The Wall Street Journal’s coverage of the Greek dent crisis has focused less on the crisis itself, and more on the markets’ reaction to it. With headlines like “Hedge Funds Try ‘Career Trade’ Against Euro” and “Speculators Bet Record Amount Against Euro For 4th Week” and “Europe Trouble, U.S. Opportunity” – among others – the WSJ has identified a collapse in the Euro (mainly against the Dollar) as one of the most prominent (and profitable!) strategies for exploiting the crisis.

As I mentioned in the last post (”Understanding the Greece Situation“), the debt crisis has become self-fulfilling, not only for Greece, but also for the Euro. In other words, as perceptions abound that Greece is insolvent and the Euro is doomed, Greek bonds and the Euro have lost value, which only makes the crisis worse. It seems that speculators are taking advantage of this phenomenon by making large bets against the Euro. In fact, large is an understatement, as the net short positions against the Euro now total a record $12 Billion, according to the closely watched Commitment of Traders report.

Some analysts have taken such information at face value, noting that “The fact that the shorts got even shorter when they were already at extreme levels highlights just how negative the sentiment is toward euro.” On the other hand, there is evidence (and some degree of admission) that large speculators are now acting in concert to bring down the value of the Euro. The WSJ reports mention private meeting between hedge funds managers and investment banks helping their clients bet against the Euro using derivatives. For those that are skeptical that speculators could really influence currency markets, consider that one man – George Soros – single-handedly forced a devaluation of the Pound in 1992, and made $1 Billion in the process. While the Euro is certainly bigger than the Pound ever was, there are more people watching it than ever, and when there is money to be made -  hundreds of billions of dollars in this case – it isn’t inconceivable that the Euro could suffer a similar fate.

Already, there is evidence that this strategy is working, as the Euro has fallen 10% in less than three months, which is unbelievable for a currency whose daily trading volume is estimated at $1.2 Trillion. In fact, one popular options trade is based on the the Euro falling to parity against the Dollar. Once unthinkable, such a possibility now faces odds of “only” 1 in 14 (based on options premiums), compared to 1 in 33 in November. On the one hand, it’s frustrating to accept the market power that these speculators have. But emotion has no place in (forex) trading, and standing in the way of momentum would be costly.

On the other hand, Euro fundamentals remain strong. To be sure, a currency is only as strong as its constituent parts, and the fact that a handful of EU member states have shaky finances certainly cannot be dismissed. At the same time, the fact that such currencies have no direct control over the Euro is just as important. Before the inception of the Euro, currency traders would be justifiably concerned that a country in a similar position to Greece would deliberately devalue its currency (by printing money) in order to devalue its debt and make it more manageable.

Now, this would be impossible, since the Euro is controlled by the European Central Bank, over which Greece has no power. The current crisis in Greece notwithstanding, “The European Central Bank’s (ECB) resolve to maintain sound money is…important. This is especially true for the ECB, which has a single mandate—price stability—unrelated to fiscal problems.” While there is legitimate concern that the ECB will be forced (or voluntarily) print more money to fund bailouts of bankrupt EU member states, this doesn’t seem very likely, given the history of the ECB. Its monetary policy has always been quite conservative, and it’s no wonder that the Euro has come to be seen as a viable alternative to the Dollar.

In my opinion, the decline in the Euro is mostly baseless, and if it were to continue, it wouldn’t represent the prevailing of logic. Then again, logic is not exactly a word that I would apply to the forex markets, now or ever.

Kudos to anyone who correctly identifies that reference. But seriously, in light of the proposed changes in forex regulation that have generated a heated response on this blog and elsewhere, I want to offer some insight into a tangential issue: jurisdiction.

Part of the problem with existing forex regulation is not that it’s insufficiently strict, but rather that it’s essentially optional. That’s because retail forex brokerages do not technically need to be registered in order to operate. Moreover, if they do register, they can choose between several organizations, depending on whose regulations most jive with their business models.

The Commodity Futures Trading Commission (CFTC) is probably the most prominent regulatory organization in retail forex, and of which most retail brokers are registered. [It is also the organization that has proposed the rule changes that everyone in forex is currently talking about]. It was only in 2008 that the CFTC was vested with the power to regulate retail forex, but contrary to popular, only its members (rather than all forex brokers) are subject to the sword of its regulation.

The Financial Industry Regulatory Authority (FINRA), the self-regulatory body for securities brokers,meanwhile, is trying to reach its regulatory powers into the arena of retail forex. In coordination with the SEC, it has proposed enhanced regulation for its own member brokers. Under this proposal, the handful of retail forex brokers that are registered with the SEC would be subject to stricter regulation than their counterparts under the control of the CFTC. Brokers registered only with the CFTC, then, would probably enjoy a competitive advantage (specifically the right to offer 10:1 leverage, instead of 4:1, as proposed by the SEC).

Then, there is the National Futures Association (NFA), which operates in association with the CFTC. Not to mention the exchanges, themselves, which impose their own set of rules on brokers. Make no mistake; all of these organizations are fairly vigilant in pursuing violations and in revoking membership for those brokers that really run afoul. The problem is that such does not nothing to stop a broker from simply registering with another regulatory agency instead, and/or not taking advantage of client apathy/laziness by either not registering at all, or even worse, lying about the registration.

In the end, most forex traders probably don’t care which regulatory organization ultimately wins the turf battle over the right to regulate retail forex. Ideally, though only one such organization would have such power, and all brokers would be subject. Given that this issue isn’t likely to be resolved anytime soon, for now, you would be wise to choose a broker that is registered with the CFTC. You can confirm a broker’s membership here.

I try not to editorialize much when writing this blog. There are too many talking heads as it is, which is why I try not to interject own opinions into the facts. Admittedly, the notion of facts in forex is obviously a bit murky, but I stand by my approach, nonetheless. Today, I would like your permission to stray from the facts (well, not entirely) and offer my opinion on the recently proposed regulatory overhaul for trading forex.

For those of you who haven’t been following this story, let me give you an overview. On January, the U.S. Commodities Futures Trading Commission (CFTC) proposed a set of sweeping changes to the rules that currently govern forex trading in the US. Among the changes are beefed-up requirements for forex dealers which would be legally required to register with the CFTC as “retail foreign exchange dealers”, and satisfy certain capital adequacy requirements, aimed at mitigating counter-party risk (i.e. dealer bankruptcy.) In addition, “introducing brokers,” (i.e. those that act as intermediaries between customers and dealers) would be required to sign exclusivity agreements with dealers, who would in turn be required to vouch for their brokers. Last, but not least, would be a bombshell change that would shrink leverage (i.e. raise margin requirements) to a maximum of 10:1.

We have are now partially through a 60-day “comment period,” during which the CFTC is soliciting feedback from stakeholders to determine if and in what form it should ratify these changes. And feedback is indeed reverberating around the blogosphere (more so than traditional media, based on my observation). Most industry insiders are predictably opposed to the regulation, on the grounds that it will make them less competitive with their (lightly regulated) foreign counterparts. Based on an online poll, it seems the majority of forex traders are as well. On forums, many have promised to shift their accounts overseas (or are gloating about already having done so) as soon as the measures pass. Meanwhile, the blogger to come out most prominently in favor of the regulation, is none other than Karl Denninger, who champions the the potential increase in transparency in decrease as leverage, but notes that it will probably bring about the “Death of Retail Forex.”

Personally, I am inclined to agree with Denninger (though not his flawed math, nor his erroneous tirade against rollover fees), on the grounds that transparency – especially with regard to commissions, which are dissimulated and ultimately buried in spreads – can only benefit customers. In addition, requiring all brokers and dealers to register, while strengthening the CFTC’s jurisdiction over forex will surely go a long way towards minimizing fraud, which remains rampant and in disguise, even among major brokers. Interestingly, industry lobbyists have come out in tepid support of this measure, but only because it will also raise the barriers of the entry.

As for the clause that aims to limit margin – and is really the only one that anyone is seriously protesting – this is also a step in the right direction. While libertarians and the 1% of traders that have turned a profit employing 100:1 leverage (the current U.S industry standard) will surely disagree, I think that sometimes, people need to be protected from themselves. I don’t want to frame this debate in political terms, however, since at the end of the day, such high leverage is both de-stabilizing to the market, and unnecessary. It’s destabilizing, because of the massive speculation it invites, and its resulting contribution to volatility and systemic risk, and unnecessary because it’s impossible to produce a viable trading strategy that’s built on borrowing 100 times as much money as you are able to commit. For the sake of comparison, consider that the average hedge fund, its reputation for excessive risk-taking not withstanding, will rarely employ leverage greater than 2:1. How about another comparison: Has 100:1 leverage (i.e. 1% down-payment) been good for the housing market, from both the standpoint of individual and society?

As for the argument that retail traders will instead send their money off-shore to gamble (cough, I mean trade), well I suppose that’s possible. But given that a related piece of  recent regulation has been very successful at preventing Americans from patronizing offshore casinos, I’m sure the government can ensure a high rate of adherence with this piece as well. But obviously, this too, is a highly charged political issue, and it’s probably not practical to examine forex from this angle.

In the end, I think the government has (rightly) identified retail forex as the casino it is, and is finally taking steps to make it legitimate. For regular readers of the Forex Blog and those that follow its implicit approach (i.e. not churning your portfolio on a daily, or even weekly basis), I am confident that this regulation, if approved, will NOT adversely affect you. As for everyone else, maybe it’s time to either re-think your strategy, or ask yourself whether trading forex is still right for you.

After the impressive rally in the US Dollar at the end of 2009, many market observers predicted that the end was near for the Dollar carry trade. That’s because volatility is the sworn enemy of carry traders; whenever there transpires a sudden change in direction in a funding currency, investors will usually race for the exits, regardless of whether the change was justified by fundamentals.

Alas, 2010 has seen a stabilization – even a modest appreciation – in the Dollar, which means the carry trade is here to stay. For now at least. This is based on two abiding notions. The first is that US short-term interest rates – and, hence, borrowing costs for carry traders – will remain low for the foreseeable future. The second belief is that the most attractive investment opportunities can still be found outside the US, namely in emerging markets. Let’s explore both of these ideas in greater details.

The minutes from its last monetary policy meeting suggest that the Fed is in no hurry to raise rates. On the contrary, it may ease monetary policy even further. According to St. Louis Federal Reserve President James Bullard, U.S. interest rates may remain low for “quite some time.” Added another analyst, “The U.S. economy is chugging along, albeit at a slow pace, and that means the Federal Reserve has no real urgency to raise interest rates.”

In short, investors are rapidly scaling back their expectations for interest rate hikes; futures prices now reflect a mere 20% of a hike by the Fed’s June meeting. If Bullard’s comments carry any weight, investors might turn their attention to the other tools in the Fed’s arsenal- namely quantitative easing. A rise in inflation, portended by many economists, could spur the Fed to draw money out of the markets by selling some of its $1 Trillion in credit securities.  Regardless of what it decides on this front (expand, hold steady, rein in), however, the long and short of it as that interest rates aren’t going anywhere anytime soon. And that means funds will remain cheap and available for carry trading.

On the other side of the equation is an enduring optimism in emerging markets. The last decade has been very kind to investors that bought emerging market stocks, returning a “modest” 100% in some cases and an incredible 1000% in others. The S&P, in contrast, declined slightly over the same period. In some ways, 2009 was a microcosm for this trend, as the MSCI emerging markets index gained 73%, compared to 25% in the S&P. While investors are cautious about bubbles forming in some of these markets (bubbles seem to form and burst with alarming regularity), they continue to pour money in. $75 Billion was added to emerging market equity funds in 2009, to be precise. They are buoyed by predictions that emerging markets will account for the lion’s share of global GDP growth going forward.

This has facilitated a twist on the carry trade, whereby investors are now commonly using Dollar-funded loans to buy stocks, rather than sit back and earn a modest return investing in comparatively low-risk interest-bearing securities. This “traditional” carry trade is perhaps less popular now because interest rates are at all-time lows in many countries. But this is already starting to change as a healthy recovery in emerging markets has paved the way for rate hikes. While this could put a damper on stocks, it would re-open the bread and butter for carry traders, which is to sit back and earn a simple interest rate spread. Moreover, these carry traders can rest assured that if/when the Fed eventually raises rates, Central Banks in Asia and Latin America will almost certainly be in the same position.

The main threat at this point is uncertainty. “Investors plying the carry trade should tread cautiously — economic data will continue to be volatile, as befits a recovery that will proceed in fits and starts,” summarizes one columnist. In short, while fundamentals continue to support a carry trade strategy, it could be undone (rapidly) by an uptick in volatility.

As I outlined in my last two posts, the Dollar could witness a rapid appreciation if/when the Fed finally raises interest rates. Given Chairman Bernanke’s frequent erring on the side of inflation, however, it could be months (at the earliest) before the Fed actually pulls the trigger. With forex markets guided by interest rate differentials, and traders’ uncertainty about the timing of interest rate hikes, its fair to say that the Dollar is at a crossroads.

Currently, the case for an interest rate hike (as the Fed confirmed this week) remains weak: “They will need to see a lot more, better numbers consistently, not just for one or two months, before they would start to genuinely be talking more hawkish…I think the markets may be disappointed if they’re looking for hints of hikes coming soon,” said one strategist. While the data continues to improve – witness last week’s miracle jobs report – it has not yet been demonstrated convincingly and unequivocally that the economy has exited the recession. There are too many contingent possibilities that could send the economy into relapse for the Fed to even consider acting. As I said in my last post, I don’t personally expect a rate hike until next summer.

Still, the markets are alert to the possibility. And where perception is reality, any sniff of rate hikes is enough to send the Dollar soaring; it has risen an impressive 5% against the Euro over the last couple weeks. That investors are acting so early to protect themselves against a possible rate hike shows the precariousness of the foundation on which the Dollar’s rise has been predicated.

What I’m talking about here is the Dollar carry trade, in which investors borrowed in Dollars at record low rates, and invested the proceeds in riskier currencies and assets. It wasn’t so much the interest rate differentials they were chasing (only a few percentage points in most cases, hardly enough to compensate for the risk), but rather outsized returns from currency and asset price appreciation. In other words, while the S&P has risen by an impressive 50% from trough to peak (providing a handsome return to any investor smart enough to have foreseen it), stock markets outside of the the US have performed just as well. Factor in currency appreciation, and in some cases you are talking about gains of around 100%.

But we all know that volatility is the enemy of the carry trade, and volatility is slowly creeping up. First, there was the Dubai debt crisis, then came the downgrading of Greece’s sovereign debt. With talk of interest rate hikes, it’s no wonder that investors are becoming jittery. Bloomberg News reports that, “The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008….[and] JPMorgan Chase & Co.’s G7 Volatility Index rose to 14.43 last month from the low this year of 12.32 in September.”

The consensus remains that neither the Dubai nor Greece episodes signals broad systemic risk, and that the Fed probably won’t hike rates for a while. Still, investors must brace themselves for the possibility of surprise on one of these fronts, or from a completely unsuspected “bolt from the blue” as one analyst put it, because of what happened to the Dollar after Lehman’s collapse in 2008. As evidenced by the Dollar’s sudden turnaround in the last couple weeks, this kind of uncertainty is self-begetting. As some investors get nervous and begin to unwind their carry trade positions, other investors also begin to move towards the exists, lest they get stuck short the Dollar after the music stops (or when it starts, depending on how you look at it.)

In that sense, the best paradigm for analyzing the Dollar is the end of the carry trade on one hand, weighed against the possibility of interest rate hikes on the other hand. “The dollar will depreciate to $1.55 against the euro by March from $1.49 last week, and to $1.62 by June, according to JPMorgan,” which is betting heavily that investors will remain clear-headed about interest rate differentials. Those that are looking at the Dollar from a risk-aversion/carry trade standpoint have slightly different projections: “I wouldn’t surprised if the euro makes it to $1.40 before the end of the month without much trouble, maybe a little bit lower.”

In short, in forex, it’s never enough to be able to predict the economic future. Instead, you must be able to predict how these predictions will be syncretized into currency valuations by the markets. In this case, that means you need not necessarily be able to accurately predict when the Fed will hike rates; rather you need only be concerned with how other investors view that possibility, and whether that makes them feel more or less confident about holding certain currencies.

Yesterday, emerging markets (proxied by the MSCI Emerging Markets Index) recorded their biggest fall since July, ending a week of solid gains. Still, this one-day slide of 1.4% pales in comparison to the nearly 100% gain that the index has achieved since bottoming last March. In other words, while investors might be starting to pull back, the direction of asset prices is still upward.

As for what’s causing this across-the-board appreciation, that was the subject of my previous post (Inverse Correlation between Dollar and Everything Else…Still), in which I merely stated the obvious; that the Fed’s year-long program of negative real interest rates and quantitative easing (i.e. wholesale money printing) has unleashed a flood of cash into global capital markets. Since we’re not just talking about the Dollar, here, it makes sense to point out that the Fed’s easy money policies have been copied by Central Banks in most other industrialized countries, including the UK, Canada, Switzerland, Sweden, and to a lesser extent, the EU.

As for why emerging market assets and currencies seem to be outpacing appreciation in other asset classes, that’s also not difficult to explain. First of all, by some measures, emerging market stocks have hardly outperformed other assets. Oil, for example, has risen by 131% in less than a year, to say nothing of other commodities. Still, by other measures, growth has been remarkable. Most emerging market stock indexes and currencies have fully erased (or come close to erasing) the losses recorded during the peak of the credit crisis. Bonds, meanwhile, have gone one step further. Yields are collapsing, and prices have exploded – by 25% in the last year, sending the JP Morgan Emerging Market Bond Index to a new record.

Is it safe to call this a bubble? Intuition would suggest so; given that all assets are rising across the board, without regard to particular fundamentals, it would seem that only a herd/bubble mentality could offer an explanation. Some analysts, in fact, have given up completely on fundamental analysis, instead using fund inflows (i.e. investor demand) to predict whether some emerging market assets will continue rising. As Nouriel Roubini (the NYU economist that famously predicted the credit crisis) summarizes: “Traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade.” P/E ratios are nearly twice as high in some emerging markets, compared to stocks in the S&P 500.

On the other side of the equation are the bulls and the efficient market theorists.”By historical price-to-earnings ratios — the ratio of stock prices to per-share profits — these levels can be justified, if the economic recovery continues. With massive layoffs, business costs have been cut sharply. “The hope is that when consumers and companies start spending, the added sales will drop quickly to the bottom line [profits].” Other proponents argue that the rise in asset prices is exactly what the Fed wants, since it implies that the markets are once again characterized by stability and liquidity.

Regardless of whether growth materializes, however, that doesn’t change the fact that the free ride can’t and won’t last forever. At some point, Central Banks will be forced to raise interest rates and start withdrawing Trillions of Dollars from global capital market. This will cause the Dollar to rise, and investors to rapidly unwind their carry trade positions. Warns Roubini, “A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.”

If the tech-bubble and real-estate bubble taught us anything, it is that there is no free lunch in the markets. It is not possible for all investors in all assets classes to simultaneously win. At least, in the long-term. In the short-term, meanwhile – it pains me to say this – let the party continue. My only warning is this: when the music stops, don’t be the one caught with your pants down…

I deliberately concluded my last post (US Dollar: Same Old Story) on a somewhat ambiguous note; even though though the deck is stacked against the Dollar, its 14% decline in 2009 has left it perilously close to record lows, and traders are nervous about pushing the limits further.

On the one hand, everyone believes that the Dollar is fundamentally still in a weak position. The US balance of trade remains deep in deficit. Government spending has exploded, with record-setting deficits and an expansion in the national debt. Interest rates are at rock bottom, and are by some measures, the lowest in the world. Despite signs of life, the economy remains mired in recession. The money supply has also expanding, to the extent that some long-term investors are wondering out loud about the possibility of future inflation.

As a result, the decline in the Dollar since last spring has suffered very few blips, with volatility declining at the same pace as the currency, itself. “There seems to be a paradigm shift underway where more and more foreign investors are becoming concerned that the long-term path of the dollar is downward,” summarized one analyst. The consensus among investors is almost eerie. “Speculators betting that the dollar index will fall outnumber those betting that it will rise by nearly 2 to 1, according to the Commodity Futures Trading Commission.”

Some (mainstream) analysts have even begun to open consider the possibility of a crash in the Dollar, a view that had previously been relegated to conspiracy theorists and doomsday scenarists. “In a run on the dollar, that thinking would create a cascade — fearful global investors would shy away from dollars, expecting further steep declines, creating a self-fulfilling prophesy.” Adds a former Chief Economist of the IMF, “Every time the dollar starts depreciating there is angst and everybody starts raising the question what happens if there is a collapse.” While the majority of Dollar-watchers still believe that a Dollar crash is unlikely, the point is that they are now discussing it actively.

Despite the fact that all of these factors are already in place, the Dollar remains relatively buoyant. Personally, I think this is because investors don’t really want to acknowledge that this is a real possibility. For one thing, the alternatives aren’t any better. While forex investors in recent years have enjoyed ganging up on the Dollar, the fact remains the fundamentals for the other major currencies remain just as weak. For example, a model of purchasing power parity developed by “the Organization for Economic Cooperation and Development finds the dollar is worth roughly 0.85 euro, compared with its market valuation of 0.67 euro, suggesting that the euro is 21% overvalued.” Likewise, the Yen is held to be 22% undervalued.

As a result, the market as a whole is having trouble pushing the boundaries. The Dollar has approached the psychologically important level of $1.50/Euro on several occasions, but has retreated each time. “People are wondering whether we’re going back to $1.46 in euro/dollar or heading toward $1.54. But one thing is for sure, as we head toward $1.50, we’re going to experience a lot of volatility,” summarized one analyst.

“Risk reversals, a measure of currency sentiment in the options market derived by looking at the difference in implied volatility between out of the money calls and out of the money puts, show a bias for euro puts, trading at a mid-market level of 0.2. That means investors are hedging their short dollar positions with bets for a euro downside even though no one expects the euro to fall.” Meanwhile, volatility has edged up slightly, reflecting an increased level of uncertainty surround the near-term direction of the Dollar. It could be the case that if the Euro breaks through $1.50, heartened investors will send the currency up even higher, while a failure to break through means investors just aren’t read to commit. A classic technical crossroads!

The performance of virtually every currency against the Dollar (with the lone, major exception being the British Pound) in the last quarter has been downright impressive. Put another way, the performance of the Dollar has been downright pathetic.

The Dollar’s under-performance is no mystery. While some critics have pointed to long-term weaknesses such as the trade and budget deficits, most of the current impetus continues to come from low US interest rates. As I have reported recently, US short-term rates (based on the 3-month LIBOR rate for Dollars) is already the lowest in the world, and is still moving lower.

As a result, investors have been able to comfortably borrow in Dollars, and invest the proceeds in (comparatively) risky assets, predominantly outside the US. “Low rates have weighed on the dollar as equities have rallied over the summer, leading risk-based traders to buy the higher-yielding euro and commodity-based currencies, such as the Australian dollar, over the safe-haven greenback,” summarized the WSJ.

For most of the last 20 years, such a carry trade strategy would have been most profitable if funded using Yen or Swiss Francs. Since the stock market rally in May, however, buying a basket of emerging market currencies using the Dollar as a funding currency would yield the highest returns, as much as 10% higher than if the same trade had been funded using Yen. Moreover, the Sharpe-ration for such a trade (which seeks to measure the invariability of returns) is the highest when shorting the Dollar, implying that not only is this strategy lucrative, but also comparatively stable.

For a few reasons, however, analysts are beginning to wonder whether the Dollar carry trade has (temporarily) run its course. Technical indicators, for example, suggest that the Dollar may have appreciated too far, too fast. “The U.S. currency rose…after the 14-day relative strength index on the euro- dollar exchange rate climbed yesterday to 74, the highest level since March. A reading of 70 may indicate a rally is approaching an extreme and a reversal is imminent.” Stochastic indicators yield similar interpretations. “Traders have placed an unusually high volume of bearish bets against the U.S. dollar in recent weeks and may want to lock in profits by reversing those trades.” Besides, anecdotal evidence implies that anti-Dollar sentiment may be reaching irrational levels, as every other investors now seems to be betting against the Dollar.

From a rates perspective, the Dollar carry trade may soon become less viable. The markets (as reflected in futures prices) largely expect the Fed to be the first major Central Bank to hike rates, perhaps as soon as 2010 Q2. The ECB, by comparison, is not expected to hike until at least two quarters later, while the Bank of Japan is nowhere even near close to tightening monetary policy. The Fed is also beginning to contemplate possible exit strategies for its quantitative easing programs, which suggests that it is becoming concerned about inflation. One analyst connects this to a decline in the carry trade: “There might be a little bit of nervousness going into the FOMC if they start signaling any potential unwind of quantitative easing. There is a bit of risk over the next couple of days of the dollar starting to recover a little bit of ground.”

Finally, there are concerns that another crisis could trigger a pickup in risk aversion, in which case investors would likely return to the Dollar en masse. Recall that in 2007, when the Japanese Yen carry trade was in vogue, the main concern was volatility. Traders weren’t ever afraid that the BOJ would hike rates. Rather, they feared that some kind of event would inject uncertainty into the markets, making their returns (via the Yen) erratic. If investors suddenly got nervous about the ongoing stock markets rally, then the Dollar could conceivably become more volatile, which would make carry traders think twice.

At the same time, emerging market currencies will continue to offer much higher interest rates than the Dollar. While the Dollar, then, could conceivably become more attractive relative to the Yen, for example, it will remain extremely unattractive compared to high-yielding currencies. The yield differentials are currently so enormous that even if the Fed raised rates tomorrow, it would still be immensely profitable to short the Dollar relative to the Brazilian Real or South African Rand. While the Dollar slump may be reaching an endpoint, a Dollar rally will not necessarily follow. Brace yourself for sideways trading.

I concluded a recent post with a reference to the X-factor in forex markets: the US National Debt. In fact, the surging debt is only one of several factors that is exerting downward pressure on the Dollar, though it is perhaps the one that receives the most attention, and it probably represents the most pernicious threat to the Dollar’s long-term viability as the world’s reserve currency.

It’s difficult to say for sure how large the federal government debt currently is, and even more difficult to forecast. We can begin by looking at gross debt (Treasury securities) outstanding, which is around $11.4 Trillion. Since half of this represents intra-governmental debt, debt owed to external parties is probably about $6 Trillion. Going forward, meanwhile, the latest government projections indicate a $9 trillion increase over the next decade, touching a whopping $20 Trillion in 2020. In absolute terms, it would smash all previous records, while in real terms (as a percentage of GDP), it would be the largest increase since World War II.

Over the long-long-term, the growth in national debt is projected to be catastrophic, as the baby boomer retirement leads to an explosion in entitlement spending. The resulting strain on the system is summarized by the Government Accountability Office: “Without changes, spending for Social Security, Medicare, and Medicaid would permanently and dramatically increase the Government’s budget deficit and debt, leading eventually to renewed financial and economic instability.”

For simplicity’s sake, let’s ignore the politics of deficit spending and national debt expansion, and focus on the implications for the Dollar. “Major investors like Berkshire Hathaway Inc. Chairman Warren Buffett and bond investment firm Pimco fear the government’s fiscal and monetary stimulus programs could end up fueling inflation in coming years and hammering the dollar.” Buffet’s prognosis is grounded in the beliefs that government will be too timid to raise taxes, and that growth in new Treasury issuance will outpace investor buying capacity. In other words, even if we make the (dubious) assumption that Central Banks remain committed to holding US Treasuries, their needs/finances will constrain their collective ability to absorb more than a fraction of new debt.

The result, predicts Buffet, will be a calculated political preference for inflation: “Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes.” If this (potential) inflation is not accompanied by higher interest rates, it would erode returns on US investments, and by extension, interest in the Dollar.

Ironically, the Dollar is being driven down in the short-term because inflation (and crucially, interest rates) are too low. In fact, the Dollar is now the cheapest currency in the world to borrow, since the Dollar LIBOR rate fel below than the corresponding Japanese rate for the first time in 16 years. “The historic shift — and the decrease in the three-month dollar Libor — underscores how global financial markets are now awash in liquidity, especially dollars, as central banks have flooded their economies with low rates and cheap financing.”

This pessimism in the Dollar has been accompanied by a search for an alternative, with all parties so far coming up empty-handed. The Euro is a logical choice, but mounting economic and political problems equate to high levels of uncertainty. The Chinese Yuan has also been proposed, but its capital markets and economy remain too opaque for it to be taken seriously as a reserve currency. The final possibility is the Japanese Yen, which is characterized by a perennial stability and transparent capital markets. Unfortunately, Japan’s economy is both too small and too weak for the Yen to be a serious candidate. Not to mention that its national debt already exceeds 170% of GDP and its looming entitlements crisis will make America’s look mild in comparison.

In short, it looks like investors are stuck with the Dollar – for now at least. Actually, a rise in interest rates would alleviate both the short-term and long-term pressures on the Greenback, by making it more expensive to short, and offering a higher risk-adjusted return for investors concerned about the ever-increasing national debt. But, this could create a whole new set of economic pressures, and make US investments just as unattractive in nominal terms. Sounds like a lose-lose currency.

According to a recent report by the Reserve Bank of Australia (RBA), forex volume is down in nearly every major category. “However, turnover declined by over 20 per cent between October 2008 and April 2009 to US$2.5 trillion, to be at its lowest level in over two years, a move reflected in all six markets indicating global, rather than location-specific, causes. The largest markets – the United Kingdom and the United States – experienced the sharpest percentage falls.”

The report was based on a survey of the world’s six largest forex trading hubs – US, UK, Japan, Canada, Singapore, and Australia – and produced a few interesting revelations. The first is that forex volume peaked well after other capital markets. This can probably be attributed to the notion that there is never a bear market in forex. In other words, after stocks and bonds began to collapse in the summer of 2008, investors embarked on a mission, unprecedented in its speed, to move capital from risky countries to safe-haven countries. This switch, by definition, required the forex markets to facilitate.

This point is further illustrated by the fact that, “the decline in turnover of spot and forwards occurred somewhat later than that in foreign exchange swaps and derivatives….Spot turnover reported in October 2008 was likely to have been supported by large cross-border capital flows as investors sought to reduce risk by repatriating foreign investments. In addition, the high frequency and impact of news at the height of the crisis would have generated the need for investors to frequently adjust their positions.”

The final revelation is that the change in forex volume was not always commensurate with changes in trade volume. A general relationship between trade and forex turnover has been observed, although speculators ensure that currency is exchanged much more frequently than actual goods and services. The two currency pairs registering the greatest unbalance are the CHF/USD and CAD/USD. Forex volume for the former fell much more sharply than trade, while the opposite is true of the latter. One can only speculate as to why this is the case. As for the CHF/USD, forex volume probably suffered disproportionately more because both the Swiss Franc and US Dollar were perceived as safe haven currencies, in which case it would be relatively less useful to exchange them for each other. In the case of the CAD/USD, meanwhile, it makes sense to view the imbalance in terms of the spectacular decline in trade, which was largely a product of declining commodity prices.

It’s impossible to predict whether forex volume will remain depressed. Given the efforts underway to increase regulation and curtail leverage, I don’t personally expect volume to recover for a while. As for the implications, the less might be to stick to the majors. If volume is declining, it will probably affect emerging market currencies most. Lower liquidity might translate into higher volatility. However, it’s worth pointing out that volatility has been declining ever since it skyrocketed after the collapse of Lehman Brothers last fall. In that case, it might be that investors are behaving more prudently with less funds to trade with.

It’s safe to say that the inverse correlation observed between the Dollar (and also the Yen) and global equities is largely a product of the carry trade. “The U.S. stock market bottomed and the U.S. Dollar Index peaked almost simultaneously in March. While U.S. stocks are up more than 50% in that time, the Dollar Index (which measures the greenback’s value against the euro, the yen, the British pound, the Canadian dollar, the Swedish kroner and the Swiss franc) is down nearly 12%,” observed one analyst.

On one level, this represents a return to 2008, prior to the explosion of the credit crisis, when carry trading was THE dominant theme in forex markets. However, there is one important difference. While the Dollar and Yen were the funding currencies then and now (due to their low interest rates), there has been a slight shift in the currencies selected for the opposing/long end of the trade.

Traditionally, the most popular long currencies were those of industrialized countries, rich in commodities and backed by high interest rates and often rich in commodities. To be sure, these currencies have shined in recent months, certainly due in part to speculative (carry) trading. “Strategists at Wells Fargo Bank in New York ‘believe that the gains in the dollar-bloc currencies (Australia, New Zealand, Canada) have run ahead of the gains in commodity prices.’ ” The Bank of Canada also noticed that “At the time of its last statement, oil prices were about $75 a barrel, but now they are in the $60-to-$65 range. That suggests the currency’s appreciation has outpaced the demand for its commodity exports.”

But the run-ups in the Kiwi, Aussie, and Loonie have been overshadowed by even more rapid appreciation in emerging market currencies. This shift is largely a product of changes in interest rate differentials, which are now gapingly large between developed countries and developing countries. Compare the 2.75%+ spread between the US and Australia, with the 8.5% spread between the US and Brazil or 12.75% between the US and Russia. For investors once again becoming complacent about risk, the choice is a no-brainer.

Still, some analysts are nervous about this change in dynamic: “While the new carry trade may be less leveraged, it’s an inherently riskier bet. As such, it’s more vulnerable to the kind of swift unraveling of risk appetite observed across all nations and sectors in 2008, but which occurs with far more frequency in emerging markets.” Meanwhile, emerging market stocks have behaved volatilely over the last few weeks (with Chinese stocks even entering bear market territory), and some investors are concerned that they may be temporarily peaking. There are also signs that bubbles may be forming in carry trade currencies, with bullish sentiment at high levels. Accordingly, one strategist suggests waiting out a 5% pullback in the Australian dollar, and a 10% pullback in the New Zealand dollar before going back in.

There is also the outside possibility that the Fed will raise interest rates, which would crimp the viability of the US Dollar as a funding currency. Granted, it seems unlikely that the Fed will tighten within the next six months, but investors with a longer time horizon could begin to adjust their positions now, rather than wait until the 11th hour, at which point everyone will be rushing for the exits.

“Mrs Watanabe, the market’s metaphor for Japan’s housewife yen speculators, has come back to life.” In other words, the Yen carry trade is back. Precise data remains elusive, as always, but several recent papers/articles have nonetheless succeeded in bringing some clarity to this growing, but murky, type of trading strategy. According to one source, “Monthly capital and financial account outflow rose to a nine-year high of ¥3.75 trillion in March, up from ¥1.93tn in February, according to Japan’s Ministry of Finance. Similarly, Japan’s Investment Trusts Association reported last week that Japanese investment trust holdings of foreign assets surged by ¥1.77tn ($15bn) in April to ¥32.3tn and are now up ¥4.57tn year-to-date. This is the biggest monthly increase since the monthly data began in 1989.”

If it’s not already clear, allow me to spell it out. Japanese investors are collectively shorting their own currency, based on the expectation that it will neither appreciate suddenly nor fluctuate wildly so that they can earn profits from investing in higher-yielding alternatives. Research has showed (backed by common sense) that volatility is the main enemy of the carry trade. “When the carry-to-volatility ratio (i.e.,the ratio of the interest rate differentials to the volatility in the two currencies) increased through summer 2008 — in other words, when investors were able to make returns from the interest rate differentials under the low FX rate risk — they increased their positions to a remarkable degree.” On the flipside, “The reaction of the Japanese retail investors to the increase in financial market volatility (the VIX index measure of US equity market volatility is used as a proxy) was particularly apparent in October 2008 when investor positions were wound back sharply.”

A pickup in risk appetite over the last few months, however, has brought about a decline in volatility. “Implied volatility on seven major currencies has fallen to 13.8 percent from a peak of 26.6 percent in October…from an average of 15.4 percent over the past year.” As a result, Japanese investors have rushed back into the market. The total number of  forex margin accounts in Japan is estimated to have increased 50% over the last year, with account balances rising by 30%. In 2008, Japanese retail investors already accounted for 20% of daily turnover in the Japanese Spot Forex market. When you consider these growth rates, this figure is probably even higher now.

There is evidence, however, that such investors are shifting their trading strategy. Prior to the credit crisis, the data shows that they “Increased their foreign currency net long positions when the investment currency depreciated and reduced these positions when the investment currency appreciated. This behaviour is consistent with realising returns by selling positions when the investment currency appreciates and adding to positions when the investing currency depreciates.” Now, however, they have taken to copying “professional” speculators, who tend to swing trade short-term changes in momentum.

As for which currencies represent the most popular targets for carry trades, investors typically buy those currencies that are less volatile and higher-yielding. “The favorite bet is for the Australian dollar to strengthen versus the yen. Wagers on the Aussie more than tripled to 64,293 contracts in the five weeks to April 27, while those on the kiwi — named after a flightless bird native to New Zealand and depicted on the one dollar coin — rose to 36,454.” The Euro is in a distant third.

Perhaps in response to this pickup in carry trade activity, the Bank of Japan is finally clamping down. Rather than raise interest rates – which could harm the prospects for economic recovery – it will require Japanese brokerages to lower margin rates by 2010, to 25 x collateral. Still, logic (and legislation) doesn’t rule, when it comes to forex. ” According to  a Federal Reserve Bank paper, “The currencies of countries with low interest rates have tended to depreciate, or to not appreciate sufficiently to offset arbitrage opportunities.” For now at least, it likes like the carry trade is still safe.

We have recently published what we believe is the largest glossary/dictionary in the forex market.

Please let us know what you think of our forex glossary, and if there is any definitions we missed. And if you think we did a good job please show us some love on your blogs, Twitter, etc.

Plot the Japanese Yen against almost any “major” currency over the last few months (or few weeks for that matter) and you get a pretty consistent picture. Moreover, when you graph most Yen currency pairs against the S&P 500 (I like the AUD/JPY), the correlation is uncanny! Sure enough, it was reported recently that “Japan’s currency also fell the most in a week against the euro as futures on the Standard & Poor’s 500 Index rose 0.5 percent.”

This suggests that the main driver for the Yen is proximally, the demand for US equities, and ultimately, appetite for risk. “We’re seeing high-yielding currencies still rallying along with stock markets…The market is reverting to business as usual. That’s just spurring risk currencies forward,” explains one analyst. In other words, the carry trade is back, and investors are borrowing in the world’s cheapest currency (Japanese overnight interest rates are only .1%) and investing in higher-yielding alternatives. “There’s strong momentum behind this risk taking. You cannot keep your money in cash for zero returns unless you believe in deflation,” added a trader.

Experts on both sides of the Pacific Ocean are now encouraging their clients to short the Yen. “Japanese financial institutions are encouraging investors to put money into mutual funds focused on assets denominated in currencies such as the Turkish lira, South African rand and Brazilian real…Japanese investors were net buyers of 709.4 billion yen of overseas assets in the week ended July 11…” Goldman Sachs, meanwhile, has declared that the Yen is still overvalued, and “recommended investors use three-month forward contracts to sell the yen.”

There’s certainly some second-guessing taking place, especially with earnings season upon us. “Risk aversion is likely to stay prominent, given earnings announcements by companies including CIT. The bias is for haven currencies such as the yen to be bought,” insisted one analyst. In addition, Central Bank diversification has created some demand for the Yen and the Euro, but this is more of a Dollar-negative story than a Yen-positive story.

There are also signs that the Japanese economy is recovering, thanks to a pickup in exports. The fact that its economy remains so dependent on exports to drive growth certainly exacerbated the impact of the credit crisis. On the other hand, it could also magnify any recovery. “Japan’s merchandise trade surplus widened in June…to 508 billion yen ($5.42 billion) from 104.1 billion yen a year earlier. The nation’s trade performance appears to be improving, as the surplus was bigger than May’s 299.8 billion yen figure.”

Still, prices in Japan are falling (by 1.1% at last count), and there are strong concerns among economic officials that deflation could take hold. Accordingly, carry traders borrowing in Yen can rest easy, knowing that Japan is probably the least likely of any industrialized country to raise interest rates in the near-term.

There is a pattern in the following smattering of forex soundbites: “It feels like we’re already in the summer doldrums;” “[We] are moving into summer trading;” “We are in a summer period.” From three different analysts, three identical conclusions- summer has arrived.  Granted, summer officially began on June 21, but given all that’s transpired since last summer, I think we can excuse investors from delaying their summer vacations this time around by a few weeks, until the kickoff of second quarter earnings season.

Summer usually means a couple things for the financial markets: less liquidity/volume and less fluctuations. The decline in volume is largely self-explanatory, due to what can best be summarized as more play and less work. The decline in volatility is due to a different, but related cause, which is a delay in important investment decisions until the fall, when traders return to their desks and resume monitoring the markets full-time. Both phenomena tend to cause asset prices to move sideways.

This is especially true for forex markets. “Traders noted major currency pairs remain largely range-bound…Markets for now are hung up by uncertainty over the shape of any future economic recovery, he said. Economic data at this point ‘can be spun either way,’ likely leaving currency markets next week to key off of any earnings surprises from U.S. companies,” observed one analyst. As far as the decline in volume is concerned, “Emerging markets are becoming particularly volatile as liquidity declines over the summer period,” and “Bid-offer spreads are quite wide.”

Kathy Lien, of Forex 360, has observed another summer trend: “Over the past 10 years, the Canadian, Australian and New Zealand dollars have seen their steepest slides in the month of July. In addition, we have seen the U.S. dollar outperform the Canadian and New Zealand dollars 8 out of the past 10 years during this month.” This could be a byproduct of delayed allocation, as investors shift capital out of risky markets/positions/currencies. The lesson might be to stick to the majors.

Based on all current indications, this summer will be no exception to this rule. While investors have certainly grown more complacent about risk over the last few months, there is a lingering uncertainty. “Economic data at this point ‘can be spun either way,’ likely leaving currency markets next week to key off of any earnings surprises from U.S. companies.” Even with across-the-board positive earnings results, investors will likely remain wary and could hold off on taking any risky (overseas) positions until the fall.

While volatility in the financial markets has certainly declined from the record highs of October, a spike in the last week means that it is still problematic, and hence relevant. With this post, I will examine one theoretical method that has the potential both to limit volatility and to improve returns: currency hedging.

Generally speaking, there are a few situations in which currency hedging is useful: international equity/bond investing, currency investing/trading, and inflation hedging. The latter typically involves using commodities/metals to hedge against inflation, which is typically proxied by the Dollar. In other words, inflation hawks might buy gold/oil to offset a declining Dollar. This dynamic is currently on display in commodities markets, where “Speculative money has increased oil’s sensitivity to dollar movements, and if the dollar continues to strengthen, this will weigh on prices.” This type of hedging, however, is probably the most nuanced, and I will set it aside it for another post.

Hedging indirect exposure to currencies (from overseas investments) involves the separation of currency risk from credit/equity risk. In other words, if you are an American invested in a European stock, you may wish to hedge against fluctuations in the Euro (which impact you insofar as the stock is priced in and pays dividends in Euros, but your account is denominated in Dollar), so that you are exposed only to fluctuations in the stock, itself. Simply, this would involve selling Euros simultaneously with buying the stock; the amount of Euros that you sell depends on what level of exposure to currency risk you are comfortable with. If you buy $100 worth of stock in a European company and buy $100 USD/EUR, then you are fully hedged.

Hedging direct exposure to currencies is inherently more sophisticated. For example, if you sold $100 EUR/USD, you can’t hedge your position by simply buying EUR/USD, or you will negate any return without changing the level of risk. Instead, you can use financial derivatives (options, forwards, futures, swaps), which if executed properly, are tantamount to buying insurance on your portfolio. For example, if you are long the Dollar, you can buy put options in order to protect yourself from significant downside. Likewise, if you are short the Dollar, you can buy calls to achieve the same end.

The advantage of options is that strategies can be as complex as you want; likewise, they can be as simple as buying calls or selling puts. Other derivatives, however, have another component: carried interest. Since forwards/futures/swaps are all contracts (an option represents a right, other derivatives represent obligations), they are priced to take short-term interest rate differentials into account. Simply put, “For currencies with high short-term interest rates, there is a positive “carry” associated with hedging, while for currencies with low short-term interest rates, the “carry” is negative.”

I pulled that snippet from a study on currency hedging that I read recently. According to this report, “For most base currencies, over most periods, hedging seems to have reduced the volatility of international equity portfolios.” [See chart below]. However, while hedging seems to reduce risk, it doesn’t necessarily boost return. “Again, given one man’s meat is another’s poison, one would expect the results to be distributed evenly around the horizontal axis, and that is in fact the case.” In other words, one currency’s gain is inherently another’s loss. Still, if you could maintain the same returns but limit volatility, why wouldn’t you?

Pretty much every brochure advertising forex trading highlights the fact there is no such a thing as a bear market in forex. Stocks, bonds, and commodities can all lose value simultaneously (as happened when Lehman Brothers declared bankruptcy in October 2008) but it’s impossible for all currencies to decline simultaneously. A bear market in the Euro might be offset by a bull market in the Dollar; or Swiss Franc; or Brazilian Real. Regardless, you don’t have to search far to find currencies that are outperforming, whereas a stock picker would certainly have his work cut out for him during an economic recession.

I remind you of this cliche because in the current market environment, it has apparently taken on new significance. Anecdotal reports of investors frustrated with stocks, or having been burned by China, or disappointed by the collapse in oil, are flocking to forex by the thousands. Angry about suspended trading rules on stock markets? This could never happen in forex (at least not under current rules), since currencies are traded on multiple exchanges linked through a decentralized system.

Here are the stats: at Forex.com, “New accounts have increased about 30 percent a month in the last six months from pre-September levels, while the number of trades per day has risen almost 50 percent. GFT Forex said trading volume rose 187 percent from late 2007 to late 2008….By the end of 2006 [the last year apparently for which this type of data is available], average daily trade volume reached over $60 billion, a 500 percent increase from 2001…Trading volume generated by ‘retail aggregators’ — electronic trading platforms that cater to individual retail traders — rose almost 43 percent from 2007 to 2008.” This dwarfs both overall growth in forex, as well as retail growth in the bread-and-butter securities markets.

One trend worth drawing attention to is that new investors are focusing on the most popular currency pairs. [See Chart below, courtesy of Wikipedia]. It has been proposed that this is because of widening spreads (i.e. more PIPs) on less liquid pairs, but it is just as likely being caused by investors applying the stock market logic of “buy what you know” to forex. It is understandable that those new to the game would want to get their feet wet by dabbling in the Euro/Dollar/Yen, rather than diving right in to niche currencies such as the Mexican Peso or even Korean Won, whose movements are both more volatile and more difficult for the average trader to understand.

As always, all investors are advised to be on the lookout for scams. In the last few months, it seems hundreds of low-profile forex ponzi schemes have been discovered, which means there are doubtless hundreds of more still flying below the radar of the authorities. If you are suspicious, check out the National Futures Association registry.

In my experience, currency markets (and most other securities) markets tend to be governed by trends. There are short-term trends, long-term trends, and medium-term trends. Granted, this is an oversimplification, but generally speaking, if you were to chart a given currency pair, you could characterize its fluctuations in accordance with this paradigm.

Short-term trends are typically the focus of technical analysts, who ignore the broader forces affecting a given currency pair and instead try to discern slight trading patterns. Long-term trends, on the other hand, are the purview of economists, and reflect interest rate and growth differentials. Medium-term trends, meanwhile, unfold over a period of months (sometimes shorter, sometimes longer) and require a combination of technical and fundamental analysis to discern and trade successfully. With this post, I want to focus on the current medium-term trend, which is that of declining risk aversion.

I would not use the expression “old” news to describe the stock market (and accompanying) rallies that have taken hold broadly since the beginning of March, since it’s still be unfolding. Given that hindsight is 20/20, it now appears that the (perceived) stabilization of the US financial sector provided the impetus for the rally. In the weeks that followed, investors pulled an about-face and piled back into risky sectors and trades. The US stock market rapidly reversed course and is now trading around the level following the Lehman Brothers collapse last October.

The rally in March marked the end of one medium-term trend and the beginning of a diametrically opposed, but conceptually similar medium term-trend. Sorry to make it sound complicated, since it’s actually quite simple; in an overnight switch, investors went from being bearish and risk-averse to bullish and risk-seeking. These mindsets (and the switch between) is also reflected in currency markets. You can see from the chart below how the Australian Dollar, British Pound, and Down Jones Industrial Average have tracked each other closely over the last year, and moved in lockstep since March 3.

I suppose you could say that the correlation between US stocks and currencies represents one continuous long-term trend, and based on this chart, you would be making an accurate assessment. However, it’s equally important to unveil the underlying mindset that is driving both stocks and currencies, and is causing them to move in tandem. This is a nuanced distinction, and an important one to understand. There is a difference between a change in sentiment that causes investors to simultaneously pour money into risky investments (stocks and currencies, etc.) and a change in sentiment that causes a stock market rally and consequently, a currency rally. In the first scenario, both currency traders and stock market investors are in tacit agreement over risk-seeking, while in the second scenario, currency traders are uncertain, and hence taking their cues from the stock market.

Part of what makes a good currency trader is discerning which of these scenarios accurately describes the current reality in forex markets, so that a viable forecast and trading strategy can be implemented. Scenario 1 suggests that if the stock market rally falters, risky currencies will also decline. Scenario 2, meanwhile, suggests that currency traders would maintain their positions even in the event of stock weakness, which would cause the correlation between forex and the S&P to break down.

On June 1, the Forex Blog reported that Brazil is considering a forex tax on capital inflows as a way of discourage the inflow of speculative capital that is causing the Real to appreciate. It turns out that Brazil is not alone; England and France, among others, are also mulling taxes on forex transactions. Their goal is not necessarily to discourage capital inflows, but rather to raise money to fund projects that would otherwise not be viable under current budgetary conditions. The UK “levy would raise $30bn-$50bn a year – enough to double spending on health in low-income countries.” The French plan, meanwhile, would “involve taking 0.005% of the proceeds of currency transactions, perhaps on a voluntary basis, to benefit global aid projects.”

While Brazil and England/France appear to be pursuing different ends, together their plans capture the idea behind the “Tobin Tax.” Originally proposed by Nobel Laureate James Tobin after President Nixon declared the end of the gold standard, the tax would be levied on all forex transactions with the proceeds deposited in forex stability funds. One of the most popular versions would only impose the tax during periods of volatility (i.e. speculation) so as not to punish those exchanging currency for “mundane” reasons.

While still a fringe idea, the tax initially gained momentum following the 1997 Southeast Asian economic crisis, and has found new followers in the wake of the ongoing credit crisis. Consider the unprecedented volatility in currency markets of late, manifested in wild daily fluctuations.

Even the US Dollar, the world’s reserve currency, has been on a veritable roller coaster of late, rising and falling by 10% in a matter of months. Prior to the rise of forex speculation (already a $1 Quadrillion/year market!), it was rare for a currency to move that much in a year. Given that such speculation probably accounts for 90% of daily turnover, it seems obvious as to who is causing this volatility.

Don’t get me wrong; there’s a role for speculation in the forex markets, just like there’s a role for speculation in all securities markets. When markets function efficiently and players act rationally, currences should and will reflect economic fundamentals and act to minimize global imbalances. Due to the rise of the carry trade and the herd mentality, however, the oppose often obtains in practice. This can cause currency runs and or artificially inflated currencies that compel Central Banks to act counter to the way they otherwise would (i.e. by raising interest rates rapidly to deter capital flight, crimping economic growth.)

A Tobin tax would work both to minimize speculation in the short-term (by taxing trades) and promote stability in the long-term (by providing Central Banks with funds that they can use to fight speculative “attacks.” Besides, given that forex traders already enjoy favorable tax treatment – i.e. taxed below the short-term speculative rate – it wouldn’t be the end of forex trading as we know it.

The only thing predictable about currencies these days is that they will remain unpredictable. Forgive me for speaking in cliches, but when you consider that the last twelve months have seen both record rises and record falls, I think a cliche might be justified in this case. We’ve seen the Dollar soar, only to collapse again. On the other side, we’ve seen the bottom fall out from emerging market currencies, before rising 20-30% in a matter of weeks.

Volatility levels have certainly declined (see Chart below) from the record highs of October 2008, when Lehman Brothers collapsed. At the same time, the oft-cited VIX index remains well above its average over the last decade. This suggests that while investors may have been lulled into a relative sense of security, serious doubts remain.
If the current rally is to be seen as “legitimate,” then perhaps the worst of the 2008-2009 recession is truly behind us, and the global financial system has been given a reprieve from a meltdown. The concern going forward then will naturally shift past the steps that governments and Central Banks are taking to fight the crisis, towards the long-term economic impact of those measures.

Jim Rogers, a famous and perennially outspoken investor, is now sounding alarm bells over the possibility of “meltdown” in currency markets, due to inflation and currency debasement that he views as an inherent byproduct of quantitative easing and deficit spending.

Most of the attention is being focused on the US, whose stimulus and monetary programs are probably larger than all other economies in the world, combined. Offers one analyst, “We keep very low U.S. Dollar exposures because we think a further devaluation of the greenback is imminent, and we see a structural weakness for at least a number of years.” Meanwhile, there is speculation that the US could soon receive a ratings downgrade, following a similar threat by S&P directed towards Britain. But this remains highly unlikely.

The problem that Rogers (and all other investors who are worried about currency debasement) faces is how to construct a viable strategy to protect yourself and/or exploit such an outcome. Rogers himself has admitted, “At the moment I have virtually no hedges…I’m trying to figure out what to do there.” The difficulty can be found in the inherent nature of currencies, whose values are derived relative to other currencies. While you can short the entire stock market or the entire bond market (via market indexes), you can’t short all currencies simultaneously- at least not yet.

Instead, you can pick one currency or a basket of currencies, that you believed is best protected from currency collapse and buy it against threatened currencies. But how do you deal with an environment when all currencies appears equally questionable- when all governments all loosening monetary policy and risking inflation? Really, the only answer is to invest in commodities that you think represent good stores of value, such as oil or gold, or the currencies that benefit when prices of such commodities are high. Naturally, the relationship between commodities and currencies is not cut-and-dried, and if the currency system were indeed beset by meltdown, it’s not clear to me that commodities would hold their value. But that’s fodder for another post…

“The Dow Jones Industrial Average has bounced an astounding 30% from its March 9 low of 6547. Is this the dawn of a new era? Are we off to the races again?” Asks Andy Kessler provocatively in a recent Op-Ed for the Wall Street Journal.

This is an important question not only for stock market investors, but also for forex traders. By no coincidence, the stock market rally has coincided with a steady decline in the Dollar, which recently broke through a key level of resistance and touched a four-month low against a basket of currencies, and is similarly nearing a four-month low against its chief rival, the Euro. ”

Experts” point to a decline in risk aversion as the chief driver of the rally; when investors become more comfortable with risk, they buy stocks, which in turn causes investors to become even more complacent with risk. Hence, a 30% rally only six months after stocks recorded their worst day and worst week ever.

In this case, however, the experts are not in complete agreement. Economic fundamentals, for example, remain relatively weak, and corporate profits are still anemic. Andy Kessler blames the Fed for distorting “asset allocation formulas” by dropping yields to zero and for its quantitative easing program, which “gets money into the economy the fastest — basically by cranking the handle of the printing press and flooding the market with dollars (in reality, with additional bank credit). Since these dollars are not going into home building, coal-fired electric plants or auto factories, they end up in the stock market.”

Sure enough, trading data suggests that in fact this rally is being driven by retail investors, as opposed to institutions. Says Lou Ritholz, ” ‘The ‘dumb’ retail money is leading the gains. ‘In this type of environment, the market is guilty until proven innocent. We have to assume this remains a bear market until we see a more normalized economy.’ ” In short, it looks like analysts have confused the chicken with egg, by emphasizing the decline in risk aversion, rather than the self-fulfilling nature of the rally.

If the rally does end, it will almost certainly be good news for the Dollar, at least in the short-term. There has emerged a strong correlation between global stock prices and emerging market currencies, for example, which virtually ensures an outflow of capital from emerging markets. One professional idiot- err investor- Jim Rogers has prognosticated an end both to the stock market rally and the Dollar rally. Credit Rogers for his long-term thinking, but he seems to have impugned a direct relationship, when recent trends suggest it is actually inverse.

I agree with Kessler, and abide by the same maxim “Only a fool predicts the stock market…” My point here is not to convince you that the market rally is unsustainable, but rather to emphasize the importance of knowing where you stand. I’m personally quite bearish on the Dollar in the long-term (food for a future post), but a damper in the stock rally would almost certainly be positive for the Dollar.

On Wednesday, the latest addition the Wisdom Tree family of currency ETFs officially debuted, and in its first two days of trading, the Emerging Currency Fund (CEW) returned an impressive 2.2%. It’s not worth annualizing this figure, but suffice it to say that its performance is already turning heads.

According to the prospectus, CEW “is an actively managed exchange-traded fund that seeks to provide the investor with a liquid, broad-based exposure to money market rates and currency movements within emerging market countries.” Investors will gain exposure both to the currencies themselves and to their respective short-term interest rates, via “short-term U.S. money market securities and forward currency contracts and swaps of the constituent currencies…designed to create a position economically similar to a money market security denominated in each of the selected currencies.”

Chosen from three regions (Latin America, Africa/Europe/Middle East, and Asia), the inaugural 11 currencies are as follows: Brazilian real, Chinese yuan, Chilean peso, Indian rupee, Israeli shekel, Mexican peso, Polish zloty, South African rand, South Korean won, Taiwanese dollar and Turkish new lira. According to WisdomTree, these currencies were selected not necessarily for economic reasons, but rather because of their relatively high liquidity and low correlation with each other. In addition, “The selected currencies are equally weighted in terms of dollar value at each currency assessment date and after each quarterly re-balancing,” to reflect fluctuations in exchange rates. Naturally, WisdomTree reserves the right to rejigger the portfolio in terms of constituent makeup, but this would probably only be effected to improve overall liquidity, rather to replace an under-performing currency.

The advantage of CEW lies in its automatic diversification, such that investors gain access to a variety of currencies but only have to transact in the fund itself. WisdomTree also points out that, “Emerging market currencies often move independently of domestic stock, bond and money market investments…[and] exhibit low correlations to other alternative asset classes, such as commodities and gold.” The chart below [courtesy of CEW promotional materials] makes this point indirectly, and it probably comes as a surprise that US stocks are collectively more volatile than individual emerging market currencies. “Incorporating a 10% allocation of emerging currency into balanced portfolio mixes of the domestic stocks and domestic bonds over the last ten years…raised annual returns by an average of 0.66%, while lowering overall portfolio volatility” in a hypothetical exercise.

“In terms of taxation, WisdomTree says normal capital gains rules will apply to the sales of fund shares. However, income from the portion of the fund invested in U.S. money market securities usually will be taxed as ordinary income, while the tax treatment of the local currency forward contracts could vary with the situation.” The fund’s expense ratio, meanwhile,  is .55%.

If the preceding paragraphs read like a sales pitch, I apologize, as that was not my intention. At the same time, I’m personally quite positive about CEW (as well as ETFS in general, for that matter), since it provides quick and easy exposure to a bunch of quality currencies, eliminating the need to buy them separately. Not to mention that this fund is debuting right when both the carry trade and emerging markets (and their currencies) are coming back in vogue.

I’m not sure if the timing was deliberate, but it could certainly have been worse. It’s tough to say whether the market rally of the last two months is sustainable, but if the decline in risk aversion that ignited the rally continues to obtain, it will be good for CEW.

Against each other, the New Zealand Kiwi and Australian Dollar have traded in a pretty tight range for the last year (except for a “blip” in the fall of 2008). This makes sense, as both currencies rise and fall in accordance with exports and interest rates.

Against other currencies, meanwhile, both have torn upwards in the last couple months. Despite steep interest rate cuts, both currencies have maintained their interest rate advantages against other industrialized currencies. This has not gone unnoticed, and the return of the carry trade has been kind. “The current improvement in sentiment is providing an underpinning of support and while that remains the case – and that may be until midyear – the New Zealand dollar is going to remain well-supported,” said one economist.

The correlation between the New Zealand Kiwi, specifically, with the US stock market has become remarkably cut-and-dried of late, which you can see from the chart below. For carry traders, therefore, it probably makes more sense to follow stock market commentary than to track New Zealand economic data. The same economist, for example, warned “that the equities rally, which has seen the broad U.S. Standard & Poor’s 500 index climb 36% from its March low after rising another 3.4% Monday to its highest since Jan. 8, may be dissipating.”

Besides, given the deteriorating economics in both countries, lower interest rates are probably inevitable: “We think this case for further cuts will be made in the second half of this year…we think it will be very difficult, no matter what the global economy is doing, for the RBA to ignore rapidly rising unemployment,” offered one analyst who predicted that rates would be cut to a “trough of 2%.” In such a scenario, the interest rate spread would still remain healthy, but perhaps not enough to offset the additional risk.

Australian home prices are falling at a rapid clip, the labor market is sagging. In New Zealand, meanwhile, a decline in sentiment and consumer spending has corresponded with a 1% contraction in GDP in the quarter ended March 31. Tourism is down, although net exports are increasing. The current account deficit continues to expand, but this is mostly a product of an investment balance – perhaps related to the carry trade.

For now, forex traders remain optimistic, albeit slightly less so than before: “The difference in the number of wagers by hedge funds and other large speculators on an advance in the Australian dollar compared with those on a drop — so-called net longs — was 16,692 on April 28, compared with net longs of 17,250 a week earlier.”

Yesterday, the South African Reserve Bank (SARB) lowered its benchmark interest rate by 100 basis points to 8.5%. Since December, the Central Bank has now cut rates by 3.5%, from a high of 12%. [As an aside, the SARB uses a repo rate to conduct policy, as opposed to a discount rate. In theory, a repo rate is slightly unique in that it reflects the rate at which the Central Bank will repurchase government securities from commercial banks. The Federal Funds Rate, in contrast, "is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions." In practice, both rates function as modulators of liquidity in the financial system.]

“The outlook for domestic economic growth remains subdued, with no indications of a quick recovery,” offered the SARB as a rationale for the rate cuts. Activity in manufacturing and mining, two of the cornerstones of the South African economy, have plummeted since the inception of the credit crisis, along with exports and retail sales. As a result, “Central bank Governor Tito Mboweni said April 7 he would ‘not be surprised‘ if the nation’s economy shrank for a second consecutive quarter in the three months through March, following a 1.8 percent contraction in the fourth quarter.” Meanwhile, South Africa’s producer price index (PPI) has declined for seven consecutive months. Coupled with a moderation in food and energy prices, inflation is no longer perceived as a serious problem.

The South African Rand actually rose on the news of the rate cut, as part of a trend that has seen the currency rise nearly 40% since touching a low of 11.7 Rand/Dollar in October. In April alone, “South Africa’s rand, the laggard of 27 major world and emerging-market currencies last year, rallied 12 percent against the dollar.” This reversal of fortune is due largely to the recovery of risk appetite and consequent return of investors to the carry trade.

South Africa is especially poised to benefit from this trend for a couple reasons. Primarily, the Rand’s advantage lies in in interest rate differentials. Even if the SARB hews to economists’ predictions and cuts its repo rate by another 100 basis points, the differential will still be tremendous, as virtually every industrialized country has lowered rates close to zero. In addition, South Africa is perceived as a relatively safe place to invest, especially relative to interest rate levels. According to one trader, “We’re seeing a re-assessment of the rand’s relative value because of the fact that South Africa’s economy and financial system are relatively more sound than is the case in many other countries.”

As Bloomberg News summarized, you can’t stand in front of a freight train: “Emerging-market stocks are poised for their best month in 20 years as evidence the global recession is easing spurs investor demand for higher-yielding assets.”

In the end, you can’t fool the markets and carry traders ignore fundamentals at their peril. The recent election of Jacob Zuma as South African Prime Minister “hardly adds to confidence in the South African economy.” In addition, South Africa continues to maintain a sizable current account imbalance, “at 7.4 percent of gross domestic product last year.” Despite declines in February and March, the deficit touched a “record 17.380 billion rand deficit in January” and the markets are “expecting large deficits to persist this year as exports come under pressure.”

Everyone has heard the cliche that currency markets are the most viable because there’s no such thing as a bear market; a decline in one currency must necessarily be offset by a rise in at least one other currency. This truism has taken on a new significance in the context of the credit crisis, where sell-offs in virtually every other asset class has sent investors scrambling in search of yield. Despite even the current rally in stocks and commodities, forex volume is surging.

Aggregate forex data is essentially nonexistent, and also unreliable since its based on surveys rather than actual numbers. But anecdotal evidence from the major players in forex suggests that interest has exploded. “Volumes on dbFX, the online retail trading platform from Deutsche Bank, increased 37% in the first quarter of 2009 from the same period a year earlier. ….particularly impressive given sharp volume gains in October, at the height of market fears, when retail investor interest spiked due to intensified volatility.”

Ironically, the increase in retail forex trading has coincided with a relative decline in institutional trading, as banks collectively make an effort to get back to their roots of providing financial services and move away from position-taking. “The crisis has also led many houses to disable algorithmic trading models, which had been big volume drivers.”

Japanese retirees were probably the first, or at least the most famous, mainstream group to trade in the currency markets. They famously used the carry trade to bet against the Yen. When this strategy imploded, it was left to investors from other countries to pick up the slack. “Contracts for Difference (CFD) providers [in Australia] are noticing the shift. Many newcomers to CFDs, they say, are overlooking margin trading over shares for the prospect of trading currencies instead.”

Equity traders are also starting to pay attention to forex. The Dollar’s recent volatility has effected significant changes in corporate profitability. For companies that are export-oriented and/or are net buyers of commodities, the strong Dollar has provided a windfall. One analyst added, “Travel and leisure companies will also benefit from the weak dollar as this means that travel is now more affordable for foreigners.” If and when the Dollar recovers, companies that do business overseas are poised to reap the benefit.

For novice forex traders, the most important decision involves choosing a trading approach; “The type of forex trader you are will determine how frequently you trade, the type of currency pairs you choose to trade, the charts you use, and even the strategies that you employ to make money on the markets.” Generally speaking, day traders churn their portfolios daily, and hence stick to the most volatile currency pairs. Swing traders typically hold positions from one day to several weeks, and rely on a combination of technical and fundamental analysis.

Position traders, in contrast, don’t worry about “short-term market movements like the day trader or swing trader, but about long-term trends spanning weeks or months.” These types of traders, as well as those who aren’t ready to take the plunge directly into forex, should also consider currency ETFs, currency options, and currency CDs. As one instructor summarized, “The upside to these is that you can get started in currencies right through the same stock brokerage account that you would buy IBM, GE or Google.”

Yesterday’s post on the resurgence of the Australian Dollar largely ignored a broader trend in forex markets: the return of the carry trade. This strategy, which involves borrowing in low-yielding currencies, and selling them in favor of higher-yielding ones (such as the Aussie) is making a comeback, as risk aversion ebbs and investors resume the search for yield. As Bloomberg News outlined in an excellent piece on the subject, “Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher.” [Chart below courtesy of the WSJ.]

Technically, the change in investor sentiment has already been manifesting itself (in the form of higher asset prices) for a couple months. In reality, it wasn’t until Goldman Sachs published a report entitled “Time to Reconsider Carry” on April 8 that analysts began to specifically focus on the decline of risk aversion in forex markets. In the report, GS argued that “There are increasing signs that FX volatility has peaked” and “The conditions are about to fall in place to make carry strategies attractive again.”

The point is well-taken when you consider the paltry yields offered by the Euro, Dollar, and Yen, for example, combined with the fact that these currencies are now expensive, relative to a few years ago. “Borrowing U.S. dollars at the three-month London interbank offered rate of 1.13 percent and using the proceeds to buy real and earn Brazil’s three-month deposit rate of 10.51 percent rate would net an annualized 9.38 percent,” according to Bloomberg.

Investors could theoretically choose between any of these currencies, as well as the Swiss Franc, Canadian Dollar, and British Pound, all of which are backed by benchmark interest rates less than or equal to 1.25%. Ironically, the New Zealand and Australian Dollars- which could still be considered candidates for the long side of a carry trade – now feature interest rates well below those of the US and EU when they were at that their peak in 2008. This gives you an idea just how far rates have fallen since the inception of the credit crisis. It looks like the Yen has emerged as the favorite among the spectrum of funding currencies. The Yen makes a good choice because inflation and interest rates are extremely likely to remain close to zero for the foreseeable future.

The hard part is choosing which currency to go long. A summary of interest rates for actively-traded currencies reveals several yielding more than 10%. “Goldman Sachs recommended on April 3 that investors…buy Mexican pesos, real, rupiah, rand and rubles from Russia.” Bloomberg meanwhile pointed out that “An equally weighted basket of currencies consisting of Turkish lira, Brazilian real, Hungarian forint, Indonesian rupiah, South African rand and Australian and New Zealand dollars — bought with yen, dollars and euros — earned an annualized 196 percent from March 2 to April 10.” Standard Chartered Bank, meanwhile, recommends the Indonesian rupiah, the Indian rupee and the Philippine peso. Investors not wanting to trade forex directly can buy the iPath Optimized Carry Trade Fund (ICI), an ETN which trades on the NYSE Arca exchange.

During the run-up in asset prices that preceded the current downturn, investors could count on stability, maybe even appreciation in riskier currencies that constituted the long end of their trades. This time around, such an assumption is not wise. One analyst warns investors not to be “caught short on the unwind.”

Risks also need to be evaluated specifically to the currencies on the short and long ends of the trade. In analyzing the worth of the Brazilian Real as a long currency, one analyst notes that, “Lower commodity prices, a sudden dive back to safe haven currencies and fluctuation in inflation numbers all have the potential to squeeze the spread on carrying the real.” On the flip side, there is a risk that rates will increase for the funding currencies, although probably not for at least the next 12 month, if not longer.

Until the Fed announced an expansion of its quantitative easing program two weeks ago, gold had begun to fade into relative obscurity. Sure, gold had risen in value from a low of $710/ounce back up to $900/ounce, but prices were still off 10% from the highs reached in 2008. Meanwhile, risk aversion had begun to decline and the stock market had begun to rise, such that pundits were talking more about stocks and less about gold.

Since the Fed’s announcement, however, gold has been thrust back into the spotlight. The same trading session that saw a record fall in the Dollar and a record rise in Treasury prices, also witnessed a 7% spike in gold futures prices. ” ‘Money is being pushed into the system and that’s creating the inflationary threats that the markets are contemplating…Commodities are a decent way to hedge against that potential threat,’ ” observed one trader.

Other analysts, however, caution that rising gold prices are a sign of the fear/crisis mentality, not inflation. “There are just not a lot of alternatives for global investors. You will see more and more investors moving into gold as a safe haven, and you will see more institutions putting money into commodities indexes.” In other words, gold is being driven by the safe-haven trade, which is evidenced by an increasing correlation with Treasury bonds. One commentator calls it a hedge against uncertainty: “The demand for gold is for gold coins, a massive flurry of bullion buying by ETF’s (and investors), and the institutions and traders buying the hell out of it.  The reason is simple… pure fear.”

With the exception of the perennial gold bulls and conspiracy theorists, the short-term consensus is that due to “massive spare capacity now opening up in the global economy, soaring unemployment and a dysfunctional banking system – it would be very hard for central banks to generate a surge in inflation even if they wanted to.” This analyst further argues that the Fed is undertaking the expansionary program under the implicit assumption that it will have to siphon this money out of the financial system, if and when the economy recovers.

Of course, there is not even a consensus that gold is a good hedge against inflation. Mike Mish points out that the correlation between the US money supply and the price of gold is not very robust. When examined relative to a basket of currencies (rather than the Dollar), however, the relationship suddenly becomes much stronger. Especially when you filter out fluctuations in the value of the Dollar (which is affected by many factors unrelated to inflation), “gold is doing a reasonably good job of maintaining purchasing power parity on a worldwide basis.” This can be seen in the following chart:

Ascertaining a relationship ultimately depends on the time period of analysis, and the currency(s) in which prices are being tracked. Given also gold’s notorious volatility, it probably makes sense to use special inflation protected securities, rather than gold, as an inflation hedge.

You have probably seen the advertisements – “Trade Forex with 400:1 Leverage” – without being entirely clear as to what exactly these brokers are offering and/or wondering why someone would want to leverage trades to such an extent.

Simply put, forex leverage (also referred to as margin) “is a loan that is provided to an investor by the broker that is handling his or her forex account.” With leverage, you can effectively increase your purchasing power, and buy securities in excess of what you would otherwise be able to afford, with the goal of maximizing relative returns. For example, if you achieve a 25% return on a $2000 trade/investment that was carried out with 2:1 leverage, you actually achieved a 50% return on the $1000 of capital that you personally invested; the other half, by implication, was provided in the form of a loan by the broker. Of course, the inverse also holds, such that a 25% loss would be magnified into a 50% loss, under the same parameters. See the table below for further understand this “multiplier effect.”

While traders can theoretically use margin to trade any kind of financial instrument/security, leverage is especially common in forex. The reason is that currencies are typically bought and sold in units of 50,000 – 100,000, which is more than retail traders can afford, or are willing to commit. Moreover, currencies are not as volatile (outside of the credit crisis, that is) as other securities, and typically don’t fluctuate more than 1% in a given day. Changes are often so minuscule that 1/10000 of a unit (one Pip) has become the benchmark for measuring fluctuations. Accordingly, “currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of leverage.”

Leverage allows traders to put up only a fraction of the capital required to make a given-sized trade ; with 200:1 leverage, for example, $500 would be enough to fund a $100,000 trade. Unfortunately, leverage always favors the broker, much the same way that casinos benefit on average from extending credit to gamblers. According to one especially cynical commentator: “The game basically works this way: The broker is the shark. The retail trader is the shark food. If you want to make money currency trading, give yourself a fair chance and our advice is not to go more than 10x.”

A browsing of forex chat rooms and message boards reveals a surplus of disaster stories involving leverage, such that one can safely conclude that excessive leverage almost invariably leads to excessive losses. This lesson even seems to apply to institutional investors, despite the perception that they have an edge when trading forex, and hence would seem to represent excellent candidates for making leveraged trades. In the context of the current economic quagmire, “Investment banks were trading with 40:1 leverage in some cases. The banking crisis in the US was caused by banks not buying based on solid fundamentals and using insane leverage to buy securities.”

When trading a strategy that is based on technical analysis, “Even though you find one with 80-90% successful system on the paper, when you trade it usually come down 60%. So if we are losing at 40% of the time it is essential that we control risk.” Accordingly, putting more than 3% of your capital at risk on a given trade would seem suicidal. Applying more than 20:1 leverage (which seems trivial compared to 400:1) is very dangerous when you consider that a relatively benign 25 pip decline would result in a 5% loss. You can use the matrix below to calculate a “worst-case” scenario and figure out how much leverage you can get away with in the event that your trading strategy fails on consecutive occasions. It is surely much lower than you expected!

To give you an idea as to how excessive forex leverage has become, consider that the Financial Industry Regulatory Authority (FINRA) recently submitted a proposal that would prevent retail forex brokers from offering customers more than 1.5:1 leverage. While it’s possible that “The FINRA proposal sadly appeals to the lowest common denominator: the people who over-leverage positions with inappropriate stop-losses,” it nonetheless serves as a testament both to the danger of excessive leverage and to the importance of adequate risk management.

Since touching a fresh 24-year low in the beginning of March, the British Pound has recovered strongly, rising 5% against the USD in a matter of days. Analysts are at a loss to explain the sudden strength of the Pound, outside the confines of the safe-haven hypothesis: “The risk premium that sterling has taken on works both ways, and you can see sterling outperforming whenever risk appetite picks up.”

As another analyst points out, however, ascertaining the role of risk aversion in the markets has become somewhat circular: “Observers…draw this assessment purely from price action. Rising equities means the market is less risk averse. And the way we know there is less risk adversity is that the stocks have rallied.” Applying this argument to forex, softening risk aversion is contributing to a stronger Pound. At the same time, observers point to the rising Pound as a signal that risk aversion has softened. In short, the safe-haven trade is surely not the most convincing explanation.

In fact, by all accounts, the Pound should be falling. The latest data shows that retail sales plunged by 1.9% on a monthly basis. GDP is projected to fall to such an extent that “in 2009 Britain will slip to 12th place (from 7th in 2007) among the 15 ‘old’ members of the European Union, behind all except Spain, Greece and Portugal.” Meanwhile, the Central Bank of the UK has warned that Britain’s government finances have become so fragile that the government will have difficulty carrying out new spending plans. Investors have taken note, and demand for the latest auction of UK government bonds is believed to be the “lowest in history.”

Given all the bad news, perhaps the Pound’s recent rise can be best attributed to technical factors. “The $1.45 level represents so-called resistance on a descending trend line connecting the January high of $1.5373 and the February peak of $1.4986.” Given that the Pound has since sunk back below $1.45, it can be reasonably discerned that a cluster of sell orders were executed at this level.

Over the longer-term, the prognoses for the UK economy generally, and the Pound specifically, are not good. Thanks to a low exchange rate, inflation is actually rising. It is perhaps a welcome development, since it indicates that the UK was (temporarily) averted deflation, but it could also be a product of the quantitative easing plan announced earlier this month, whereby the Bank of England will flood the banking system with newly minted money. “Such a tactic can dilute the currency, and the perception that such dilution is about to occur is dragging the Pound down right now.”

2007 was the year of the carry trade. 2008 was the year of the safe haven trade. 2009, meanwhile, is shaping up to be the year of the deflation trade. In other words, traders have completed an about-face in their collective approach to forex, such that those currencies with the lowest rates are now favored, because they are perceived to best hedge against deflation.

The New Zealand Dollar illustrates this trend perfectly. For most of 2008, it collapsed as investors pulled money from risky, high-yielding currencies, in favor of a capital preservation strategy: accepting limited or zero return in exchange for security. Beginning at the tail-end of last year, however, it stabilized around the psychological level of .5 USD/NZD, failing to breach the important technical level of .4915.

While such technical factors undoubtedly have played a role in the reversal of fortune, the NZD has benefited by the aggressive interest rate cuts effected by the Bank of New Zealand, which today cut its benchmark rate yet again by 50 basis points, to 3%. While it’s too early to speculate whether the Central Bank will cut rates again at its next meeting, all signs point to further cuts. The economy is in a paltry state, having contracted for five consecutive quarters. Chinese demand for commodities is abating quickly, and the most recent numbers suggest it will continue to erode.

Based on investors’ current priorities, however, the most important indicator is the monetary situation, which appears under control. “The expectation that the RBNZ will be more moderate with cuts going ahead has provided support to the currency.” said…a currency strategist at Bank of New Zealand…“For a sustained bounce above 52 U.S. cents we’ll have to see an improvement in the global backdrop and evidence that equity markets have stopped falling and risk appetite is rebounding.”

The holy grail of forex is a trading system that can turn a consistent profit, irrespective of the currencies involved and prevailing market conditions. While this has been promoted disingenuously by many a forex broker and forex software provider, suffice it to say that it remains elusive. A more realistic goal would be to build a strategy that is profitable most of the time (i.e. wins more than it loses). I don’t pretend to have developed such a strategy; instead, I would like to outline a method that can be used to confirm (or deny) whether your strategies are strong enough to withstand the daily whims of the forex markets: backtesting.

Simply put, backtesting involves applying a trading strategy to historical data. In other words, by checking the parameters that normally guide your trading against the way markets actually performed in the past, you can easily determine the stipulations/conditions that will make such parameters robust. Parameters include time period (hours, days, weeks, etc.), expected profit per trade (percentage, or number of pips), cumulative profit goal (i.e. 25% annual return) currency pair (USD/EUR, EUR/YEN, etc.) and comfort with risk (i.e. stop/loss). Stipulations, on the other hand, can be as simple or as complicated as you would like. For example, let’s say you want to buy whenever the currency pair breaches its 15-day moving average, and/or sell when the stochastic falls below a certain threshold. These kinds of stipulations can also be qualitative; let’s say, for example, you sell the Euro every time the European Central Bank lowers interest rates, or buy the Dollar every time the consumer confidence index records a rise.

The most robust strategies are profitable under a variety of market conditions, when profit goals are flexible. (For example, try adding or subtracting 5 pips to your expected profit per trade, and see if your strategy is still profitable). It is also important to remember that some strategies don’t lend themselves well to backtesting. Trendlines and other technical ‘patterns,’  for example, are often too circumstantial to be applied and tested generally. Backtesting also doesn’t account for market psyschology. While it would be nice to devise a strategy that is profitable in a variety of conditions, sometimes it must be condeded that when market sentiment is especially (and often irrationally) bullish or bearish, one’s strategy may not apply.

Having developed the paramaters and stipulations, how can you backtest your strategy? The pioneers (and perhaps even some stalwarts today) manually parsed reams of data, going through daily and weekly charts to determine the sets of conditions, if any, their strategies were viable. With the use of powerful computers, this tedious process can be completed automatically. If you’re not up for building/coding a system yourself, don’t despair, as there are a handful of great programs that have been professionally designed for amateurs to use.

Here, you have two main options. You can open a (demo) account with any of the forex brokers that incorporate backtesting software into their trading platforms. Pay special attention to those that use MetaTrader4 (MT4) – of which there are several reputable brokers- because it is the most critically-acclaimed and user-friendly. For those of you who don’t have access to such software, several downloadable versions can be found here, and a quick google search turned up a list of commercial software. Sometimes, such software requires you to provide your own historical data, which can be found here.

I recently stumbled across an article that argued that forex trading is not a zero-sum game. The author is (unwittingly) correct in his conclusion, although not in his reasoning that it is possible for a trade to produce two winners. The conclusion verged on truth only because after accounting for broker commissions (i.e. the bid/ask spread), forex trading is actually a negative-sum game. It is important to recognize that the nature of forex is such that all currencies cannot simultaneously appreciate, and hence, every trade involves a winning party and a losing party. Even if all parties manage to break even over the long run, the existence of spreads and commissions ensures a long-term average return that is negative. This does not mean that it is impossible to to profit in forex, but rather that the profits of the winners are underwritten by the losers. While one cannot expect to always occupy the winning side, there are steps that can be taken to minimize being on the losing side. Admittedly this is vague; the idea here is simply that it’s vitally important to be well-informed when investing in forex so as to enter and exit trades only at levels that are “fundamentally” sound.

Convention forex wisdom, as well as the "immutable" laws of economics, have long held that higher interest rates correspond with currency appreciation. This has been especially true in recent years, as risk-hungry investors used low-yielding currencies to fund carry trades, the proceeds of which were invested in higher-yielding alternatives. In the context of the credit crisis, however, this logic has been turned on its head, as the countries with the lowest interest rates have seen their currencies outperform. Emerging market economies that have turned bearish on inflation have likewise been rewarded with strong currencies, despite a potential imbalance in the risk/reward profile. This phenomenon suggests that investors are primarily concerned with deflation, and are parking their money in the countries they believe can best preserve their capital, even if the real rate of return is negative. One analyst argues this could spur further interest in gold, reports SeekingAlpha:

If it [the Euro] also joins the zero interest band-wagon then one may wonder what’s left for the currency markets to play with? Is this is a precursor to a crisis brewing here? Does gold get a further leg up – it’s a zero yield currency anyway!

Read More: The Currency Conundrum: Is It Another Leg Up for Gold?

Efficient markets theory would suggest that the inherent randomness of commodity prices should be preserved from month to month, such that on average, prices are equally likely to go up as they are to fall. In practice, we know that earnings and tax calenders are such that stocks consistently perform better in some months, than they do in others. Such patterns can also be observed in forex markets.The Dollar, for example, typically rises in January, probably as a result of the US stock market to rise likewise. In February, meanwhile, one analyst has observed a consistent decline in volatility between the Yen and the Dollar. The implication is that with lower volatility will follow a sell-off in the Yen, due to renewed interest in the carry trade. Of course, this may not hold in the current market environment, as both currencies are now being used to fund carry trades and are being punished accordingly when risk tolerance increases.

Read More: What Is Unique About Forex in February?

Investing wisdom has long held that gold is used to hedge (Dollar) inflation; historically, the two commodities have tended to trade inversely with one another. In the last month, this relationship appears to have broken down. As the credit crisis has entered a new critical stage, investors have come to view both the Dollar and the gold as safe havens in a sea of uncertainty. To elaborate, the Dollar is being purchased primarily to pay down debt, with the proceeds invested in low-risk, low-return vehicles. Gold, in turn, is being used as a form of insurance, as a "deflationary backstop" in case the bets on the Dollar miss the mark. In short, the Euro and Gold are no longer friends. BullionVault reports:

"The new dynamic in risk aversion now means that when the EUR/USD goes up then traders must sell their gold – since a higher Euro implies lower risk in the overall markets and hence less need to hoard the yellow stuff."

Read More: Gold and the Dollar Running Together: Why?

Since the inception of the credit crisis, perhaps no currency has been beaten down more than the British Pound, with analysts bitterly divided about whether the currency will fall further. A lot depends on whether the British efforts to save its devastated banking sector are successful. The government has already moved to nationalize the Bank of Scotland, and is quickly moving to shore up the capital positions of other vulnerable banks. Experts point to the Pound's historic volatility, however, as an indication that investors have always fled, and will continue to flee the UK in times of uncertainty. Jim Rogers, whose partner George Soros famously "broke" the Bank of England in 1992, forecasts a bleak future, although his motives are questionable. Ultimately, the fate of the Pound is entirely relative, as is the case with all currencies. In other words, if investors suddenly changed their minds about the perceived stability of the Dollar and Yen, the Pound could quickly recover. Business Week reports:

As investors begin to renew their focus on the problems of other economies, the pressure on sterling may ease. The selling could turn to buying if investors suddenly decide they'd rather take a little risk to earn return, rather than watching their cash evaporate.

Read More: Playing a Rebound in the Pound

A steady decline in risk aversion has taken place over the last few months, such that investors once again appear willing to own riskier assets, especially in the developing world. If this continues, increasing demand for emerging market assets would probably be accompanied by currency appreciation. While there are several ways that investors could conceivably profit from this trend, there is an overlooked strategy: currency options. Specifically, some traders have begun to write "out of the money" put options- the equivalent of selling insurance to investors that wish to protect themselves from further declines in emerging market currencies. Those who specialize in currency options, however, have noticed declines in both implied volatility and the risk-reversal rate, which together suggest that such a possibility is now perceived as less likely. Regardless of whether you plan to employ such a strategy, it's worth paying attention to currency options prices, as they represent valuable snapshots of a given currency's perceived health. Bloomberg News reports:

Traders quote implied volatility, a measure of expected price swings, as part of setting options prices. Options are contracts granting the right to buy or sell a specific amount of a security in a given time span.

Read More: Currency Options Best Bet on Risk Aversion Drop, Barclays Says

US government bond issuance in 2008-2009 will shatter all previous records. Fortunately, risk tolerance remains low as a result of the ongoing uncertainty surrounding the credit crisis,and demand for US Treasuries remains proportionally high. However, analysts are beginning to wonder just how much more the market can support, as it appears that a bubble has begun to inflate. A slight recovery in risk appetite, and/or institutional investor concern that the bubble is on the verge of popping could trigger a mass exodus from US Treasuries. Moreover, foreign holders would likely rush to repatriate the proceeds in order to minimize currency conversion risk. The result would be a self-reinforcing downward spiral between the Dollar and bond markets. Reuters reports:

A tanking U.S. dollar on the back of a decline in the U.S. bond market would signify the global economy may not be recovering anytime soon, however, which could leave very few places to hide.

Read More: Dollar investors wary of bond market bubble

Economic and monetary fundamentals throughout the world have become so paltry that one analyst notes tongue-and-cheek that investing in forex has become tantamount to identifying the "least worst" currencies. In virtually every country, all economic indicators are pointing downward, with the lone exceptions of unemployment rates and government spending. In other words, continuing declines in both production and consumptionherald a protracted worldwide recession. On the monetary side, Central Banks have embarked on a race to the bottom, with interest rates on pace to converge at 0% sometime in late 2009. Meanwhile, most governments have announced vast stimulus plans, which could prove highly inflationary if they can't find lenders willing to provide financing. In such an unfavorable climate, where then should savvy forex investors turn? The Financial Times reports:

Asian (ex-Japan) currencies, with relatively healthy banking systems, limited debt problems, positive demographics and undervalued currencies should be the natural harbour for fundamentally-driven investors. Commodity currencies, such as the Brazilian Real, Norwegian Krone, or Canadian dollar, offer characteristics akin to those in Asia and…[could also] participate in the rally.

Read More: A homely parade in the currency 'ugly' contest

While the Yen's 30% rise in 2008 is no mystery (a result of the unwinding of carry trades), its performance nonetheless defies economic fundamentals. Exports have fallen and industrial production has collapsed, such that recession now appears inevitable. Japan is not alone in this regard, as a number of economies have suffered unnecessarily as a result of excessive volatility in currency markets. The solution could be the so-called "Tobin tax," which aims to limit forex speculation by levying a nominal tax on short-term currency trades. The proceeds from such a tax would be used to restore some equilibrium in forex markets by providing Central Banks with funds for direct intervention. While the tax itself has never been implemented, countries have previously taken to cooperating on forex matters for the sake of global macroeconomic stability. Seeking Alpha reports:

Exchange rates have to be within a certain range for all economies to prosper. The major economies have to work together to ensure this. If the Group of Five could work together to depreciate the "Super Dollar" in 1985, so the major nations today can and should work together to stem the surge of the super Yen.

Read More: Japanese Yen: An Excessively Strong Currency Spells Recession

Yesterday, the Forex Blog reported that the Yen could soon peak as a result of renewed interest in the carry trade. On the other side of this equation are emerging market currencies, most of which offer interest rates well above their industrialized counterparts. The spread between South Africa's benchmark interest rate and the rates of Switzerland, Japan, and the US, now exceeds 10%. As a result of near-zero rates in these countries, investors have once again taken to scouring the earth for yield. Apparently, government stimulus plans and monetary incentives have restored confidence in risk-taking. South Africa is especially poised to benefit, as it is one of the world's largest producers of gold, which recently resumed its upward trend. Bloomberg News reports:

“South African interest rates are very high relative to other markets and that yield differential is underpinning the rand at a time when trading is very thin.”

Read More: Rand Rises Versus Dollar on Bets Zero Rate in U.S. Boosts Carry

As 2008 comes to a violent end, forex analysts are releasing their predictions for 2009. Most believe that risk aversion and interest rate discrepancies will cease to weigh on forex markets, especially compared to 2008, when investors unwound carry trades and parked their money in low-yielding (but apparently less risky) US and Japanese securities. Instead, investors will probably begin to focus more on economic fundamentals. With regard to the Dollar, this approach could work either way. On the one hand, it is conceivable that the US will outperform (this could translate into a milder recession) the EU and Japan, since the Fed's interest rate cuts were implemented at such an early stage. On the other hand, the US twin deficits continue to expand, which suggests the possibility of long-term inflation as well as a potential reluctance in foreigners to continue to lend to the US. Marketwatch reports:

To be sure, the dollar's 2009 trajectory depends a lot on what the U.S. and global economies do, and when they do it. The U.S. recovery could begin midyear, or the clouds could linger until the fourth quarter or even longer.

Read More: Dollar faces correction, but could head up in 2009

The last few months have born witness to an unprecedented level of volatility in forex markets, to say nothing of the fluctuations in other areas of securities markets. Emerging markets currencies in particular, as well as a handful of industrialized currencies, have crashed violently, as a process of de-leveraging continues to send capital back to the US and Japan. This instability has led some policy-makers to revive an erstwhile exhortation to limit the role of speculators in forex markets, who collectively may account for as much as 90% of daily forex turnover. Specifically, a 1% tax on all forex trades has been proposed, which would be deducted automatically and used to finance infrastructure projects around the world. It has also been suggested that forex markets follow the lead of equity markets by adopting a so-called "up-tick" rule, which would be used to counter sudden waves of predatory short-selling that can cripple a country’s currency in minutes. CSRwire reports:

Such bear raids are rarely to "discipline" a country’s policies, as traders claim, but rather to make quick profits. In the transparent FXTRS system, traders selling falling currencies begin to see that the rising tax is cascading into the country’s currency stabilization fund and cutting into their gains.

Read More: Why Obama Missed Bretton Woods II

Since the credit crisis heated up several months ago, the theme of risk aversion has predominated in equity markets. This is also true in forex markets, where deleveraging and a shift to perceived investing "safe havens" has led to a collapse in the carry trade, leading to a sharp rally in both the Dollar and Yen. In fact, the recent rise of these two currencies has coincided remarkably with stiff declines in the prices of virtually every class of risky asset.

Read More: Currency Trading Markets Remain Highly Correlated to Dow Jones, Crude Oil Prices

Today, I’m going to take a break from covering the credit crisis in order to cover an important logistical topic: how should one go about choosing a forex broker? There are dozens (if not hundreds) of retail forex brokers, a fact which can be overwhelming to those considering dabbling in forex for the first time. The first step is to assess the quality of the broker, itself. Where is it registered? Those based in offshore tax havens should be treated with some degree of skepticism, as they are subject to lax, if any, regulation. It could be difficult to withdraw funds from an account held with such a broker. Along the same lines, what is the broker’s reputation? Typically, the most "visible" brokers will also offer the best customer service, as much of their business is generated through word-of-mouth. Next, you should examine the product(s)? What kind of trading platform will you have access to? Will you have access to research and advanced (technical) analysis tools? What is the average execution time? The final considerations are financial. In other words, what is the spread and what are the terms of financial leverage. At the same time, you should be careful not to allow this latest aspect to weigh too strongly on your selection, reports The American Chronicle:

It’s far too easy to be attracted to brokers that offer up to say 1:400 leverage, and therefore allow you to take out very large positions with a small margin, but this is a very dangerous game and it’s all too easy to over-leverage yourself and wipe out your account completely.

Read More: 5 Important Things To Consider When Choosing A Forex Broker

Most of the commentary surrounding the dual Dollar-Yen rally that has unfolded over the last couple months has focused around monetary policy and risk aversion. Accordingly, the prevailing theory is that both currencies are being driven upwards because of narrowing interest rate differentials and a collapse in risk tolerance. However, it’s also important to consider the role of technical/financial factors. Specifically, liquidity in forex markets is dissipating rapidly as market participants have found it difficult to secure lines of credit to finance leveraged currency trades. In addition, those with leveraged short positions in the Dollar and Yen have been forced to partially unwind their positions for the same reason. In hindsight, the decline in both the Dollar and the Yen over the last few years now appears to have been driven primarily by the same expansion in credit that underlied the real estate bubble, which enabled traders to take advantage of interest rate differentials to earn relatively risk-free profits from a carry trade strategy. Regardless of the fact that these interest rate differentials persist and a carry trade strategy remains theoretically viable, it’s becoming impossible to undertake because of a shortage of credit and liquidity. FX Solutions reports:

The credit crash has affected participation rates in all markets. Many speculative players who depended on credit and leverage to fuel their trading have withdrawn. They will not return anytime soon. In the currency markets this permanent drop in liquidity may keep price movement volatile long after calm has returned to other markets. It has substantially diminished liquidity in the yen crosses which were, for so long, the speculative favorites of currency traders.

Read More: Volatility and the Carry Trade

With the Dollar rallying to multi-year highs and the Yen surging to multi-decade highs, some analysts have begun to re-assess the possibility of Central Banks intervening in forex markets. As if on cue, leaders from the G8 countries also released a statement expressing their concern. It is not a stretch to say the last few weeks have been awash with stories about emerging market economies that have been destabilized as a result of the rapid depreciation of their currencies, as well as companies that were forced into bankruptcy as a result of currency speculation gone bad. Meanwhile, the US and Japan are certainly nervous about the impact of more expensive currencies on their respective export sectors. Ironically, it was only six months ago that some analysts were gaging the same probability of intervention; at that time, however, the purpose would have been to prop up the Dollar, whereas now it would be to bring it back down to earth. I suppose the moral of the story is that in forex terms, six months is practically an eternity. Besides, as we reported yesterday, both the Dollar and the Yen have already begun to fade. The Wall Street Journal reports:

"But, this is not a currency crisis" said a foreign exchange strategist. "This is a liquidity crisis, a growth crisis, a confidence crisis. As such, probably the first step should not be to intervene to save currencies."

Read More: Do Currencies Require an Intervention?

The British Pound is perhaps one of the worst victims of the credit crunch, having fallen 25% against the USD in the year-to-date. According to analysts, hedge funds deserve much of the blame. Apparently, most hedge funds, including those that are based in the UK, denominate their portfolios in terms of Dollars. As a result of the exodus away from emerging markets, such funds have found themselves awash in cash, which they have promptly converted into Dollars. The reasoning behind this investment strategy is twofold: first, as the incredible strength of the Dollar has illustrated, the prevailing wisdom among investors is that the US is currently the least risky place to invest. Second, the interest rate gap between the US and the rest of the world looks set to narrow, which means the yields on US security will become relatively attractive. The Telegraph reports:

Worldwide interest rate forecasts are being revised downward, which has increased interest in the US where rates have already been slashed.

Read More: Sterling caught up in ‘currency market tsunami’

While the Dollar rally may ultimately prove beneficial to US consumers (due to cheaper imports), it is certainly not helping US-based multinational corporations. Companies that earn a significant portion of their revenue abroad would normally be considered stable investments during times of economic uncertainty, since their exposure to individual economies is minimal. In the context of the current crisis, however, such companies have struggled; since they must report earnings in terms of USD, a strong Dollar is equivalent to lower earnings on foreign sales. Some companies have turned to hedging their exposure, while others have opted to either ride out the fluctuations and/or hope that they cancel each other out, banking on the notion that forex is ultimately a zero-sum game. Dow Jones reports:

To be sure, such global currency fluctuations are hard to manage and even those companies that do have hedges in place may only be able to limit and not completely offset the pressures of a strengthening greenback and oscillating exchange rates.

Read More: Multinationals Turn To Hedging To Manage Rising Dollar

One can usually assume that any talk of the carry trade is in reference to the Japanese Yen. In this case, however, it is the Dollar that is being driven by a shift away from the popular strategy of borrowing in one currency and investing the proceeds in assets dominated in another. In explaining the recent Dollar rally, analysts have tended to focus on the pall of risk aversion that has descended upon global capital markets, coupled with the spread of the credit crisis from the US to the rest of the world. While these are certainly contributing factors, perhaps they should also look at the repatriation of Dollars that were initially sent abroad over the last decade in search of loftier returns. Hedge funds and other institutions, including those based outside of the US, took advantage of record-low interest rates to borrow Trillions of Dollars and invest them abroad. Due to a combination of margin calls and client "withdrawals," however, such investors have been forced to not only unwind such positions, but return the proceeds of the US. The Guardian UK reports:

Data collected by the Bank for International Settlements shows that European and UK banks have five times as much exposure to emerging markets as US and Japans banks, with surprisingly big bets in Latin America and emerging Asia – where they rely on dollar funding rather than euros.

Read More: Dollar roars back as global debts are called in

Emerging Market currencies are becoming the latest victims of financial derivatives, proving Warren Buffet’s claim that such contracts represent "financial weapons of mass destruction." Apparently, companies throughout the developing world (although predominantly in Latin America) had used derivatives to bet on the strength of their home currencies, relative to the US Dollar. Given their record appreciation over the preceding few years, such bets probably appeared risk-less. As investors have fled emerging markets en masse, however, such currencies have tumbled. This has forced companies that had bet against the Dollar to rapidly unwind their derivative positions, which only caused their currencies to decline further. The Mexican Peso and Brazilian Real, to name the most prominent examples, are now in a virtual tailspin. Another "short squeeze" is probably not far away. The Wall Street Journal reports:

[Investors] had begun pulling money out of Mexico and other emerging markets. Since Aug. 1, the peso has dropped 24% against the dollar, and in October careened through its biggest daily drops since a 1994 currency crisis.

Read More: Big Currency Bets Backfire

Today marked the official launch of financial news website Tip’d, which combines news, social networking, and investing. The site enables users to upload news stories which fit into several categories of finance and economics. Stories are ranked in terms of popularity (based on the number of times that users "tip" them), with the most-read stories appearing on the front page. Users can post comments, as well as forge relationships with other users, perhaps based on common interests. I am posting about Tip’d here on the Forex Blog, because of the amalgamation of forex news that can be found on the site. In addition, the democratic nature of the site should ensure that only top-quality (or at least interesting) forex stories make the cut.

Update 1/15/09: The guys over at Tip’d have just posted this short video tutorial on how to use the site.

In times of financial crisis, investors can reasonably be expected to park their money in the least risky capital markets. In this case, that means those in the US and Japan. Compare this so-called "safe haven" trade with the "carry trade" that preponderated in previous years, as investors shifted capital away from Japan in order to earn higher yields. Now, as volatility surges to dangerous levels, investors are going to increasingly great lengths to mitigate risk. At least until the negotiations surrounding the US government bailout are resolved (whether in success or failure), big bets are off the table. In other words, few investors continue to scour the globe for yield, which eliminates the raison d’etre of the carry trade. Bloomberg News reports:

"These are not the right times to be putting on any bold trades because it’s the perfect environment for getting whipsawed,” said [one analyst]. "I think waiting on the sidelines is probably the most prudent thing to do.”

Read More: Yen Posts Biggest Weekly Gain Since May on Bailout Clash, WaMu

At the end of each quarter, banks usually make an effort to balance their books. As a result of the ongoing credit crisis, however, completing this task at the end of the 3rd quarter fiscal 2008 was nearly impossible for most banks. Fortunately, the Federal Reserve Bank intervened to relieve the situation. In conjunction with the world’s major Central Banks, the Fed moved to make hundreds of Billions of Dollars in short-term capital available to financial institutions. The Fed will utilize swap agreements, which involve the exchange of blocks of currencies at agreed-upon exchange rates on agreed-upon dates. These particular swaps should help both to mitigate the shortage of Dollars on the open market and to further buttress the Greenback. AFP reports:

These expanded facilities will now support the provision of US dollar liquidity in amounts of up to 120 billion dollars by the ECB and up to 30 billion dollars by the Swiss National Bank.

Read More: Global central banks offer more dollars to markets

Read the rest of this entry »

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.

Read More: Don’t Lose Sleep Over Forex

There are four banks which dominate the market for exchange-traded currency instruments. In order of marketshare, they are Rydex, PowerShares, Wisdom Tree, and Barclays. By coincidence- or perhaps not- the leading three use an ETF structure, while Barclays’ products are issued as ETNs. While technically the two forms differ from each other in that ETFs are akin to equity while ETNs function as debt, in practice they are interchangeable. Barclays, itself, has certainly not connected its poor market share with this distinction. Its latest product, a composite of eight Asian currencies, assumes an ETN structure. Furthermore, two additional regional currency ETNs are in the planning stage, focused around Eastern Europe and Latin America, respectively. Seeking Alpha reports:

"If you look at the history of timing on Exchange Traded Product launches…you would likely see a lot of products launching right after run-up and launching right into a decline, so I’d rather launch after a decline and into a run-up."

Read More: The Birth of a Barclays Currency ETN

The Yen has been hammered over the last month, by both the sudden strength of the Dollar and increasing comfort with risk-taking. Now that the US government is set to bail out the two American mortgage giants, Fannie Mae and Freddie Mac, investors are likely to become even more confident that the global economy is in strong enough shape to weather the credit crisis. As demand for risky investments- such as stocks and high-yielding currencies- grows, the Yen (because of low interest rates) will once again find itself as one of the main funding currencies for the carry trade. Of course, risk-aversion is a two-way street, and one stumble in the US economy, for example, would benefit the Yen. Bloomberg News reports:

"The yen is likely to take a hit. A government bailout will certainly stabilize Freddie and Fannie and improve risk appetite for carry trades."

Read More: Yen Drops Most in 3 Months as U.S. Takes Over Fannie, Freddie

While the factors affecting gold are no doubt nuanced, its popularity is primarily vested in the belief that it represents a stable alternative to the Dollar. Accordingly, as the Dollar fell over the last five years, gold prices soared. Likewise, the ongoing Dollar rally has been matched by a proportional decline in gold prices. However, at least one analyst believes this link could soon break down. While gold is traditionally viewed as a specific protection against US inflation (and the concomitant Dollar depreciation), perhaps its role could expand to offer protection against worldwide inflation.

For example, analysts largely agree that the Dollar rally is as much a product of global economic weakness as of US economic recovery. In fact, the monetary and economic situation in the US continues to deteriorate. But, the global economic situation is deteriorating even faster. By this standard, it is conceivable that the Dollar could continue to outperform its rivals. Meanwhile, it is also conceivable that gold would continue to rise, since the long-term economic picture of the US remains bleak.

Read More: Will gold now move separately from the US dollar and euro?

John Taylor is head of the world’s largest currency hedge fund, International Foreign Exchange Concepts. Accordingly, when he speaks about currencies, people tend to listen. In an extended interview with Bloomberg News, Taylor noted that volatility has surged in the forex markets. On average, the Dollar is fluctuating 46% more against so-called major currencies and 23% more than emerging currencies, compared to 2007. However, this volatility is largely random- perhaps as a result of increased liquidity- which means inefficiencies in the markets are becoming harder to exploit and profit from. One of the fund’s largest bets is against the US Dollar, specifically against the Euro. Taylor’s rationale for this bet is nuanced, and is more fundamental than technical, which is surprising given his fund’s primary trading strategy. Bloomberg News reports:

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.

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

Over the last few years, the inverse relationship between the price of oil and the value of the US Dollar has been remarkable. As the Dollar has fallen to record lows, oil has risen to record highs. Now, with a massive Dollar rally underway, the price of oil has virtually collapsed. This relationship is understandable, since expensive oil contributes to the US trade deficit and crimps the economy, while the weaker Dollar, in turn, drives oil-producing countries to charge more in Dollar terms for their oil so that the price remains constant in absolute terms.

However, there are signs that this link may be coming to an end. Hedge funds, which are famous for spotting such trends and riding them to profitability, are winding down their long/short positions in currency and commodity prices because such strategies have evidently become unprofitable. Apparently, analysts and traders expect other fundamental factors to assume control over the price of oil and the Dollar. Namely, the still-unfolding credit crisis and the projected long-term supply/demand imbalance in energy markets will become more relevant. In short, don’t expect a further drop in the price of oil to necessarily help the Dollar, and vice versa.

Read More: Dollar-Oil Relationship In Doubt As Market Drivers Diverge

Yesterday, the Forex Blog published a commentary piece exploring the rally in the Dollar that is currently under way. While the rally is strongly grounded in fundamentals (falling commodity prices, the spread of the credit crisis to the rest of the world), some traders are nonetheless crying foul. They claim that the European Central Bank (with or without the assistance of the US) furtively intervened in forex markets to the tune of 10 Billion Euros. Even if their claim is true, it is unlikely to have meaningfully contributed to the Dollar rally, since the amount in question is quite small. Central Bank intervention would require an expenditure of at least $100 Billion to be even partially successful. Japan, for example, has spent nearly $1 Trillion (if its foreign exchange reserves are any indication) holding down the Yen over the last decade. Besides, the Dollar rally is unsurprising, given certain recent economic developments and the benefit of hindsight. Minyanville.com reports:

Whenever global liquidity tightens relatively speaking, it is very US$ supportive. Obviously, there are always time lags between economic events until the the market perceives them. So as a result of weak demand in the US, lower imports, the demand for oil declines, and that led to a tightening of global liquidity which led to the strong dollar

Read More: Currency Intervention and Other Conspiracies

Forex Capital Markets (FXCM) recently unveiled a new offering aimed specifically at retail forex traders interested in trading small lots of forex. The new type of account is appropriately termed "FXCM Micro," and can be funded with as little as $25. It will feature extremely tight spreads- as little as .015%- and automatic execution. By its own admission, FXCM is only able to offer such a competitive product because it maintains extremely low overhead and support costs. The product is quickly gaining notoriety, and 15,000 accounts have already been opened. Those wishing to dip their feet into the pool of forex without wetting their entire bodies should take note.

Read More: FXCM Micro

The USD is officially trending upwards, having appreciated over 7% against the Euro in only a few weeks. Of course, hindsight is 20/20, and some analysts now claim that support for the Dollar had been building for several months. They point out that the first break for the Greenback came in March when the Fed stopped lowering interest rates. Then, at a meeting of the G8 nations, several high-ranking officials indicated that they were unhappy with the recent decline of the Dollar and suggested that coordinated intervention should be effected in order to prevent a further collapse of confidence. While this "verbal intervention" was ultimately not backed by any kind of substantive action, investors apparently took the hint.

Further comments by America’s Federal Reserve Bank and the Secretary of the Treasury made clear that the US remained committed to the Strong Dollar Policy. A reprieve in the rise of commodity prices, followed by the proposed bailout of the two cornerstones of American’s sprawling mortgage industry, convinced currency traders that the world’s economic policymakers simply would now allow the Dollar to fall further. Lo and behold, the Dollar failed to break through a resistance level at $1.60/Euro (near a record low), and has since rallied sharply. The International Business Times reports:

It seems that that the big money had committed to a long Dollar, and was waiting for the economic slowdown to spread to the Euro Zone. Once the Euro Zone began to experience a slowdown, it just became a matter of time before the short positions that had been built for several months would pay off.

Read More: U.S. Dollar Takes Control of Forex Markets

As the credit crisis has unfolded, the Dollar has remained (relatively) strong, especially considering the deteriorating state of its economy. The reason for this, of course, is that in times of crisis, investors flock to perceived safe havens, such as the US and EU. However, an especially pessimistic series of economic developments has called into question the wiseness of this strategy. A handful of American banks and mortgage institutions have already collapsed, and bankruptcies in all sectors of the economy will surely become more common. The picture in Europe is equally bleak. Several economic indicators have fallen to multi-year lows, and the ECB’s decision to hike rates looks increasingly misguided. Given these circumstances, where can investors turn? Perhaps, to Japan and Switzerland, reports The Market Oracle:

The Swiss franc and the Japanese yen…were the great beneficiaries during the Crash of ‘87, the Debt Crisis of 1998 and again during the current credit crisis, enjoying sweeping and massive upward moves.

Read More: Crisis Currencies Poised to Surge as Frightened Capital Flows from Risk to Safety

Earlier in the week, the Forex Blog reported that the potential for intervention in the forex markets seemed to have declined, due to a brief Dollar rally and toned-down rhetoric at the most recent G8 conference. However, we would be remiss if we didn’t point out that the intellectual justification for intervention remains. While statistics have not been forthcoming, it appears that Sovereign Wealth Funds and Central Banks are paring their exposure to Dollar assets, which is both a cause and effect of Dollar weakness. In addition, the falling Dollar and rising oil prices have reinforced each other, and contributed to surging inflation around the world. Investment Banks are advising clients now would be a perfect time for the world’s economic policymakers to take coordinated action. GoldSeek.com reports:

In his testimony yesterday, Ben Bernanke, stated that “dollar Intervention should be done rarely” but that it “may be justified in disorderly times.”[In addition,] Treasury Secretary Paulson said last month that he would never rule out currency intervention as a potential policy tool.

Read More: U.S. Government To Intervene in Markets to Prevent Run on the Dollar

Typically, only the savviest (or the most foolish) of forex traders dabble in currency options. Leverage is already so high (often exceeding 100:1) when trading forex directly, that the additional leverage gained from trading options can seem unnecessary. However, even if not trading options, you would be wise to at least pay heed to options prices. The reason is that movements in the options market often precedes movements in the forex markets.

To explain further, the premiums built into options contracts serve as a proxy for demand for those particular currencies. When premiums on call contracts, which give the holder the right to buy a particular currency at a fixed price, are unusually high, it signals a "risk reversal;" the currency may be overbought. To offer a practical example, call premiums on EUR/USD contracts are approaching a one-year high, which has led some analyst to speculate that a Dollar rally is just around the corner. MarketWatch reports:

"Whenever risk reversals hit critical levels, it indicates that everyone who wants to be long euros are already long and as a result, sentiment has hit an extreme." The last time euro/dollar risk reversals were that high….a U.S. dollar "relief rally" followed.

Read More: Forex options market held clues to dollar’s moves

Over the last few months, the Dollar has bounced up and down against the Euro, but never breaking out of a range defined by $1.53 and $1.60. Analysts remain divided not only over if the Dollar will soon break-out, but also over whether its next major move will be upwards or downwards. The recent Dollar upswing has led some to speculate that more permanent strength is inevitable, but naysayers note that this rebound was a product of lowered oil prices, caused by global economic weakness, which is actually Dollar-negative. According to a recent poll, though, the bulls outnumber the bears; the consensus forecast for the Dollar 12 months from now is $1.50. The Wall Street Journal reports:

A Dow Jones Newswires survey last week of 23 analysts forecast the dollar would
begin to recover on longer-term basis.

Read More: Dollar Likely to Extend   Downward Euro Spiral

Without exception, every time there is a period of sustained volatility in forex markets, a flood of new forex accounts are opened as new traders try to capitalize on the action.  Also, without fail, a concerned journalist inevitably takes it upon himself to warn these would-be profiteers that trading forex is risky, as if that were not abundantly obvious. This past week is a perfect example, as the Dollar touched a record low against the Euro on the basis of credit concerns. One columnist pointed out the significant upside potential of purchasing a CD denominated in foreign currency, but also implored investors to hedge their exposure and limit leverage. His advice: diversify by buying multiple currencies and/or equities for foreign companies and/or exchange traded funds based on hard-to-mimic strategies. Marketwatch reports:

[He] recommends…hedging your bets in you think the dollar will continue to weaken…[through] specialized mutual funds or exchange-traded funds that move inversely to the dollar. He holds the Pro Funds Falling U.S. Dollar Fund

Read More: Foreign currency trading is as risky as it gets

2008 has witnessed an explosion of volatility in emerging markets, affecting both debt and equity securities. Fluctuations have been especially dramatic in the forex markets, compounding the turmoil and skewing returns for foreign investors. The South African Rand and Brazilian Real, for example, have moved so violently that for both countries, a 10% gap distinguishes the returns earned by local and foreign investors. As a result, some institutional investors are re-examining their hedging strategies with regard to emerging markets. According to experts, currency hedging among equity investors is still rare because it is expensive and often complex. If hedging is undertaken at all, it is usually outsourced to a third-party. Some investors are quite dogmatic in their insistence that hedging is a complete waste of money, and argue instead that diversification (into different countries/currencies) represents a "natural" hedge. Since, the net change in exchange rates must ultimately be zero, a diversified, long-term approach to investing in emerging markets may automatically mitigate against currency risk. The Guardian reports:

"Currency movements tend to be noisy but over the long term they are just reflective of the economy and not the driver of economic performance."

Read More: FX swings wreak havoc with emerging equity returns

Global capital markets remain caught in a tug of war between inflation and economic growth. For most of 2008, the economic growth story prevailed as the Federal Reserve Bank cut interest rates aggressively to cushion the blow from the housing crisis. However, the pendulum soon swung to inflation and the Fed began to worry that perhaps it had lowered rates too far and may in fact need to hike them in response to surging food and fuel prices. In fact, the European Central Bank recently hiked its benchmark interest rates. Now, a slew of negative economic data threatens to shift the rhetoric back to the other corner. Securities and currencies have fluctuated wildly over this period, and investors remain unsure about which side the world’s Central Banks will err on. Currency traders need to look no further than credit markets for a snapshot of the current consensus, which often presages changes in currency valuations. A quick and dirty analysis would place American and Euro-zone short-term bonds side by side and compare the yields (or prices), as a proxy for the EUR/USD exchange rate. The Wall Street Journal reports:

Two-year yields in all three markets have been on a wild ride in June, driven up by tough inflation rhetoric from central banks, then down again by renewed worries about the credit crisis and the state of financial markets.

Read More: Inflation and Growth   Compete for Attention

In the context of fundamental currency analysis, we usually talk about inflation, interest rates, economic growth, politics, etc. But perhaps these variables mask some deeper "truth" in forex, specifically that there is some ultimate "force" guiding the decision-making processes of forex traders. What we are really talking about here is comfort with risk. Especially in the medium-term (the short-term consisting of hours and defined by randomness and the long-term consisting of years and defined by relative changes in the money supply), investors are constantly re-evaluating the level of risk that they want to assume.

To make this idea more concrete, let’s look at how the credit crisis has impacted forex markets. In general, it has favored major currencies, such as the Dollar and the Euro, although sometimes one more than the other. This is to be expected since the capital markets of the US and the EU are the most stable and in times of uncertainty, investors seek out stability. Likewise, the Japanese Yen has fared well. Despite a continuation of its easy money policy, investors have unwound their Yen carry trade positions, ever-fearful that a spike in volatility could cost them dearly. On the other end of the equation are emerging market currencies and beneficiaries of the carry trade, which have faltered as investors pare their exposure to risk. The underlying narrative is the same; only now, investors are willing to accept lower returns in exchange for proportionately lower risk. 

Volatility, the perennial enemy of the carry trade, has returned with a vengeance. The US stock market, a proxy for global risk appetite, has fallen significantly (nearly 20%) over the last six months, a trend that has accelerated over the last two weeks. By no coincidence, the Japanese Yen and Swiss Franc have rallied dramatically over the same time period. On one hand, currency trading is seemingly becoming more cut-and-dried, as correlations strengthen between different sectors of the global capital markets and specific currencies. The respective inverse relationships between the Dollar and oil, and between the Yen and US stocks, have been particularly strong of late. In the end, though, it is anyone’s best guess whether the price of oil will continue to rise and stocks will continue to fall. Reuters reports:

"We’re back on the brink," said one analyst. "It seems there is a feeling of resignation and helplessness amid this credit crisis."

Read More: Yen and Swiss franc gain as risk appetite fades

The field of currency exchange-traded products keeps getting better and better. Only a few years ago, the selection of such products was quite small, and limited to the major currencies (i.e. Dollar, Euro, Yen).

Next came the introduction of riskier currencies, namely those of the so-called emerging markets, such as the Mexican Peso, Brazilian Real, Indian Rupee, and most recently the Chinese Yuan. This was followed by multi-currency and strategy funds, such as the Dollar Bearish fund and a Carry Trade fund.

This brings us to the present day, where Barclays Capital has brought to the market the Asian and Gulf Currency Revaluation ETN. As its name suggests, this ETN aims to capture any gains from the revaluation of five select currencies that are currently pegged to the Dollar. Index Universe reports:

The index currently includes the currencies of Saudi Arabia, Hong Kong, the United Arab Emirates, Singapore and China…Many expect these currencies to have their pegs adjusted upward, creating a potentially low-risk investment with significant upside in the event of a revaluation.

Read More: Pegged Currency ETNs

The Carry Trade is one of the simplest strategies in forex, and if executed correctly, can also be one of the most profitable. The basic mechanics of a carry trade involve borrowing in one currency that offers a low interest rate, and selling it in favor of a higher-yielding currency, in order to capture the interest rate spread. This strategy carries two key risks. The first risk is that the "long" currency will depreciate. This also includes country risk, the possibility that political or macroeconomic instability will adversely affect the long currency. Then, there is the risk that the interest rate differential will change such that the spread shrinks, and a smaller carry is earned. For a while, the most popular funding currency was the Japanese Yen, with its negative real interest rates. Now, however, the Dollar has become a popular funding currency, due to low interest rates and a self-fulfilling belief that it will continue to depreciate. It should be noted that there are variations to the carry trade, which may involve combinations of currencies and hedging. SeekingAlpha reports:

Another way of protecting against the downside is to write covered calls. Depending on the size of your investment and your risk preferences, either short selling or writing a covered call will let you sleep better.

Read More: The Burden of the Carry Trade

In a recent article for Seeking Alpha, financial journalist Ray Hendon offered an overview on the four principal strategies employed in the forex markets: carry trade, technical trade, fundamental trade, and arbitrage. The carry trade, which involves borrowing in a low-interest rate currency and buying a higher-yielding currency, can be undertaken by either buying ETF(s) or by trading directly using a retail forex account. The ETF route can be further subdivided into two possibilities: to buy a particular currency ETF to take advantage of the spread, or instead to buy one of two ETFs (symbols: ICI & DBV) that use computer models to mimic the carry trade.

Currency traders are probably familiar with the second and third strategies: technical trade and fundamental trade. Hendon refers to the technical trade as "momentum trade" but this is overly simplistic. Traders employing a technical strategy can make use of a range of technical indicators designed to show where a particular currency pair is headed in the short term. On the other end of the time horizon is the fundamental trade, which usually involves a long-term commitment. Fundamental trades make use of differentials between countries/currencies which can involve economic growth, inflation, interest rates, even politics, to try to determine whether a particular currency is undervalued or overvalued. 

Finally, there is the arbitrage trade, in which traders attempt to spot minute differences in currency pairs that trade in different markets. There is also the possibility of triangular arbitrage in which the respective exchange rates between 3 currency pairs aren’t congruent. However, Hendon concedes that such trades have become the bastion of institutional investors which make use of sophisticated computer models to instantly identify and profit from arbitrage opportunities, which limits the average retail trader to the three strategies listed above.

Read More: Strategies for Currency Investors

Most of the stories and analysis featured on the Forex Blog concern the Dollar, or at the very least, how other currencies are performing relative to the Dollar. But there are many important currency pairs that don’t involve the Greenback, including the Euro/Yen. Last week, the Euro climbed to its highest level in 2008 against the Yen, thanks to diverging economies and interest rates. Neither economy is particularly strong, but the Bank of Japan is using especially bearish language to describe its faltering economy. It should be noted that despite a prolonged period of economic growth, the Bank of Japan avoided raising interest rates even once. Meanwhile, the European Central Bank is becoming increasingly hawkish in its monetary policy rhetoric. The result has been a sustained (and soon-to-widen) interest rate differential, which has contributed to a dynamic that is unique to these two currencies. Bloomberg News reports:

The yen fell against every major counterpart today after a government report showed Japan’s longest postwar expansion may be over.

Read More: Euro Climbs to Year’s Highest Against Yen on Rate Speculation

George Soros, one of the most well-respected investors who sits in the same echelon as Warren Buffet, just released his book on the current state of the world’s financial markets. His conclusion is that a "super-bubble" is forming. Connecting to all of the major financial markets, namely property, commodities, and equities, Soros outlines how the expansion in credit that has unfolded over the last 30 years has caused an unsustainable run-up in the prices of most investable assets. Due to the resulting inflation, investors are now fleeing en masse from mainstream securities and parking their money in commodities, triggering a super-bubble therein. With regard to the Dollar, Soros expects the currency to fall as the credit crisis runs its course and Central Banks gradually replace it with more stable currencies. CBC reports:

I think that the dollar is probably still, will emerge as the most widely used currency but the United State will have to abide by the limitations that are imposed on it by the willingness of the rest of the world to hold dollar reserves.

Read More: Bubbles building in financial markets

After sinking to a record low of $1.60 against the Euro in April, the Dollar has rallied to a 3-month high. According to analysts, the interest rate story appears to have driven the sudden reversal. In short, expectations surrounding the EU-US interest rate differential are changing, such that investors now believe the ECB will begin lowering rates just as the Fed begins hiking them. This story is also consistent with the broader economic picture, whereby the Fed is shifting its attention from the economy to inflation, while the ECB is doing the opposite. Meanwhile, the Treasury yield curve has gradually expanded in order to reflect expectations for higher medium-term interest rates. It doesn’t look like the Dollar will be a funding currency for carry trades for much longer. Thomson Financial reports:

John Noonan, a senior foreign exchange analyst at Thomson IFR, said the hawkish turn in Fed expectations is coinciding with a growing view that the euro zone economy will suffer more from the U.S. economic fallout than previously thought.

Read More: Dollar near 3-month highs vs euro on U.S. GDP revision

The slight recovery of the USD has been accompanied by a couple of other interesting trends: falling gold and oil prices, and rising equity and bond prices. What is the connection here? With regard to gold and commodity prices, the prevailing theory was previously that high prices were caused not by supply issues, but rather by the Fed’s easy monetary policy, which was stoking the embers of inflation. The recent rise of the Dollar has poked a broad hole in this theory, because of the simultaneous fall in prices for certain commodities, namely gold. This has led some analysts to conclude that commodity prices are fluctuating irrespective of the Dollar.

With regard to oil, there does exist a 95% correlation between the price of oil and the EUR/USD exchange rate. However, it now appears that strong oil had been driving the weak Dollar, and not vice versa. The Dollar is also deriving some impetus from a rally in equity and bond markets, which have outperformed their European rivals.  Bond yields remain lower in the US, but with the stabilization of the Dollar, perhaps foreign investors will be convinced that the US is the least risky place to invest during the global economic downturn.

Read More: The dollar rallies at last

"The credit crisis is over! No it’s not! Yes it is!"

Such back and forth represents the tenor of the debate currently transpiring in the financial markets. Every day seems to bring new economic data, which is quickly seized upon by both sides as evidence for their respective positions, causing the markets to rise and fall accordingly. In this regard, the Japanese Yen and the Swiss Franc serve as proxies for investor sentiment. When the markets rally, investors are quick to dump both currencies in favor of higher-yielding alternatives. On the other hand, when a large investment bank announces a write-down on its subprime investments, or when economic data indicate falling housing prices, investors are quick to unwind their short positions (carry trades). The advice of the Forex Blog is to take every development in stride and to remember that no definitive conclusions can be reached at this point.

Read More: Yen Weakens on Speculation Worst of Financial Crisis Is Over

WisdomTree and Dreyfus Funds recently unveiled five new currency ETFs in order to fill a broad gap in the emerging markets category. Previously, investors were limited to such mainstay currencies as the US Dollar, Euro, Japanese Yen, British Pound, Australian Dollar, Canadian Dollar, and Swiss Franc. These new ETFs will expand this list to include the Indian Rupee, Brazilian Real, and the much-anticipated Chinese Yuan. It will also offer products for the Euro and Yen, but these probably won’t draw much attention. The RMB ETF, especially, will be pounced on by investors, who have been clamoring for years for a cheap and easy way to capture the upside of the Yuan’s inevitable appreciation. In addition, all of the ETFs will also return modest yields based on prevailing interest rates in the representative countries. Reuters reports:

In the case of India, Brazil and China, the yields on the ETFs may differ from yields available locally due to restrictions on foreign investors.

Read More: WisdomTree, Dreyfus to offer five currency ETFs

The anecdotal evidence for surging retail interest in forex is cropping up everywhere. Moreover, investors are no longer even limiting themselves to the spot market, utilizing derivatives to speculate on future exchange rates. In the UK, for example, 10% of investors intending to purchase real estate in the EU are utilizing forward agreements to hedge their exposure to the Euro, which has risen 10% against the Pound since the beginning of 2008. Evidently, prospective home buyers are hoping that the Euro returns to 2007 levels, which would significantly lower the cost of buying property there. However, if the Euro continues to appreciate, such investors could end up losing more than they bargained for. Homes Worldwide reports:

Even the movement in the markets over a couple of days can make the difference between owning a property and no longer being able to afford it.

Read More: Brits Gambling On Volatile Currency Markets

The word "parity" is becoming a mainstay of traders in the forex markets.  In 2007, it applied to the Canadian Dollar, which had rallied 70% over the course of five years to reach the mythical 1:1 level against the USD.  This year, it is the Australian Dollar that is threatening to surpass the Dollar in value. The AUD has always benefited from general USD weakness, but now the focus is shifting to the AUD, itself. The most recent Australian price data suggests that inflation in Australia remains problematic, which could force its Central Bank to raise the benchmark lending rate to 7.5%.  In addition, high commodity prices and consequently strong exports should provide demand for the currency. As always, analysts are divided over the likelihood of parity, but that hasn’t stopped them from bandying the term about. The Australian Age reports:

Parity was never a "ridiculous suggestion." "But it’s probably a bit tougher going because the Australian economy is slowing," says one analyst. "Then again, if you saw a reacceleration in growth, that might be a different story."

Read More: Our dollar on a roll…

Forex Capital Markets (FXCM) recently unveiled a product that represents a viable alternative to currency exchange trade funds. A currency ETF is "index-passive" because it is linked to an index and rises and falls in line with the value of the currency with which it is associated.  FXCM’s Enhanced Dollar Index programs, however, are "actively managed" and  aim to capture all of the upside of currency movements with only some of the downside. This is achieved through sophisticated trading algorithms that combine a leveraged index approach with market timing and directional investing. To explain in more concrete terms, a leveraged investment in a Dollar ETF would yield an above-market return if the ETF appreciates, but a proportionately below-market return if the ETF loses value.  The Enhanced Dollar Index Program, in contrast, would yield the same above-market return in the first scenario but a smaller loss in the second scenario.

Read More about FXCM Enhanced Index Programs

The USD continues to dominate conversation in forex circles, as investors ponder whether the currency will fall further or whether it has already sunk as low as it can go. One commentator recently encapsulated the debate into six factors, three bullish on the Dollar and three bearish.  Number one on the side of bearishness is the interest rate situation. Short term US rates are negative in real terms, and savvy investors are using the Dollar to fund carry trades in order to take advantage of higher yields outside the US. The second and third factors are technical: based on one measure, the Dollar is not nearly as "oversold" as it was in 1992, the last time the Dollar suddenly reversed a multi-year decline.  In addition, the "open interest" on the Euro is not as large as it should be if traders were preparing to dump it.

First on the list of factors supporting a bullish outlook is the US recession. This is somewhat counter-intuitive, but history shows that US economic weakness typically coincides with Dollar strength.  Perhaps this is because many countries depend on the US to drive the global economy.  In fact, the Dollar is already rising against certain emerging market currencies that rely on the US as an export market. In addition, overseas investors tend to park their capital in the US during periods of global economic instability because of its continued reputation as a safe haven.  Second, the economies of the UK and the EU are already weak and growing weaker every day.  The only reason their respective Central Banks have not eased monetary policy is because they are also focused on combating inflation. However, they may soon have to sacrifice price stability in favor of economic growth, at which point interest rate differentials will begin to reverse themselves in favor of the US.  The final reason for bullishness is technical; based on a series of indicators different from those listed above, the Dollar IS oversold  and the recent slip downward may presage an upward shift.

Read More: Has the U.S. Dollar Bottomed?

For a recent article, EuroMoney Magazine pulled together some of the top currency analysts on Wall Street for a comprehensive discussion on the state of forex.  The conversation zigs and zags, covering such varied topics as volatility, interest rates, trading strategies, emerging markets, central banks and market infrastructure.  Among other things, it was noted that volatility has surged by 50% since the inception of the credit crunch, returning to levels last seen at the beginning of the decade.  One of the participants broached the possibility of deflation, but that was quickly dismissed by the others due to surging food and energy prices. It was also noted how Central Banks are caught between fighting inflation and facilitating growth, in deciding whether to raise or lower rates, respectively. The main theme in the markets is the sagging Dollar, which is being punished for both economic and strategic reasons as investors sell it in response to the economic downturn and to fund carry trades. Finally, one participant commented that despite growth in liquidity, forex strategy hasn’t evolved much, and the markets remain vulnerable to a huge sell-off due to the "mob mentality."

Read the Discussion in its Entirety

With average daily turnover of $3 Trillion, the foreign exchange markets are the largest financial markets in the world.  Despite boasting such impressive volume and liquidity characteristics, forex is nonetheless considered extremely risky, and thus viewed as the bastion of experienced traders.  This is slowly beginning to change, as investors have moved to diversify their portfolios away from the traditional allocation of stocks, bonds, and cash.  Investing directly in forex still not recommended by financial advisers.  However, there exist alternative strategies, such as buying CDs denominated in foreign currencies and/or securities that are issued by foreign companies and trade on domestic exchanges.  These kinds of "indirect" strategies typically take the form of either "single play" or "double play" strategies. With both strategies, investors attempt to profit through cross-border interest rate disparities, but with "double play" trades, investors seek to profit from currency appreciation as well. The New York Times reports:

Mr. Orr advised currency buyers to research foreign nations and their credit risks, determine at the start their own risk-reward ratio and tolerance to volatility, and have exit strategies, while watching their positions constantly.

Read More: While Alluring, Foreign Currencies Can Be Elusive

The last week has seen a spate of positive developments in the financial markets, including reassurances by several bulge bracket investment banks that their respective capital positions are in strong and in no need of shoring up. As a result, some analysts are speculating that the worst of the credit crunch has already been priced into securities and the USD, and that actual write-downs on subprime mortgage obligations won’t match the "Himalaya-like guesstimates." At the same time, job losses are mounting and the unemployment rate recently crossed 5% for the first time in two years. Interest rate futures contracts suggest a 20% chance that the Fed will cut rates by 50 basis points at its meeting on April 30. Then, there is the ECB, which has been vocal about fighting inflation and European financial markets, which have benefited from "domestic" investors diversifying within the EU rather than to the US.  Thus, there is no definitive answer regarding where the Dollar is headed in the near-term: everyone seems to have their own opinion.  Bloomberg News reports:

The Dollar Index traded on ICE Futures in New York, which tracks the currency against those of six trading partners, dropped 0.2 percent to 72.049, its third straight decline. It was at a record low of 70.698 on March 17.

Read More: Dollar Falls Against Euro; Report May Show Payrolls Declined

In recent months, the credit crunch has ignited a global trend towards risk aversion.  As a result, a correlation has developed between equities, which serve as a proxy for risk, and certain currencies.  The Forex Blog previously covered the link between the S&P 500 and the Japanese Yen, whereby the Japanese Yen moved inversely with the S&P as a decline in  risk appetite led carry traders to unwind their positions. Perhaps, this connection can be seen in other currencies.  Since the forex markets are open 24 hours a day and are the most liquid financial markets in the world, macroeconomic events are often priced into currencies before they are priced into equities. In addition, carry trading strategies have expanded beyond the Japanese Yen.  In fact, the USD is now a decent candidate as interest rates are negative,when adjusted for inflation.  Thus, an increase in risk appetite could simultaneously boost the S&P and punish the Dollar!

Read More: Using Currencies to Time Equity Moves

In the first three months of 2008, the USD notched its worst quarterly performance since 2004, falling over 8%. During the same period, the Dollar lost 10% of its value against the Japanese Yen and 6.4% against a broad basket of currencies. Forex analysts reckon the slide was so steep because investors have taken stock of the US economic situation and have concluded that recession is inevitable. The story is also being driven by interest rates. The Fed has already cut rates by 300 bps in the current cycle of easing, making the benchmark federal funds rate the lowest in the industrialized world, in real terms. Meanwhile, the European Central Bank is giving every indication that it will maintain rates at current levels in order to keep a lid on inflation. As a result, the Dollar could fall further, especially if the Fed continues to hike rates and investors use the currency to fund carry trades. Reuters reports:

[According to one analyst], "And to call a bottom now is still a very risky call. It’s too early to say the worst is behind us and the dollar’s in for a sharp rebound."

Read More: Dollar logs weakest quarter vs euro since 2004

Through its trademark iPATH line of funds, Barclays Bank recently introduced a new ETN designed to mimic the carry trade.  In accordance with this strategy, this note is linked to  the performance of the Barclays Intelligent Carry Index, which aims sell low-yielding currencies and use the proceeds to invest in those that offer higher yields.  This index holds varying combinations of the so-called G10 currencies, which includes all of the majors as well as the Norwegian Krona and Swedish Krona.  Traditionally, carry traders have sold one specific currency (i.e. Japanese Yen) in favor of another currency (i.e. the New Zealand Dollar).  By instead purchasing this note, which will trade under the ticker ICI, investors can buy a share of an entire portfolio, optimized expressly for this strategy. Comtex reports:

The index is composed of ten cash-settled currency forward agreements, one for each index constituent currency, as well as a "Hedged USD Overnight Index" which is intended to reflect the performance of a risk-free U.S. dollar-denominated asset.

Read More: Barclays Launches New iPATH ETN

Since 2002, the Dollar has lost 70% of its value, relative to the Euro.  Meanwhile, the same factors that signaled bearishness in 2002 persist in 2008, or even worsened in some aspects.  The twin deficits are still growing, though the current account deficit may be leveling off.  The US economy is headed towards recession.  Inflation is set to rise due to soaring commodity prices and a loosening of monetary policy.  As a result, many investors are betting that the Dollar’s slide will continue well into the near future.

However, prudent investors would be wise to "handle with care." While not entirely applicable to forex markets, efficient markets theory dictates that inherent in a security’s current valuation is all relevant, publicly available information. Thus, all of the bad news listed above has already been priced into the Dollar, to some degree at least. The rule of diversification is in full effect when betting on forex. Thus, rather then putting all of one’s chips directly behind one currency, an investors could buy foreign securities (stocks and bonds) instead, which also capture any currency appreciation (and depreciation).  Investors can also purchase Treasury Inflation Protected Securities (TIPS), whose yield is linked to inflation and, thus, acts as a hedge against a declining Dollar. The Wall Street Journal reports:

While some market watchers believe the six-year dollar bear market isn’t over yet, investors should recognize that trends in the currency markets are typically marked by volatile ups and downs along the way.

Read More: Don’t Bet the Farm on Dollar’s Skid

After the Fed cut its benchmark lending rate by 75 basis points last week, the Dollar immediately rallied 2.5% against the Japanese Yen, marking its highest daily rise in nine years.  Some analysts are at a loss to explain this phenomenon, since a narrower interest rate differential should have produced the opposite effect.  Perhaps, the answer can be found in the carry trade, whereby investors sell Yen in favor of higher-yielding currencies.  Support for the carry trade typically moves inversely with volatility.  For example, when risk aversion rises due to economic uncertainty, investors typically unwind their carry trade positions.  With the Fed rate cut last week, however, risk aversion actually fell, and the S&P 500 Index surged.  By no coincidence, the Yen fell. Reuters reports:

As U.S. stocks rallied, with investors willing to take on more risk, the dollar recouped some of Monday’s sharp losses versus the low-yielding yen.

Read More: Dollar posts biggest gain vs yen in nine years

Last week, the Euro retreated from the record high of $1.60 that it achieved earlier in the week. Policymakers are still concerned, however, and are perhaps using this lull to come up with a plan of action should the Dollar resume its slide. In fact, the consensus among analysts is that coordinated intervention is likely if the Euro crosses a certain threshold- perhaps $1.65. In order to be successful, the intervention would need to involve the Federal Reserve Bank and the European Central Bank principally, as well as the peripheral participation of the Central Banks of Switzerland, Japan and England.  The situation is complicated by the monetary policy of the ECB, the tightness of which is causing the interest rate differential with the US to widen dramatically. Already, volatility levels in forex markets are slowly climbing, suggesting that investors are bracing themselves for a big move.  The Guardian UK reports:

ECB Executive Board member Lorenzo Bini Smaghi said in a speech on Tuesday markets sometimes overshot, with possible negative implications for the world economy. Since his speech, the dollar has strengthened by almost 2 cents against the euro.

Read More: Euro intervention edging nearer, but still distant

In a recent commentary piece, the Market Oracle used the analogy of baseball to outline why this will be an "off year" for the Dollar, listing three reasons to support its claim. Consumer spending was listed first because it represents the largest component of US GDP.  Since much consumption is financed through borrowing and since the credit crunch has forced banks to rein in lending, the Oracle reasoned that consumer spending will be especially hard hit. Next, there is the worsening employment picture. As its moniker implies, the "jobless recovery" that has characterized the US economy over the last few years did not add many jobs, and due to the economic downturn, jobs are now being shed.  Finally, the Market Oracle has identified the Federal Reserve as a primary contributor to the decline of the Dollar. While the Fed is trying to shore up the economy, it is simultaneously enabling inflation.  Thus, even if the battle is won and recession is averted, the Fed may still find that it has lost the war- on prices.

Read More: Three Strikes Against the U.S. Dollar

Over the last couple weeks, the Dollar has plummeted against all of the major currencies, falling below the $1.50 mark against the Euro for the first time ever.  It seems investors are reacting to a spate of negative economic data which are painting an increasingly bearish picture for the US economy.  In addition, the Fed seems likely to lower rates further while the ECB will maintain rates at current levels. For a brief period, talk of recession was actually helping the Dollar, as investors predicted that the global economy would be harmed more than the US economy, but it looks like that period has passed. As a result, the EU is growing increasingly alarmed, and the pressure is building for some kind of intervention.   AFX News Limited reports:

Euro group president Jean-Claude Juncker said currency markets are overreacting to the short-term outlook for the US economy. " We don’t like excessive volatility in exchange rates," Juncker said.

Read More: Euro group’s Juncker says currency markets reacting too hastily to US outlook

Together with a consortium of large banks, Merrill Lynch recently formed ELEMENTS, which unveiled five new currency Exchange Traded Notes (ETNs).  Before ML entered the market via ELEMENTS, there were only two banks offering currency ETF products: Barclays Capital and Rydex, whose funds are branded CurrencyShares and iPath, respectively.  ETNs differ from ETFs in that the former represent a debt obligation whereas the latter represent a form of equity.  In practice, however, since the risk of default is relatively low, the two types of securities are functionally equivalent.  Both pay interest slightly below the benchmark interest rates of the currencies to which they are connected. The five new ELEMENTS ETNs are separately tied to the performance of the Canadian Dollar, Euro, Swiss Franc, British Pound, and Australian Dollar. Index Universe reports:

Why would anyone choose the new ELEMENTS ETFs? Because they make semiannual cash dividend payments to noteholders based on the interest income. The iPath ETNs, in contrast, incorporate that income into the value of the note … a kind of "virtual interest" that is only realized when the noteholder sells.

Read More: Currency Market Gets More Competitive 

Yesterday, the Forex Blog featured a story that explained how to make money when volatility is low.  The consensus of the article is that investors must shift their strategy from trading to trending, which requires an adjustment in outlook from short-term to long-term.  But given that volatility is low and that currencies often move laterally against each other, how do you know which direction to bet on, and accordingly, when to buy or sell?  The answer requires some minor technical analysis, involving two of the most basic tools available: support and resistance. These terms represent approximate price levels within which a specific currency appears to be trading.  The significance of these levels is usually arbitrary, and is likely grounded in psychology rather than any real math. Furthermore, once the pattern is spotted, the support and resistance levels often become self-fulfilling, keeping the currency rangebound. But, when, for whatever reason, the currency dips below or rises above the range, it is probably a signal that it is a good time to sell short or buy, respectively. Trading Markets reports:

Though support and resistance are rather basic when it comes to technical analysis, they can be extremely effective for dexterous traders. And really, sometimes, keeping things simple is the best course of action anyway.

Read More: Using Support and Resistance in Forex Trading

Based on several indexes, volatility in forex markets is nearing historic lows.  How can this be explained, given the enormous daily swings in equity and bond markets? The first explanation is that business cycles, and by extension, monetary policies, are gradually synchronizing across the industrialized world, especially among the USA, EU, and Japan. When inflation rates and interest rates are similar across different countries, this mitigates any theoretical need for changes in exchange rates. The second explanation is that the tremendous growth in forex volume ($3 Trillion per day and rising) is increasing liquidity and lowering volatility.

More importantly, is it possible to profit in a climate where volatility is lacking? The answer is "of course."  It simply involves a shift in strategy.  When volatility is high, trading is usually the most profitable strategy: using technical analysis and churning your "portfolio" on a daily basis.  On the other hand, when volatility is low, then trending is probably the best bet. Don’t forget: volatility is not the same as directional movement.  If a currency appreciates every day by only a small increment and without any wild swings, volatility is low but the profit potential is high.

Read More: Making the Most of a Benign Environment

Read the rest of this entry »

Recent news reports have painted a downright bleak picture of the US economy. Home prices are now falling. Equity prices are also falling, at an annualized rate of 20%.  Meanwhile, energy and food prices are rising, dipping into what little purchasing power consumers can still claim.  Somehow, as DailyFX, recently reported, the Dollar has held its own. Their reasoning is that there is a struggle being waged in forex markets between yield and growth. On the one hand are investors who are bearish on the Dollar because of interest rates that are headed downwards, despite already being low.  On the other hand are investors who think that yield is comparatively unimportant, since the rate cuts are needed to shore up the economy. While interest rate differentials do not favor the US, the economic growth that they are intended to bring about tell a different story. DailyFX reports:

The only problem with this thesis is that 2 percent interest rates or 100bp is about as low as the market expects the Fed will go. If banks are forced to take more write-offs and the US economy deteriorates further, the Federal Reserve may be forced to go below 1.00 percent.

Read More: What Matters More For the US Dollar:  Yield or Growth?

Over the last few years, commodity prices, equity values, and interest rate differentials all favored Canada.  By no coincidence, the Loonie rallied to such an extent that it soon reached parity with the USD. The relationship between these trends and the Canadian Dollar seemed so cut-and-dried that few analysts paid attention to anything else.  In the last couple months, however, these relationships seem to have suddenly dissolved.  For example, as the price of oil has begun to rise again, the Loonie has unexpectedly lost value.  Meanwhile, the inverse correlation between risk aversion and the Loonie has lost all validity, such that if the S&P 500 increases, the odds that the Canadian Dollar will also appreciate is essentially an even money bet. The Canadian Economic Press reports:

"The breakdown is still quiet tentative but it’s weakened in the last few sessions. For Canada in particular there isn’t one story in the market. We have several different stories going on at the same time."

Read More: Breakdown of Forex Correlations Has Market Participants on Guard

Forex Forecast- try saying that three times fast! The Market Oracle, an online financial publication, has done even better, preparing a one-year forecast for all of the major currencies along with a detailed analysis of the major factors driving each currency in the month of February. The Dollar and Yen are projected to be the strongest performers in this time frame, benefiting from a trend towards risk aversion.  It should be noted that this prediction is consistent with news reported by the Forex Blog earlier this week. On the other hand, currencies that have been propped up by the Yen carry trade, namely those of Australia, New Zealand, Canada and South Africa, will face selling pressure.  The British Pound is projected to underperform slightly, due to an easing of British monetary policy, which will narrow the interest rate advantage claimed over the US.

Finally, the Euro is something of a wildcard.  On the one hand, the EU economy is stagnating, and the ECB has hinted that rate cuts are a possibility. On the other hand, the Euro theoretically stands to inherit a significant amount of risk-averse capital, especially from foreign investors looking for a stable alternative to the Dollar.  Accordingly, the Market Oracle forecasts a short-term decline in the value of the Euro but a long-term appreciation.

Read More: Currency Market Strategy and Forecasts for February 2008

Last week, the USD recorded its best weekly performance since 2006, rising 3 cents against its chief rival, the Euro.  Apparently, analysts are becoming increasingly pessimistic about the effect of the America recession on the global economy.  The consensus is now that a dampened global economy will induce a trend towards risk aversion, which favors the world’s #1 and #2 reserve currencies, the Dollar and the Euro, respectively.  However, it also appears the near-term economic prospects for Europe are less rosy than originally forecast,.  Thus, if last week is any indication, the Dollar should receive a larger proportion of risk-averse capital. Reuters reports:

"Despite a torrent of bad economic news the dollar has been
on a tear this week, as the currency market recognized the fact that the slowdown in U.S. economic activity is likely to drag down growth in the rest of the G10 universe…"

Read More: Dollar set for biggest weekly rise since June 2006

Most of the world’s major currencies are affected by a variety of technical and fundamental factors, such that only taking into account one factor is tantamount to using P/E multiples as the sole basis for purchasing shares of stock. The New Zealand Dollar, which barely qualifies as a major currency seems to be one of the few exceptions to this common sense rule.  The preponderance of carry traders involved in trading the Yen ensures that the NZD inversely tracks the Japanese Yen.  In addition, the demand for Kiwi is directly proportional to appetite for risk, such that when risk aversion declines, the Kiwi increases, and vice versa.  The reasoning is quite simple: the Kiwi boasts the highest interest rates in the industrialized world. Because the investment climate in New Zealand is less stable than in other industrialized countries, New Zealand often witnesses capital flight during periods of global economic uncertainty.  The New Zealand Herald reports:

Gains in equities markets emboldened investors to take chances, prompting use of the low-yielding yen to buy assets in higher-yielding currencies like the kiwi in carry trades.

Read More: Equities send dollar up

The US stock market has lost over 10% of its capitalization since reaching an all-time high in October of last year.  Meanwhile, the Japanese Yen has climbed at least as much in proportional terms since bottoming out around the same time.  Coincidence?  At least one analyst doesn’t think so. Because of the steadfast popularity of the carry trade, the Japanese Yen appears to have developed an inverse correlation with the US stock markets.  The reasoning is actually quite simple. When aversion to risk is low, investors borrow in Japanese Yen and make investments denominated in other currencies, the Dollar for one.  When risk-aversion increases, as it has in the current economic environment, investors have been quick to close out their carry trade positions, causing the Yen to rise. Maktoob Business reports:

If the situation of stock markets is improving, the USD/JPY is likely to be increasing. It means that more carry trade transaction are being carried out.

Read More: Fundamental analysis – Market Correlations

So-called ‘Sovereign Wealth Funds’ are the talk of the town, stealing headlines as part of a multi-billion dollar buying spree.  Anecdotally, stories of these funds and other institutional foreign investors have made a big splash, epitomized by a few high-profile investments in struggling American investment banks.  It no longer appears these stories were isolated, as suggested by some pretty compelling economic data.  In 2007, total foreign direct investment into the United States totaled $400 Billion, which represents a 90% increase over 2006.  In addition, the first few weeks of 2008 saw a frenzy of activity, which suggest this trend will continue.  Investment in the US is being driven primarily by a weak Dollar and attractive stock market valuations.  If the bad news on the US economy continues to pour in, analysts warn that foreigners could play an even larger role in mitigating against recession. The New York Times reports:

The weak dollar has made American companies and properties cheaper in global terms. Even as Americans confront the prospect of a recession, economic growth remains strong worldwide, endowing oil producers like Saudi Arabia and Russia and export powers like China and Germany with abundant cash.

Read More: Overseas Investors Buy Aggressively in U.S.

As Asian capital markets crash in unison, the Japanese Yen is rising at its fastest pace in years.  Taken out of context, that sounds like a contradiction, since a positive correlation typically obtains between the strength of a nation’s economy, capital markets, and currency.  However, the Yen is unique, as most forex traders are doubtlessly aware.  The Yen rises and falls with the whims of the carry trade, which in turn is tied closely to volatility.  And in case you haven’t noticed, global capital markets are seesawing to such an extent that by some measures, volatility levels have reached a nine-year high.  One analyst has drawn a parallel between the current credit crisis and the 1998 Asian economic crisis, which also produced a Yen rally.

Read More: History Points to a Yen Rally

Since July, the Japanese Yen has notched a stellar performance in climbing 15% against the Dollar, without garnering much attention.  Within the last week, however, analysts have begun to take notice, as the carry trade temporarily collapsed and the Yen appreciated by another 3%. ‘But Japan’s Central Bank is no hurry to raise interest rates,’ you are probably wondering. ‘What on earth is all the fuss about?’ Volatility, the sworn enemy of carry traders has exploded.  Global capital markets, including the US stock market, are in a state of turmoil. The financial services industry, the perennial bulwark of the US economy, is set to record its worst year in recent memory.  Leading the way, so-to-speak, is Citigroup, which recently announced that it will write-down an additional $10 Billion in worthless subprime paper and will also receive a proportionately large infusion of capital.  Cue exit music for carry traders. Bloomberg News reports:

"The global and risk environment is dominating yen pricing,” said Chris Turner, head of currency research at ING Financial Markets in London. "There’s risk aversion in the background.”

Read More: Yen Rises as Traders Pare Carry Trades on Credit-Market Losses

Last week, the Forex Blog recounted what happened across forex markets in 2007, in all of its drama. Now, we would like to offer a nice counterpoint, in the form of the major themes expected to dominate forex headlines in 2008, courtesy of Dow Jones. The list includes eight distinct themes, though there is some overlap.  Three of the themes pertain directly to the USD, which is the currency most worth watching in the upcoming year.  The fundamentals bode well for the Dollar; the economy has not suffered from the credit crunch nearly as much as economists feared; the cheaper currency has boosted exports; foreigners have proven surprisingly willing to finance the twin deficits.

Then, there is inflation, which has reared its ugly head in the US as well as abroad. Foreign Central Banks, especially in Asia, may have to tighten monetary policy in order to maintain price stability. Those countries with already-high interest rates, such as Australia and New Zealand, are expected to keep rates high.  The next theme, accordingly, is the carry trade, which should continue its run due to the aforementioned high interest rates.  Next is China, which will be watched on two fronts: its economy and its currency, both of which are expected to continue rising. 

The final two themes pertain especially to the Middle East: currency pegs and Sovereign Wealth Funds. As the Dollar declined in 2007, several nations in the Mid East mulled the possibility of de-linking their respective currencies from the Dollar, but thus far, the status quo has obtained.  Sovereign Wealth Funds also made a big splash in 2007 with several high-profile investments in the US, implicitly underscoring their their commitment to the Dollar.  They represent a growing force in global capital markets, and will be watched vigilantly in 2008.

View the Complete List Here

Forex is becoming hot!  Average daily volume has surged past $3 Trillion, as the credit crunch has increased volatility and the Dollar has collapsed.  In fact, Saxo Bank, one of the most prominent acts in retail forex trading, may record $500 million in revenue this year.  As a result, several of the world’s largest investment banks have announced plans to enter the burgeoning retail forex market.  Citigroup is teaming up with a Danish bank to offer online currency trading.  Deutsche Bank is stepping up marketing of its proprietary retail trading platform.  Even Goldman Sachs is entering the fray, via a 10% investment stake in a British retail forex company.  However, not everyone is optimistic, reports GulfNews:

Some think the reputational risks of enabling individual investors who may not be able to afford to lose substantial sums in what are notoriously volatile markets outweigh the possible revenue stream.

Read More: Global banks compete for growing forex business

It’s been rough sailing for the Yen carry trade of late; the technique had been sagging in popularity due to the credit crunch and the associated trend towards risk aversion.  Over the last few weeks, however, the Yen has fallen, which is to say the Yen Carry Trade is making a comeback.  First came the announcement that the world’s leading Central Banks would be injecting hundreds of billions of dollars in the banking system, in order to ease growing liquidity concerns.  Next, the Bank of Japan hinted that it would hold rates at .5%, the lowest in the industrialized world.  Finally, a continued surge in commodity prices virtually ensures that countries rich in natural resources, such as Canada and Australia, remain viable "targets" for carry traders.  Overall, the story remains focused around volatility.  In fact, one investment bank discovered an inverse correlation between the S&P 500 and the Japanese Yen.  In other words, the appetite for risk appears closely correlated with the strength of global capital markets and the popularity of the Yen carry trade.  Bloomberg News reports:

Over the last fortnight, that odd correlation with equities has broken down…Instead the fundamental factors behind carry trades have come to the fore again. Investors are paying attention to Japan’s economy.

Read More: The resources to carry on

The return a hedge fund delivers is separated into alpha and beta; accordingly, the goal of of a good hedge fun manager is to deliver as much alpha as possible, whereby alphas is measured by the return generated in excess of beta, what is returned "naturally" by the market.  In the case of forex, the beta is effectively zero, since one currency’s gain is automatically another currency’s loss.  Thus, any and all return generated by forex investors is officially recorded as alpha.  Historically, forex was a bonanza for hedge fund managers that speculated exclusively on currencies, who averaged annualized returns of 12%, controlling for differences in trading strategies. 

That return has steadily dwindled, and in fact, the average professional forex trader lost 2.6% in 2006.  The reasoning should be self-evident: increased competition.  From the perspective of daily trading volume, participation in the forex market has tripled since 2001.  Arbitrage (buying in one market and selling into another) has steadily eroded returns to the extent that one online forex brokerage now quotes the bid/ask spread to five decimal places!  Fortunately, the evaporation of profits should drive many hedge funds out of forex in search of other investing opportunities, creating new opportunities in forex.  The Financial Times reports:

Volatility was now back to historic norms, aiding managers. "The last three years have been really quite disappointing for the industry and it needs to produce some gains in the next couple of years to justify its existence."

Read More: Dollar slide ‘hit currency managers’

After months of delay and perhaps overly wishful thinking regarding the global credit crunch, the world’s Central Banks are finally ready to take action. America’s Federal Reserve Bank will join forces with the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank as part of a concerted effort to introduce greater liquidity into global capital markets.  Under the plan, the Banks will auction off tens of billions of Dollars worth of bonds denominated in their respective currencies, and lend the proceeds to commercial banks.  The goal of the plan is to to limit growing risk aversion, which has caused banks to significantly rein in lending.  Further, while the move is designed primarily to boost confidence in equity markets, certain sectors of forex may also receive a bump.  High-yielding currencies such as the New Zealand Kiwi and Australian Dollar, which have been shunned in recent months, seem to be the most likely beneficiaries.  Forbes reports:

"If the market is convinced that central banks are finally doing enough to ease the liquidity situation we are likely to see the funding currencies (the yen and the Swiss franc) fall back, and higher-risk currencies like the Aussie and Kiwi currencies, rally."

Read More: Dollar rises as Fed, other central banks move to shore up liquidity

While covering the emergence of the carry trade over the last couple years, the Forex Blog has echoed the sentiments of the self-proclaimed experts, who argued that Japanese interest rates would never rise enough to seriously threaten the carry trade. Instead, any threats would have to come in the form of volatility, which would theoretically drive traders to spur the comparatively high returns of carry trading in favor of low risk.  As if on cue, the carry trade has retreated significantly as the credit crisis aka housing bubble shockwave has rippled through global capital markets.  As the negative fallout builds, many of the carry traders who braved the first storm are rushing for the exits.  Bloomberg News reports:

Volatility implied by dollar-yen currency options expiring in one week with a strike price near current levels rose to 13.25 percent… Traders quote implied volatility, a gauge of expected swings in exchange rates, as part of pricing options.

Read More: Yen Advances on Concern Credit Losses Will Deter Carry Trades

The last two years have witnessed a veritable collapse in the value of the Dollar, which has declined over 25% against the Euro, alone.  While opinion remains divided, many analysts are predicting a (temporary) cessation in the Dollar’s downward slide.  The reasoning is that the worst possible scenario involving the American housing crisis has already been priced into the Dollar.  Furthermore, experts argue that the inevitable loosening of American monetary policy will help boost the American economy by preventing it from slipping into recession. Finally, there is the notion that China will begin to take steps to appreciate its currency relative to the Euro, which has
actually risen against the RMB.  The law of triangular arbitrage requires that any rise in the Euro against the Yuan must be matched by a proportional rise in either the Dollar/Euro or the Dollar/RMB rate, the latter of which seems unlikely.  Dow Jones reports:

There is also the possibility that official Chinese purchases of the euro could decline after last week’s visit by a delegation from the European Central Bank to Beijing, anxious to reduce upward pressure on the single currency.

Read More: Chances Of Dollar Bounce May Be Rising

The carry trade is officially unwinding, if not coming to an outright end; the result is that the Yen is belatedly joining the ranks of the rest of the world’s major currencies, which have risen tremendously against the Dollar.  The reason for the sudden weakness in the carry trade (i.e. Yen strength) is volatility.  The US "credit crunch" began to significantly effect US bond and stock market valuations almost four months ago, but the full impact still hasn’t been felt.  The latest development concerns the quarterly earnings release for Freddie Mac, an American company whose main purpose is to provide liquidity to the US mortgage market, through the buying and selling of mortgage-backed securities.  However, Freddie Mac is now bleeding money, and while it is unofficially guaranteed by the federal government, investors are seriously questioning its ability to prop up the ailing market for housing CDOs.  And this uncertainty is causing investors to eschew risk, in short, to abandon the carry trade in favor of more traditional forex strategies.  Reuters reports:

The low-yielding Japanese currency tends to do well in times of risk aversion because investors unwind carry trades that use cheaply borrowed yen to buy higher-yielding currencies.

Read More: Dollar sinks to 2-year low vs yen, euro hits highs

As the Japanese Yen continues to enjoy the carry trade limelight, another currency fulfilling a similar role has been largely overlooked: the Swiss Franc.  While not quite as low as rates in Japan, Swiss interest rates are still extremely modest by international standards. As a result, many carry traders have used the Swiss Franc in much the same way as the Japanese Yen, selling it short in favor of higher-yielding currencies. And, just as the Japanese Yen has begun climbing over the last few months, so has the Swiss Franc.  The volatility in capital markets caused by the credit crunch is just as prevalent in forex markets, and is leading currency traders to eschew yield (high interest rates) in favor of stability, which benefits currencies like the Franc. The Economic Times reports:

Another trader with a multinational bank said with carry trades now coming under heavy pressure and banks being reluctant to fund investors entering into such trades, risk aversion seems to be taking over the global currency markets.

Read More: Swiss franc safe haven for carry trade

Yesterday, the Financial Times ran two stories on the Japanese carry trade, painting a seemingly contradictory picture.  The first article profiled the rise in the number of retail forex accounts in Japan, projected to reach 1 million by year-end.  More amazing is the fact that many of these traders are actually quite sophisticated, taking long and short positions in multiple currencies, though of course the most popular bet remains the carry trade, which involves going short the Yen and long a higher-yielding currency.  Meanwhile, as the second article expounded, the Yen carry trade is under pressure, having appreciated nearly 5% against the US Dollar, Euro and Australian Dollar.  The cause is certainly volatility in global capital markets, precipitated by what has been termed a "credit crunch," itself caused by the slump in housing prices. The hoard of Japanese retail investors may have to reverse their positions…

Read More: Pressure grows on yen carry trades and Forex Lures Japanese Investors

According to recently-released documents, the Central Bank of Australia intervened on behalf of its currency in August, marking the first such intervention in over six years.  Surprisingly, its purpose in intervening was to lift up its currency, rather than hold it down, which is the reason most central banks intervene.  Apparently, the global credit crunch that flared up over the summer, generated tremendous volatility in forex markets.  As a result, many carry traders- for whom volatility is anathema- quickly unwound long positions in the high-yielding currencies Australia and New Zealand, causing them to plummet.  However, both currencies have since resumed their appreciation, which means any future intervention will likely be aimed at holding the Australian Dollar down. Bloomberg News reports:

The Australian dollar underwent "a particularly sharp depreciation in mid-August as the increase in global risk aversion arising from the credit-market crunch triggered an unwinding of carry trades."

Read More: Australian Central Bank Bought Currency to Ease Market Turmoil

Advocates of the carry trade have long argued that the only thing that could possibly put an end to their fun would be a significant rise in Japanese interest rates, which seems quite unlikely at this point.  However, a new threat to the carry trade has emerged: volatility. Global capital markets have see-sawed over the last few months as credit concerns have surfaced, often related to America’s housing bubble.  This month, the Australian Dollar and New Zealand Kiwi have been the two worst performers among the world’s 17 most actively-traded currencies.  This is notable because these two currencies are most likely to be on the long end of carry trades.  Bloomberg News reports:

The currencies also slid against the U.S. dollar as Citigroup Inc. said it will report as much as $11 billion in additional writedowns, reducing demand for so-called carry trades.

Read More: Australian, New Zealand Dollars Fall on Renewed Credit Concerns

What better way to invest in your future than through the Internet? At any given time of day, and from any Internet connection, you can gain access to investing news and business summaries. You can plan your future through watch lists and online portfolios, as well. You can trade equities, CDs, roll over your IRA and compare fund families – all online and at your convenience. But, with so many sites to choose from, how do you make the right decisions about where to spend your precious time and money?

That’s where we come in – to provide you with the sites that will offer you the most bang for your buck. From analysts to tools for young investors, we’ve broken the sites down into easy-to-manage categories. All categories are in alphabetical order and the sites within those categories also are listed alphabetically. Plus, we’ve added a little commentary to each link to let you know what to expect from these sites.

Read the rest of this entry »

Over the last few months, the Australian Dollar has risen over 15% against the USD, bringing the currency to a 23-year high. With parity (1:1 exchange rate) in sight, some analysts are beginning to draw parallels between the Australian Dollar and the Canadian Dollar, which skyrocketed to parity against the USD just last month.  Both economies are rich in natural resources, relying heavily on them to drive exports.  In fact, more than half of Australia’s exports are comprised of natural resources.  It is no surprise that as oil, gold, and a host of other raw materials have surged to record highs, the Australian economy has outperformed even the rosiest of expectations.  With China’s economic boom promising to keep raw material prices high for the near future, the prospects for Australia’s economy, and hence its currency, are brighter than ever.

What’s more, the basic divergence in growth is clearly tipping towards the momentum underlying the Aussie economy with consumer spending, business investment and export income promising strength for the economy and currency in the months to come.

DailyFX reports: Australian Dollar: The Next to Reach Parity?

The Dollar has been sliding steadily for close to a year, and Wall Street has been rushing to introduce a spate of new investment products to help investors profit accordingly.  For those who do not want to trade currencies directly, Exchange Traded Funds (ETF’s), probably represent the best alternative. The typical currency ETF tracks a basket of currencies and most ETFs are characterized by low fees.  In fact, over $2.7 Billion is currently invested in such ETF’s, which have risen from virtually nothing over the last 7 years. Another option is to buy CDs or other money market instruments denominated in other currencies. Online banks such as Everbank offer such products. Yet another option is to buy shares in mutual funds that aim to mimic the returns offered by investing directly in foreign money market instruments.  Finally, one can simply buy shares in foreign companies or in American multinational companies that do significant business abroad.

Read More: Opinion divided on currency trading

The Bank of International Settlements just released the results from its first survey of Central Banks in over three years, and the results were startling.  Forex volume rose 71% to $3.2 trillion per day, cementing the status of forex as the world’s largest market. Trading in forex derivatives also surged, to an average of over $2 trillion per day.  While the role of the USD has slipped somewhat, it remains the world’s reserve currency as evidenced by the fact that it represents over 40% of all forex volume. FinFacts reports:

"A significant expansion in the activity of investor groups including hedge funds" as well as individual investors also contributed to the increase."

Read More: Global daily turnover in currency markets rises…

Forex Capital Markets LLC, the largest Forex Dealer Member, recently announced that it would begin offering so-called “Fractional Pip Pricing” in an effort to reduce the bid-ask spreads it offers customers. Previously, most, if not all forex brokers that cater to retail forex investors, quoted forex rates out to four decimal places (i.e. 1.4101 USD/Euro). However, due to its strong liquidity relationships with banks that facilitate forex trading, FXCM has negotiated tighter bid-ask spreads for its customers, which will enable it to quote exchange rates to five decimal places (i.e. 1.41007 USD/Euro. While FXCM expects to narrow spreads further in the future, it remains to be seen whether the competition will follow suit.

Read More: FXCM’s New Lower Spreads: Fractional Pip Pricing

The Japanese Yen is finally appreciating, though how long the upward streak will last is anyone’s guess.  These days, the Yen rises and falls on the whims of carry traders.  However, the enemy of the carry trade is volatility and the Fed’s lowering of US interest rates injected enough uncertainty into the markets to send carry traders slowly towards the exit.  As a result, currencies such as the Australian Dollar and New Zealand Kiwi, long popular with in carry trading circles, were quickly dumped as traders bought Yen to cover their positions. Whether the Yen can sustain its momentum depends primarily on the Central Bank of Japan. Bloomberg News reports:

Carry trades utilizing the New Zealand dollar lost 1.9 percent today, according to data compiled by Bloomberg, after gaining 2.3 percent so far this week as the Federal Reserve reduced the U.S. rate a half percentage point to 4.75 percent.

Read More: New Zealand Dollar Drops as Japanese Investors Return to Yen

Today, the Euro set another record, breaching the $1.40 mark.  While theoretically a meaningless achievement, $1.40 was an important psychological and technical barrier, since many traders place stop orders and limit orders at round numbers, such as $1.40.  Accordingly, upon surpassing $1.40, the Euro quickly accelerated upward, creating a short squeeze, where those who bet the Euro would not pass $1.40 were forced to buy to cover their positions. EU politicians have been surprisingly quiet as the Euro rose rapidly against the Dollar, commenting only that they would monitor the situation.  However, it seems inevitable that the value of the Euro will begin to play a more serious role in EU economic policy, since it is already beginning to hamper growth.  AFP News reports:

“Excessive volatility and disorderly movements in exchange rates is undesirable for economic growth,” European Central Bank president Jean-Claude Trichet said.

Read More: EU finance chiefs on guard over euro strength, market turmoil

With its continued strong performance against its neighbor to the south, the Canadian Dollar is almost defying logic, having jumped to 99cents against the USD in a matter of days. In purchasing power parity terms, the Loony is already among the most
expensive in the world.  However, achieving parity (i.e. an exchange rate of 1:1) has a psychological value that can’t be cast in economic terms. Plus, it doesn’t hurt that high commodity prices have helped Canada to maintain years of strong growth and become America’s largest trading partner in process.  And after the Fed chopped 50 basis points off of the US Federal Funds Rate, the Canada-US interest rate differential is virtually non-existent. One commentator thinks a 1:1 exchange could provide a basis for more economic cooperation between the two nations.  The Globe and Mail reports:

“Parity is a very normalized level. Our [US and Canada] economies have become so closely intertwined that I think down the road what you’re thinking about is more of a North American bloc.”

Read More: A call for parity doesn’t look so loony now

While the US had a rough day yesterday, European stocks performed well enough to tempt investors away from the yen. Though a stable currency, the yen is a low-yielding investment and traders are ready to try their hand at a riskier venture with European stocks. There is no word yet on how this may affect Wall Street. According to Forbes:

This has pushed the yen down as investors make tentative steps back to engaging in the risky carry trade – where investors sell low-yielding currencies such as the yen to buy higher-yielding ones elsewhere. With no US data due this afternoon, how equities fare on Wall Street is likely to determine whether the rise in risk appetite can be sustained.

Read more: Yen falls back as stable European stocks prompt revival in risk appetite

A huge turnout at the recent "Jamaica Forex Expo" shows that foreign exchange trading is becoming a widespread practice in Jamaica. This expo was organized by the Market Traders Institute (MTI), which has reportedly trained nearly 1500 Jamaicans thus far. It would seem that citizens of this impoverished nation have found a new hope for their future with the help of forex trading. According to Jamaica Gleaner News:

"Trading on the forex has been my path to financial independence," proclaimed one patron who was in attendance at the expo.

Read more: Interest in forex trading grows in Jamaica

Last week witnessed a sudden unwinding in the yen carry trade, as a global market downturn affected investor sentiment towards risk. Volatility is the only market force that could seriously contend at collapsing the carry trade, and last week produced significant volatility. All of the world’s majors fell against the Yen, namely the New Zealand Kiwi, which fell by 7.5%. The kiwi, you may recall, has been one of the main currencies on the other end of the carry trade, due to its high interest rates. However, analysts are reluctant to proclaim an outright end to the popular carry trade, preferring to wait and see how volatile the world’s capital markets appear in
the coming weeks. The Financial Times reports:

The wave of risk reduction also prompted investors to take profits in the Australian and New Zealand dollars, which have surged this year from central bank credit tightening or expectations of more tightening to come.

Read More: Yen hits 3-month high versus euro

The Economist just released its an updated iteration
of its famous Big Mac Index, underscoring growing disparities in currency valuations. For those of you that aren’t familiar, the Big Mac Index uses the price of a McDonald’s Big Mac sandwich in different countries as a proxy for measuring purchasing power parity (ppp), that perennial staple of economics that theorizes a country’s currency and its inflation rate should move in opposite directions. Thus, where a Big Mac is observed to be more expensive than in the US, it would suggest that country’s currency is overvalued relative to the USD. Of course there are numerous other factors in the local price of a Big Mac, including raw materials and taxes, but the index still packs a pretty profound punch. Unsurprisingly, the most undervalued currencies can be found in Asia – notably the currencies of Japan, China, Thailand, Indonesia, etc. The most comparatively expensive Big Macs (and hence most overvalued currencies) can be found in Europe, especially in Scandinavia and Northern Europe.

Read More: The Big Mac Index

The Japanese Yen has slid to a record low against the Euro, with no obvious end in sight to the wounded currency’s multi-year decline. The basis for the continued yen weakness is the expectation that Japan will hold interest rates at current levels until the end of the summer, a notion that was reinforced by the Bank of Japan yesterday. As a result, carry traders, who categorically fear volatility, can feel confident that a continued low interest rate environment will support the viability of the Yen carry trade in the short term. However, there are a few risks in the horizon, namely that Japan’s economy and stock market are outperforming and could prompt a series of rate hikes in the fall and lure Japanese capital back to Japan. DailyFX reports:

The rallies are becoming overextended of course and the risk of some action by the Japanese government is increasing, but until carry traders have a reason to bail, they probably will not.

Read More: Japanese Yen Continues to Fall

This week, the President of the Central Bank of Japan essentially ruled out the possibility of a near-term rate hike, which was exactly the kind of reassuring news forex carry traders wanted to hear. As a result, the Yen quickly dropped to record lows against the Euro, British Pound and Australian Dollar, as well to a four-year low against the USD.  Surprisingly, the Swiss Franc, would seem an excellent candidate to fund the carry trade, is also surging. Now that any near-term volatility-which is the bane of carry traders-has been removed, the carry trade is likely to thrive. High-yielding currencies, such as the New Zealand Kiwi, will likely attract continued attention from speculators. At this point, it seems the only thing that could possibly slow the carry trade is a Japanese rate hike, or the mere threat of one.

Read More: Carry trades hit yen but Swiss franc surges

The next FXCM Expo will be held in Dallas on July 14 & 15. On Saturday the 14th, FXCM will present over 20 free workshops, geared towards all trading levels from beginner to advanced. Paid workshops are held on Sunday the 15th.

Read more details at FXCMExpo.com.

Over the last few weeks and accelerating towards the end of last week, the US bond market collapsed.  During that period, the 10-Year US Treasury yield rose 50 basis points to 5.15%, its highest level in nearly a year.  Meanwhile, the USD rose to its highest levels in a couple months.  Coincidence? Of course not. The relationship between the USD and US interest rates has become increasingly predictable, to the extent that increases or decreases in rates are consistently followed by a proportionate change in the value of the USD.  As a result of globalization, capital can be quickly moved to the country that offers the highest risk-adjusted return.  This is especially relevant for the US, which as the world’s least risky country (from a financial standpoint), tends to attract a big chunk of the world’s savings.  Forex traders should take note.

Read More: Dollar continues to strengthen from jump in Treasury yields

Last week, the Canadian Dollar traded at 94 cents against the USD, its highest level in over 30 years. This event is even more unbelievable considering the Loonie’s all time low against the USD occurred less than five years ago, in 2002.  Now, many analysts are cautiously optimistic that the Loonie will be trading at parity with the USD by year-end, and perhaps continue appreciating past that point.  Rising natural resources prices and a strong economy may drive Canada’s Central Bank to raise interest rates, at the same time that its neighbor to the south is contemplating lower rates.  However, not all analysts are quite so optimistic. The Associated Press reports:

But with an expected dampening in the industrial and manufacturing sector on its way, other analysts predict the Canadian dollar will start to weaken because commodity prices will pull back a bit and Canada’s economy may start to struggle because of the strength of the loonie.

Read More: Canadian dollar no longer ‘a weakling’

Low volatility combined with even lower interest rates has made the Japanese Yen into a popular target among forex traders, who borrow in Yen and short the currency in favor of higher-yielding alternatives.  It turns out the Japanese Yen, however, is not the only currency that is being driven downward by the carry trade; the Swiss Franc (CHF) has also become a victim in the last couple years.  Switzerland’s benchmark interest rate, at 2.25%, is the second lowest among industrialized nations, after Japan.  Moreover, the Swiss Franc is highly stable and liquid, which means it is well-suited for the carry trade.  Dow Jones News reports:

With global risk appetite remaining strong and carry trades remaining one of the primary driving forces in global currency markets, the franc is unlikely to get much respite from rate hike expectations.

Read More: Swiss Franc Slide Likely To Continue

Two years ago, Warren Buffet made headlines when he entrenched a $20 Billion dollar bet that the USD would decline in