As 2009 begins, it is appropriate to borrow Charles Dickens’ phrase, “it was the best of times and it was the worst of times.”
The credit crises, housing bust and commodity collapse helped wipe out $50 trillion in market valuations in 2008. Global market returns also saw the worst of times in 2008: -34% for the Dow Jones Index, -31% for the FTSE.
On the other hand, U.S. government bonds had their best returns since 1995 with 30-year bond prices up 44% in 2008. It has been a year of contrasts, generating many key questions. Will aggressive interest rate easing and the huge increase in money supply work? Can it overcome the lowest levels of consumer confidence in 40 years? Is inflation lurking behind the scenes?
It is a daunting time for the forex trader. Amid the turbulence we can see the outlines of some very interesting scenarios.
First, the global financial crises have shown that the world economy is more interdependent than ever and that the dollar remains a reserve currency. But the attractiveness of the dollar is not from a position of strength. Rather it is from the vacuum created by deleveraging. As other assets such as the commodity complex are sold off, the dollar becomes a safety valve. As a result, the Aussie and Kiwi dollars had their greatest declines since they began trading in the1980s despite their higher interest rates. The problem has cascaded to emerging markets which export raw materials. The sell-off has reduced dollar reserves, creating more instability. The collapse of these currencies against the dollar has been the signature of the panic as the dollar benefits from deleveraging.
This can also be seen in the demand for Treasuries. Those buying Treasuries are being risk averse and avoiding the risk of losses in other assets. Yet we should not ignore the potential of a Treasury bond bubble. As soon as signs occur that the U.S. economy is bottoming out, reflation expectations will reappear. Bond holders better be close to the door.
However, traders betting on a dollar decline based on a forecast of a much deeper U.S. economic contraction need to account for further bad news dragging down the rest of the world. One always has to weigh the relative attractiveness of U.S. assets vs. European zone assets. Consumer confidence in the U.S. is at its lowest level in 40 years, and at the same time, business confidence in Germany, the leading economy in Europe, has dropped to its lowest level since 1982.
There appears to be a disconnect between traditional fundamentals and the dollar. Prior to the upheavals of the credit crises, a weak U.S. economy was bearish for the dollar. Now we have a very weak U.S. economy that is momentarily positive for the dollar. Economic fundamentals suggest that the enormous increase in money flooding the global markets will ignite inflation, yet bond markets have been surging. U.S. bond and note yields are at historic lows and are expected to decline further. However, caution is in order. Neither dollar bulls nor dollar bears should be overconfident. There are too many unknowns about the current environment. Selecting a dollar direction is very dangerous.
Two important landmarks should be watched as we navigate through 2009. One is the TIC report on non-U.S. owners of U.S. Treasuries. The second is the U.S. and global bond market. Selling pressure on Treasuries will increase as risk appetite returns. In response, T-bond yields will go up from the current depressed yields: two-year note at 0.72%, five-year note at 1.45%, 10-year at 2.07% and the 30-year bond at 2.57%. Those holding the bag may be significantly hurt. The TED Spread, which is the difference between what banks charge for a three-month instrument and what the Treasury charges, has now narrowed to 1.34% from highs of 4.64%. Another factor to monitor is the Libor rate, the rate banks charge each other for a three-month bond. Bloomberg reports it fell to its lowest level since 2004, indicating risk aversion is declining.
Forex traders have the luxury of choice. They can ignore the dollar altogether. One of the best opportunities may be in the EUR/GBP. In 2008, the euro rose nearly 33% against the pound as the Bank of England cut rates from 5.5% to 2%. This pair has experienced parabolic increases. The volatility surface also shows a strong and steep skew to option calls. Traders should watch closely as the EUR/GBP will likely enter into a consolidation period. In the case of this pair, we have both fundamental factors that can drive the EUR down against the GBP as well as technical factors of being clearly overbought.
Abe Cofnas is the author of “The Forex Trading Course” (Wiley), “The Forex Options Course” (Wiley) and the upcoming book “Sentiment” (Bloomberg). Reach him at abecofnas@gmail.com.
