From the November 01, 2008 issue of Futures Magazine • Subscribe!

Market turmoil and the U.S. dollar

The turmoil on Wall Street began over a year ago and has grown to become the most serious financial crisis since the Great Depression. Its core causes are many, but the key role complex derivatives played in obscuring the ability of the market is central to its origins. The events underscore the superiority of forex as an arena where transparency and liquidity remain untouched and immune from political agendas.

The forex trader doesn’t have to doubt whether the price of a currency pair is distorted from its underlying value. Nearly $4 trillion per day of currency movements guarantees effective price discovery and liquidity. While high leverage worked to exacerbate the problem for investors of mortgage backed derivatives, in contrast, forex traders whose use of high leverage (100:1 and more) may be ill advised but they pay for their losses and don’t pass them to others or expect a bailout.

The current crisis was not an extraordinary event for forex compared to the events surrounding the collapse of the hedge fund Long-Term Capital Management in the fall of 1998, which caused a three-day surge from Oct. 6, 1998 of 15% in the value of the yen. On Aug. 27, the USD/JPY hit a high of 109.89 and reached a low of 103.54 on Sept. 29, only a 6.1% increase in value. If the housing and mortgage derivatives crises grow larger, a comparable 20% decline in the value of the dollar to the yen, calculated from the recent high of 110.51, would take the yen to 88. At 100 USD/JPY, enormous pressures for concerted central bank dollar buying will occur. The trader should also keep in mind that a stronger yen is exactly what Japan doesn’t need. Japan last month had its first monthly trade deficit in 25 years. A stronger yen will hurt Japan.

Another important lesson is to differentiate between long- term fundamental weakness of the dollar as an investment vehicle and understanding the dollar as a trading vehicle. The recent crises may indeed deepen the underlying bearish fundamentals of the dollar. With interest rates at 2%, we also are faced with a U.S. government debt approaching 68% of GDP. On top of that, we are in an economy almost certainly entering a recession. In this context, the demand for dollars is weak. A critical factor to watch will be the TIC (Treasury International Capital) report showing foreign ownership of U.S. Treasuries. If dollar weakness leads to a decline in foreign ownership of U.S. Treasuries — China holds $518 billion and Japan holds $593 billion — that will put significant pressure on the dollar. China and Japan also each hold over $1 trillion in reserves. A precipitous fall in the dollar hurts them. The demand for dollars is not simply related to the single dimension of how attractive the U.S. economy is, it is always a question of what other currencies offer as a better value. The U.S. economy is in distress, but so is the Euro zone, which had its GDP decline to 1.35% along with Britain whose growth also has decelerated. New Zealand has entered a recession and Australia has slowed down. The other major economies in the world are China, Russia, India and Brazil. The Chinese renminbi is, at this time, the best performing currency. Yet while these countries offer higher interest rates and high growth, it comes along with greater political and economic uncertainty. Even if a worst-case scenario occurs and the latest rescue doesn’t work, leading to a plummeting dollar, the probability for global intervention to support the dollar would be very high.

The ultimate lesson is that the globalization of markets also brings with it the globalization of risk and fear. Confidence in financial institutions does not stop at the U.S. shores. In Europe and in Britain, bank failures are occurring. Fortis, the largest Belgian financial service firm, got a lifeline of €16.3 billion, or $29 billion USD. Fear in Britain due to the failure of a third bank (Bradford and Bingley) led the pound sterling to fall more than 300 pips against the dollar on Sept. 29, the largest drop in 15 years. But fear leads to a constant search for value. While there may be cycles of bear markets in financial assets and other equity sectors, there is never a bear market in currencies. The great lesson of the past month is that in the coming years currencies as an alternative asset category and vehicle for trading may be one of the few arenas left for unfettered trading and transparency.

Abe Cofnas is the author of “The Forex Trading Course” and the upcoming “The Forex Options Trading Course” (Wiley). He holds master’s degrees in public policy and political science from the University of California at Berkeley. Reach him at abe@secretsoftraders.com.

About the Author
Abe Cofnas

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.

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