatively better (less poor, to be more accurate) than the US, will probably witness a rise in their currencies. Think Canada and perhaps, the EU.

ESF Used to Prop Up Dollar...Kind of

The Treasury Department has officially dipped into the Exchange Stabilization Fund (ESF), the obscure and rarely utilized pool of foreign exchange whose ostensible purpose is to stabilize forex markets in times of uncertainty. The Treasury surely skirted this mandate by using a portion of the reserves to provide insurance to money market funds, which are facing a sudden collapse of confidence in the latest chapter of the credit crisis. Although, the move was not without precedent, since the ESF was used as a source of capital for a loan to Mexico as recently as 1995. Ironically, the Treasury's actions this time around will surely provide a boost to capital markets, thereby reinforcing the notion that the US remains the safest place to invest in crisis situations, which in turn, supports the Dollar. The Wall Street Journal reports:

The Fund, which now amounts to $50 billion, was created in 1934 to conduct interventions in foreign exchange markets. The enabling statute gives the president and Treasury secretary enormous latitude to act without prior consent of Congress.

Forex Reserves Used to Prop Up Currencies

Over the last decade, the Central Banks of most emerging-market economies built up fantastic quantities of foreign exchange reserves, as a result of lopsided trade and current surpluses with foreign countries eager to invest abroad. However, declining commodity prices, sagging stock markets, and a global trend towards risk aversion have propelled investors to shift massive amounts of capital back into the industrialized world. As a result, these same Central Banks are drawing down on their reserves at a similarly rapid pace, in an attempt to shore up their ailing currencies. A cheap currency can be advantageous, especially during an economic downturn, since it makes exports relatively more competitive. On the flip side, a currency that loses too much value can trigger a crisis of confidence among investors, which affected many of these countries as recently as 1997-1998. The Wall Street Journal reports:

A rapidly weakening currency is worrisome for central banks concerned about inflation, since imported goods become more expensive, driving up overall prices.

Bank of Australia Lowers Rates

It would seem as if the world is conspiring against the Australian Dollar. In the last couple months, the currency has plummeted nearly 20% from the 25-year high it had reached against the US Dollar. A combination of global economic weakness, falling commodity prices, and a trend towards risk aversion have turned the tables in favor of currencies perceived as more stable in times of crisis. To add insult to injury, the Central Bank of Australia decided to cut its benchmark lending rate, narrowing the interest rate differential that had been partially responsible for the Australian Dollar's multi-year appreciation. Bloomberg News reports: