A Forex View From Afar

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Forex Analysis

Financial Sector Re-Valuation: Forex Impact

Written by A Forex View From Afar on Thursday, June 18, 2009

The financial sector might still face a difficult period ahead, TheLFB-Forex.com Trade Team notes, as the U.S. administration is trying to impose stricter rules, while a large number of banks may still have to face further sub-prime/credit-crisis write-downs.

Consequently, the rating agency S&P downgraded 18 U.S. banks (of which five were moved into the naughty corner; to default levels) after earlier this week Moody’s downgraded another 25 Spanish banks.

Moreover, both the ECB and the S&P issued a warning this week that European banks might continue to faces losses this year , and next, continuing the trend started in 2008. According to the ECB, losses in the European financial system might reach $280 billion by 2010.

The credit crisis showed that risk is spread systematically throughout the financial system (remember now, “Financial innovation is good”), and now these losses are likely to be reflected in the U.S. bank balance sheets. But for now, U.S. financials are sheltered behind the law that allows them to value illiquid assets (toxic waste) using the bank’s own valuation models.

Additionally, the new financial regulations that President Obama’s team is trying to impose will probably reduce, even more, the sectors’ profit margin and will inflict tighter regulation; something that investors will certainly not like.

As such, TheLFB-Forex.com Trade Team notes, the strong uptrend that the financial sector experienced lately might come to a halt, after the XLF index outperformed the broader S&P 500 over the last three months of trading. Moreover, it is hard to believe that the U.S. markets can advance without the financial sector in the front line, especially in the current market circumstances.

Therefore, the U.S. equity market may well spin its wheels through the summer, as the financial sector re-alignment continues to take place; something that stock market bulls had hoped was already baked into current valuations.

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The Three States Of The Financial Market: It Is All About Risk

Written by A Forex View From Afar on Wednesday, June 17, 2009

In its natural stance, the financial market has three major attitudes towards risk, which models its behavior and actions throughout each of the global trading session. The three are; risk aversion, risk tolerance and risk-neutral.

Risk-aversion is characterized by investors selling assets considered risky, and swapping them for the safety of the bond market, mainly U.S. Treasuries. Risk-aversion can be seen relatively easy; commodities decline as investors consider that consumption will slow, while the S&P futures also head lower. In the currency market, risk-aversion strengthens the dollar, as investor sell foreign denominated assets to buy U.S. Treasuries. In this period, higher yielding currencies are the one being sold the most.

The risk-tolerance phase is seen when Treasuries are sold as investors are looking for higher yields. In periods of relative calm and positive macroeconomic reports, traders abandon the safety of the bond market and invest their capital in stocks, commodities and foreign currencies, thus in this period the dollar is sold. Usually, bull markets are characterized by risk-tolerance phases and in this period S&P futures head higher, together with the euro and the rest of the pack.

In most cases, risk-neutrality happens when the financial market moves side-ways, unable to push anywhere decisively. This period is characterized by a redistribution period, as investors shift their assets between the various financial instruments to prepare for the next leg (risk aversion or tolerance). The main difference being that the shifts are not only session-by-session, they literally happen hour-by-hour. Sentiment is seen to change from one to the other, empowered by the relentless flow of automated trades that trigger as a contingency play, as each individual market accepts risk neutrality.

The sideways moving market tends to be the more volatile as the channels are traded, and fair value sought at each regional market open. June has been a risk neutral month; the equity markets are unable to attract enough volume to make a stance on risk, and therefore the currency markets spin their wheels each day as dollar values are fought over.

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Interest Rates Or Growth; What Gives?

Written by A Forex View From Afar on Tuesday, June 16, 2009

With the recent green-shots in the global economy taking root it seems, the major central banks now have to face a difficult situation; keeping the yields on long-term bonds at relative low values.

Most market participants consider that inflation will pick up strongly in the coming quarters, in-line with the major central banks currently running strong expansionary policies. Historically speaking, most times that a central bank intervenes in the debt market inflationary expectations rise at a strong pace – Japan of the 1990’s being the only exception.

As traders price in high inflation they build in to fair value the requirement of additional yields on Treasuries, especially on the longer-term maturities, to counter the effects of money printing and asset depreciation. However, this has negative effects in the real economy, not only do yields on Treasuries rises, but on every financial instrument linked to the bond market; corporate bonds, and especially consumer and housing credit, including mortgage rates.

Consumer and housing credit pose the biggest threat to any global recovery; consumers pay more on their mortgages and credit costs, and that leaves less money to spend or save. Higher interest rates are directly linked to higher default rates as well.

For now, the major central banks have two big options to use as an exit strategy. The first would be to increase the quantitative easing programs, something that does not seem likely, since almost no central bank would obtain a substantial increase in their available funds at this point in time. Even a small increase would make most market participants think the bank had its hands tied.

The other option a central bank has is to pledge that it will maintain overnight interest rates at low levels for a longer period of time than may seem prudent, something that further fuels inflation expectations, whilst trying to address the confidence requirement that consumers need to borrow, whilst at the same time creating the pool of liquidity that regional and commercial banks can dip in to at fair value rates.

However, before any central banks has to search for an exit strategy, the global economy has to show some solid signs of growth, and maybe take the lead from the emerging markets who look to be capable of drawing on the higher savings rate to get consumers confident, and to get rates contained.

The Fed looks to be the region that will have an interest rate headache for the longest period; the printing, and key to this, the subsequent re-buying, of new notes, has inflationary pressures inherently built in. Getting out of a quantative easing program is very likely to be at the expense of forward growth, and at the expense of affordable consumer interest rates.

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The Dollar’s Future As A Reserve Currency

Written by A Forex View From Afar on Monday, June 15, 2009

A lot of talk has been heard lately regarding the dollar’s outlook as a major reserve currency, much of which has been initiated by Chinese and Russian officials, who tried to impose their global status at the international level in regard to the amount of U.S. debt held.

Despite this, the recent actions make the talk look like nothing other than empty words, as the two countries try to push more hot air into a balloon flying in a very cold environment. Despite all the recent accusations coming from Chinese officials, China still kept the same buying pace of U.S. debt, while Russia showed its support for the U.S. dollar during the G8 weekend, after it announced its plans to reduce its exposure towards U.S. denominated assets, something that caused a little shock in the financial market last week.

Ignoring the recent talks coming from China and Russia, TheLFB-Forex.com Trade Team argues that diversifying from the dollar can be really challenging for the vast majority of central banks. Right now, the only feasible alternative to the dollar as a reserve currency for now is the euro. However, what exactly a central bank would do with the euro, when the business relationships including trade balance and money transfers, are relatively low within the 16-nations, and the currency channel is illiquid most of the time.

A case in point would be Canada, of which a staggering 80% of its exports reach the U.S. economy, while only 4% of its exports and 6% of its imports are toward the Euro-area. The big question is, what could the BoC with its newly found euro reserves, when the liquidity in the euro-cad is very thin. Even the Chinese central bank would not have too many things to do with the euro, since the trade balance between the Euro-zone and China is rather small, and considerably less than 10% of the total Chinese balance.

One of the most important aspects is that, in order for a central bank to calculate a cross rate, it first has to triangulate the exchange rate to the dollar. Obviously, if the central bank is planning an intervention in the currency market (which by the way are done very often, especially for minor currencies) they would have to sell or buy dollars against the national currency, rather than euros, yuans or any other currency.

TheLFB-Forex.com Trade Team believes that the recent talks of the U.S. dollar losing its status as a reserve currency are greatly exaggerated. For now, the dollar’s status is safe, even though it is expected that the greenback will lose a few percentage points as central banks try to hedge its declines. However, this is far from the dollar losing its reserve status – as some say.

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Is Mr. Inflation Coming Back To Town?

Written by A Forex View From Afar on Sunday, June 14, 2009

An increasing number of market participants are considering that inflation is going to pick up very strongly over the upcoming period.

There are a number of signs that the market is preparing for such an event, but the most important one came from the commodity and Treasury markets. First, since the beginning of March, oil has more than doubled its value, making the current bull market the second most powerful on record. At the beginning of March, oil was trading at $32 per barrel, while on Thursday the oil market briefly tested the $73 area, which means that oil rose nearly 110% in thee months. The strongest bull trend on recorded happened in the early 1990’s, when oil gained more than 150% in a three month window, TheLFB-Forex.com Trade Team notes.

Over the last few years, oil was responsible for a large portion of the increases seen in the CPI reports. This was best seen during the summer months of 2008, when inflation reached multi-year highs in the most developed countries as oil was heading towards the $150 level. As such, TheLFB-Forex.com Trade Team expects inflation to pick up again in the coming months.

Further inflation evidence comes from the Treasury market, where the spread between the medium and longer term debt instruments is trading near the highest level on record. Mainly, the spread between the 2-year and the 10-year Treasury notes reached 2.60% in the last few weeks, even though its long-term average sits somewhere around 0.60%. TheLFB-Forex.com Trade Team said that the high spread shows that investors are demanding additional protection against inflation, as they think the Fed will be one step behind.

Remaining in the Treasury market, the 5-year breakeven spread has reached 1.90%. The 5-year breakeven spread measures the difference between 5-year conventional note and the 5-year TIPS notes, which are protected against inflation. The higher the spread between the two instruments, the higher investor’s prospects are that inflation will pick up. Moreover, the 5-year breakeven spread is the central banker’s preferred way to gauge inflation expectations over the longer term.

In the forex market, the currencies that usually have a higher interest rate backing their value will be the best performing ones during a global inflation event. As such, prospects really look for currencies like the aussie, pound (even though it is not the case right now) and more specifically for the emerging currencies.

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Trading Is About Managing Risk, Not Positive Trades

Written by A Forex View From Afar on Wednesday, June 10, 2009

One of the biggest issues a trader has to learn even from the first days of trading, but usually only after multiple blown accounts, is how to manage risk

Many traders just focus on the reward, and do not concentrate enough on the risks that go hand-in-hand. One issue many traders seem to pass by is that risk and reward are directly proportional, meaning that as one increases, the other does too. Moreover, the relationship between risk and reward has more of a fat tail behavior; the link between risk and reward decreases at high levels.

A forex trader should avoid taking trades with an associated risk bigger than 2% of their trade account, it will take more than 5 years of experience to find a rare opportunity that sets once in every while that risking more has proven to be previously advantageous. From personal experience, new traders should focus on small risk-trades, ranging from 0.5%-1.0% of the available account balance.

Even though these particular trades would not produce the same financial reward, they will keep a new trader in the game for longer, and will build a solid knowledge base that a career can be built upon. With some retail brokers offering now micro and mini lots (1K and 10K trade lot size) that cost a few dollars, and sometimes pennies to put on, a new trader does not need an account stacked with thousands of dollars just to learn to trade and manage risk.

A trade has two possible outcomes – either you win or loose. As such, in a control environment, a trader has a 50% chance to lose the next trade. Chances for 2 consecutive trades with the same outcome (win or lose) are 25%, while chances for three consecutive traders with the same outcome reach 12.5%. Even though the percentage is relatively small, new traders chase the game defying logic, and defying money management in the fear of loss gamble that comes with poor money management.

A good trader should psychologically prepare for such events during the intra-day set-ups. Too much risk can kill an account very quickly, especially for new traders who tend not to control their emotions too well, if at all. If someone is looking for risk-free trades in the financial markets, he or she should better look at a savings account, but with that being said, the other extreme is taking risk that is not at all justified.

Start with the stop area, and note the pip loss potential, 40 pips for example. Each pip costs $1 of a mini lot trade when trading Usd based pairs. On a $5000 account balance a 2% risk equals $100; with a 40 pip Stop the risk is 2.5 mini lots per trade. With 2% being the absolute maximum exposure at any one time, it also means that no new trades can go on until the original position has hit profit and the Stop moved to break-even.

Overleveraged trading is thrilling to some, while the idea of a casino type Lotto win is all consuming to others. Forex however, is a business; leave the gambling to the Thursday night card school, get a Plan, and get serious about managing risk because without it the game soon ends.

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Trade Desk View

Fundies and Trading
There is a constant question from some traders as to why anybody would ever need to consider the ‘F’ word when trading. Fundamentals: what is so damaging at looking at both Technical charts and having a Fundamental filter to gauge how many Lots to put on? Why is it that accepting that Technicals give us price points to trade, but Fundamentals determine the direction that we travel is so difficult for some traders to accept? Without a Fundamental Filter very few pure Technical traders would have seen this Dollar move coming today.

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