FOREX TRADING

After a almost 20% arise versus the US. Dollar, the British Pound has been rangebound for almost the full month of June, with one columnist likening the situation to a “pause for breath.” For him, this amounts to a irregular cessation on the Pound’s inevitable upward path: “Compared to long term levels, the pound was still better value than its peers. He said: ‘It’s still cheap – about 10% below it’s trade-weighted average at present.’ ” For others analysts, nonetheless, the picture is not so cut-and-dried.

Forgetting about buying power parity for a minute, there are a lot of factors which could halt the Pound’s rise. Most importantly is the British economy, which is still struggling to find its feet. “The U.K. economy will recover ‘mildly’ next year, according to the OECD, compared with a previous projection of a 0.2 percent contraction. Gross domestic product will drop 4.3 percent this year, against a March forecast of 3.7 percent.”
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My own experience suggests that the majority of the traders usually trades on 2 or 3 preferred Forex pairs that usually include EUR/USD, GBP/USD and USD/JPY, while not many go into other major crosses with an extremely low number of traders touching something exotic like USD/BRL or NZD/CHF.

In Forex different currency pairs are interconnected and there is no real diversification possible contrary to the stock markets. Some professional traders always insist on concentrating only on one pair. But I like to find opportunities in all the pairs that are supported by my broker and have sane spreads. What currency pairs do you prefer to trade?

For those of you that make a living (i.e. trade forex) from interest rate differentials, consider that the US Treasury yield curve is now steeper than at any point in recent memory. Short-term rates are still close to zero, while long-term rates just passed 4% and are still rising. The theoretical implication is that one can borrow at a low short-term rate and reinvest at a higher long-term yield. The question is: would you want to?

The meeting this week of the Federal Reserve Bank yielded few surprises, as the Fed voted to hold its benchmark Federal Funds Rate at the current level of nil, and indicated that they would stay “unusually low” for the near-term. According to one analyst, “It was totally as expected. The market doesn’t seem to have reacted that much. Everybody pretty much knew that for sure they wouldn’t raise rates anytime soon and they wouldn’t do anything to withdraw liquidity.” (more…)

EUR/USD trend: sell.
GBP/USD trend: buy.
USD/JPY trend: sell.
EUR/JPY trend: sell.

Posted on Forex blog.

Back on March 12, the Swiss National Bank issued a stern promise that it would actively seek to hold down the value of the Swiss Franc (CHF) as a means of forestalling deflation. The currency immediately plummeted 5%, as traders made a quick determination that the SNB threats were made in earnest. Over the months that followed, however, investors became complacent and the Franc slowly crept back up.

That was until this week, when the SNB sprung into action, buying Euros on the open market. “The franc slid as much as 2.4 percent versus the euro and 3.3 percent against the dollar, the biggest declines since…March 12.” It’s not clear why the SNB suddenly intervened after months of inaction. The Central Bank didn’t hold a press conference to “celebrate” its intervention, and the only indication was a vague declaration last week that “policy makers will act to curb any ‘irrational appreciation’ of the franc.”

Analysts have speculated that the SNB is (arbitrarily) targeting the exchange rate of $1.50 Francs/Euro, which is plausible given that the intervention occurred very close to that level: “They’re trying to put a line in the sand at 1.50. There’s a big debate as to whether they will continue doing this, and for how long they will remain successful.” After all, the idea of intervention is more effective than intervention itself. The SNB can only buying so many Euros; the real value is in the threat to continue buying, which keeps investors from building up speculative positions.

While the SNB has been criticized as “protectionist” for its actions, its premise for intervention is well-grounded. According to the OECD, “Switzerland had better keep interest rates close to zero well into 2010 and mull more fiscal stimulus to fight a deep recession and the risk of deflation.” Modest deflation has already set in, facilitated by a collapse in aggregate demand. Varying forecasts are calling for an economic contraction in 2009 equal to -2.5%-3%, and even a modest contraction to follow in 2010. Q1 GDP growth was negative and the consensus is that Q2 will prove to have been more of the same. If this trend continues, 2009 will be the worst year economically in over 30 years. Still, economic indicators suggest the bottom is soon approaching, and the overall picture is consistent with the rest of Europe.

The real concern is that other Central Banks will imitate the Swiss approach. “In the past couple of weeks we have had five or six central banks, including the Bank of Canada and the Bank of England, talking down their currencies. Like Switzerland, they are fearful that currency appreciation could offset the stimulus to the economy,” noted one analyst. Monetary and economic conditions remain abysmal worldwide, and most banks have already exhausted the tools available to them. Interest rates are universally close to zero; fiscal “stimuli” will push the OECD debt/GDP ratio past 100% in 2009; quantitative easing has given rise to wholesale money printing. Currency devaluation may be the only option left.

Since peaking in the beginning of June, the MSCI emerging markets index has fallen nearly 10%. While this is small potatoes compared to the 60% rise that the index cranked out in the previous three months, it could signal the beginning of a “correction.”

Around the peak a couple weeks ago, the Forex Blog reported that emerging market stocks had become quite expensive, relative to historical P/E ratios. It’s hard to say whether investors were/are operating under similar assumptions when the market pulled back, or rather if they have been driven by other factors. This is because emerging market currencies, like many other asset classes, have experienced a disconnect from fundamentals of late, such that the ebb and flow of risk aversion – rather than any substantive developments – now dictates the movement of asset prices.

Analysts looking for clues into why specific currencies were rising against the Dollar ignored the fact that virtually all currencies were rising, albeit some more than others. In other words, it was a Dollar-negative story as much as it was an emerging markets story. Likewise, risky investments are losing value across the board now that risk aversion is back in fashion, not because of a perceived change in emerging markets growth potential.

Still, there is much to be nervous about. Latvia still hasn’t dealt with its currency, which some experts think needs to be devalued by as much as 50%. Turkey has yet to sign a loan agreement with the IMF. Russia’s benchmark stock index fell 20% in one day. One of the best proxies for risk levels are credit default swaps, which function like insurance on bonds. If a company/country were to default on its bonds, a holder of a credit default swap contract would be compensated by the writer of the contract. Suffice it to say that credit default swap premiums, especially on emerging market debt instruments, are once again rising, as investors become more worried about the possibility of default.

Generally, the Yen is viewed as one of the most viable currencies during periods of heightened risk aversion. So is the Dollar for that matter, but the Yen has less baggage, vis-a-vis quantitative easing, etc. Sure enough, the Yen has pulled back tightly of late, rising almost 3% in one day against the Euro alone. [In the current market environment, I think it makes more sense to compare the yen with the Euro, since the two currencies are viewed as fulfilling different purposes for currency traders. The US Dollar, in contrast, is currently being driven by some of the same themes as the Yen, which can make it difficult to use this pair to distill changes in risk appetite.]

In short, as the global economy reaches a critical phase in the recession, investors will be looking for confirmation, either that a recovery is nearby or still far away. Right now, the consensus seems to have swayed towards the “recovery is faraway” side. However, a sudden uptick in a widely-watched economic indicator could send the pendulum swinging right back in the opposite direction.

So with President Obama’s popularity waning, I thought I would take this opportunity to correlate the issues facing America right now and its affect on the all mighty Dollar.