Thursday, May 20, 2010

The Great Unwind!

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By Mike Conlon | May 20, 2010

I talk often about carry trades in the currency market which go hand in hand with the risk themes that drive daily price action.  When there is confidence in the financial markets, investors look to take on risk and seek out higher yielding assets.  They can do this by selling the currency of a low interest rate country and buying the currency of a higher interest rate country, thereby capturing interest through yield differentials.  This is known as a carry trade.

The currency pair that represents the greatest “carry” among the most actively traded pairs is the AUD/JPY pair which can also be used as a proxy for risk-taking in the market.  Currently, the positive carry of this pair is roughly 4.4%, as rates in Australia are at 4.5%, and rates in Japan are .1%.  So just by owning this pair, an investor would earn that rate difference.  This is a common trade when there is confidence in the financial markets.

Currently, there is little confidence in financial markets, as the EU debt crisis has brought to light many problems in the global marketplace.  And unless you have been living under a rock for the past few weeks, this should not come as news to you.

So what we are seeing is major risk-aversion in the markets, and no pair is getting hit harder than the above mentioned as investors unwind a risk-taking position.  In addition, global stock markets and commodities are selling off, adding additional fuel to the fire as investors run to the “safety” of the Japanese yen and US dollar.

In the forex market:

Aussie (AUD):  The Aussie is the biggest loser this morning, as risk-aversion is causing the un-wind of carry trades.  It is currently at an 8 month low vs. the US dollar, as gold prices have sold off to the 1178 level.  Gold is often used as a proxy against inflation, which does not appear to be as great a concern as deflation is, as the world prepares for a global slowdown.  Concerns about a Chinese slowdown could really derail the world economy, but all eyes are on the Euro crisis for now.

Loonie (CAD):  The Loonie is also selling off as commodity prices, particularly oil at 68, are lower across the board.  The Loonie does not benefit as much as the Aussie (or Kiwi) from carry trades, as low rates in Canada do not encourage carry trades.  The Loonie may be better off in the long run, as the US is its largest trading partner, and the US keeps throwing money at its financial woes instead of adopting austerity measures that the rest of the globe seems to be taking.

Kiwi (NZD):   The Kiwi is selling off for the same reasons as the Aussie; however in NZ they just announced that they will be cutting income taxes but raising sales taxes to encourage savings and debt reduction.  This will help NZ reduce its foreign debt as financial discipline is needed in the region.

Euro (EUR):  The Euro is higher vs. the commodity currencies above on the carry un-wind as well as risk aversion pervades the marketplace.  Now this may seem counter-intuitive to some as the major risk in the market is the Euro, which appears to be stabilizing as banter about Euro intervention is thrown about.  In somewhat decent news, PPI figures in Germany were higher showing signs that massive deflation has not taken hold.  Yet.

Pound (GBP):   Retail sales were higher in the UK for the third month in a row, in what may be short-lived gains in consumer sentiment.  With the new government looking toward austerity measures and a return to fiscal responsibility, and the BOE pledging to stay the course on monetary policy, the Pound may continue to be weaker vs. the Yen and the Dollar.

Dollar (USD):   US jobless claims came in higher than expected though continuing claims fell, most probably the result of discouraged workers losing their benefits.  This does not bode well for the US economy which, quite frankly is only seeing strength because everything else looks so bad.  US equity futures are lower, though off of their lows of the morning.

Yen (JPY):  GDP figures came in worse than expected to 4.9% vs. an expectation of 5.5%.  The export led recovery did not encourage consumers to spend, and higher yen values due to risk-aversion could derail exports going forward.  Nevertheless the yen is higher on the flight to safety trade, despite the fact that the BOJ may have to do more to combat deflation.

What we are seeing now is a global “ratcheting down” of economic bubbles that ran rampant over the last few years.  As different economies around the globe pare back spending and attempt to get their debt under control; economic slowdown is the natural consequence.

This is going to send a ripple effect through the global market place and fears of a global double-dip recession may not only be founded but likely.  I believe there is much more pain to be felt in the market place and have little confidence that world leaders can come up with a solution.

Because of the fractured nature of the world economy and competing interests, a solution may be impossible.  In my opinion, we are going to start to see either debt defaults or massive money printing which will eventually lead to inflation.  But that could be YEARS away.

So for now, think globally, but act prudently locally.

And take advantage of these extraordinary times by trading forex and shoring up your own personal balance sheet!

To learn more about how you can take advantage of world events through the currency market, be sure to check out our currency trading courses!

To follow these events live with a free, real-time practice account, click here!  Don’t miss out on the world’s fastest growing market!

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