The Forex Nitty Gritty

Is Euro Zone debt resolution on the horizon? If so how will Forex markets react? The good news is that the majority of Euro Zone countries have agreed to strict austerity measures and debt talks between Greece and its private creditors are progressing. However, the ever so slow progress towards Euro Zone debt resolution always seems to take two steps forward and one backward. The downward direction of the Euro may or may not be ready to reverse. Currency traders always keep fundamentals in mind and these may, finally, be improving. However, market sentiment is something else. Currency traders as well as investors in stocks, commodities, and real estate have been pretty beaten up over the last couple of years in persistently volatile markets. As the Euro Zone gets its act together, will market sentiment coalesce to create a stronger Euro? Or, will the likelihood of a mini recession due to fiscal discipline scare investors and currency traders alike and result in a continuing decline of the Euro.

Traders who wish to trade the Euro, as well as the US dollar, Chinese Yuan, and a number of other currencies will want to keep in mind that everyone is printing money as a remedy to debt, unemployment, and reduced trade numbers. Forex trading and economic news are always intertwined. However, part of the currency trading puzzle is less obvious. As an example, US treasuries are selling at historically low interest rates. It turns out that a major buyer of US treasuries is the US Federal Reserve. This is part of the so called Bernanke Doctrine. Fed chairman Bernanke is considered one of the world’s experts on the causes of the Great Depression. He is applying measures meant to avoid the same sort of devastating economic contraction as happened in the 1930’s. His measures will tend to keep credit flowing, keep interest rates low, and steadily devalue the US dollar. A major aspect of this is that the Fed used recently printed money to buy US treasuries and to purchase other assets. The European Central Bank is following a similar course and China is said to be financing internal construction projects the same way. A Forex trader will see two forces in motion in the case of Euro Zone debt resolution as well as the US economic recovery, more jobs and currency devaluation.

On one hand traders will review how to invest in Euro and on the other hand those seeing the printing presses run at full speed will continue to consider how to short the Euro. Both approaches may be successful but, if so, it will be a matter of timing. In the short term a policy tailored after the Bernanke doctrine coupled with fiscal discipline may well lead to a timely Euro Zone debt resolution. However, a Euro Zone debt resolution purchased by virtue of the printing press will devalue the Euro over time. Then, the third aspect is that a cheaper Euro will make European products more competitive and lead to a stronger European economy and a rebound of the Euro. Forex traders need to stay tuned in to the evolving Euro Zone debt resolution in order gain profits.

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Although companies doing business internationally prefer stable currencies, speculators commonly look for profits in currency rate instability. The situation in the European Community is a case in point. A collection of European nations are to varying degrees in danger of defaulting on their national debts. The worst of the lot is Greece. There has been speculation in the press that the nation might be forced to withdraw from the European Union and quit using the Euro as its currency. For the last two years EU officials, the International Monetary Fund, the European Central Bank, and a succession of Greek officials have been dealing with the crisis. The end result is still uncertain. The continuing result of this uncertainty is currency rate instability. It starts with the Euro. However, the collective EU economy is on par with that of the USA as the first or second largest in the world. A financial crisis, renewed recession, and/or political breakup in Europe will affect markets and currencies throughout the world. Efforts to avoid financial disaster such as the French austerity plan threaten the economic growth needed to pay back the accumulated European debt load.

The most recent news about Greek debt negotiations is that European finance ministers are demanding that private investors take a fifty percent write off on the value of their investments and that they extend their loans out to two or three decades. In return the EU solvent members of the EU will provide the funds to rescue the Greeks from their financial mess. The precise interest rates involved in a new set of loans is a bone of contention as higher rates would require more money than the EU at large is willing to offer up to fix this mess. The Euro has fluctuated up and down in response to these ongoing negotiations, ministerial pronouncements, and press reports. Those who have been able to accurately read the various pronouncements have been able to profit from the resulting currency rate instability. It is not just about how to short the Euro but how to anticipate a likely recovery when the EU gets its economic house in order.

What happens if there is a Greece debt default? The concern is that many European banks as well as other investors have purchased Euro denominated bonds from Greece. If the nation defaults on its debts the resulting losses could cause banks not to loan and large investors to hold on to their money. If this happens in Europe, Spain, Italy, and even France could have problems selling their bonds at auction at reasonable rates. The doomsday scenario in this case is that government default on loans rolls across the bottom of Europe ending up in France, the continent’s second largest economy. The European Union breaks up with only the northern members remaining. The resulting currency rate instability drives the Euro down. The resulting recession in Europe hurts Asian exporters affects the Yen, Australian dollar, Yuan, and Rupee. Currency traders who do not see the whole picture sustain large losses. Those who anticipate the fallout from a poorly handled Greek debt crisis profit from the resulting widespread currency rate instability.

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Many who follow the real estate market on the mainland would not be surprised to see a Chinese real estate crash. Although some still think of China as an unstoppable juggernaut, the nation has its share of problems. For example the large number of IPO’s of Chinese stocks last year were mostly unsuccessful. The US Securities and Exchange Commission is looking into the limited transparency of and poor data available for many Chinese stocks. A likely recession in Europe could not only create problems such as a run on French banks but would certainly reduce exports from China as well. Both the EU and United States are printing money in order to avoid a depression. Cheaper dollars and Euros will make European and North American products more competitive and Yuan denominated products harder to sell. Then there is the issue of skyscrapers and a possible Chinese real estate crash.

Building booms often precede bad economic times. The “see throughs” in Atlanta and Houston years ago were silent testimony to the hubris of overbuilding during times of loose credit and excessive optimism. (A “see through” is a skyscraper that is largely unoccupied. At sunrise and sunset one can “see through” the many empty floors.) China is said to have over half of the skyscrapers in the world in construction with more on the drawing boards. Even for a large and growing economy that is a lot, especially when financing may be questionable. Property developers in general are pessimistic while construction firms express optimism. One group might be expecting a Chinese real estate crash while the other does not. However, when a construction company finishes the job it gets paid and moves on. It is the developers and investors who suffer when the real estate market crashes. At such times predicting Forex trends can be profitable.

There are three more issues that relate to the danger of a Chinese real estate crash. One is that in an effort to stimulate the economy the Chinese government has built many public projects with hundreds of billions of dollars creating their own artificial boom. The second is the nature of financing in China. Similar to Japan before the bust two decades ago, China has all too many “off the books” loans or at least loans that are not apparent to the general investor. If things go bad they could do so in a hurry with shaky financing. The third aspect is that the Chinese real estate market is already heading down hill. Residential property sales are down substantially in major Chinese cities and sellers are dropping prices in order to get out before things get worse. As the China current account surplus falls so might property values throughout China.

So, what would a Chinese real estate crash mean to the average Forex trader? The global economy is interconnected. Problems in Europe lead to problems in China and problems in the USA lead to problems virtually anywhere in the world. The coming year could be one of extreme volatility of foreign currency rates. The general consensus is that the Euro will fall due to a recession in Europe or a recession avoided by printing money. The seemingly impervious Chinese Yuan could fall as well, or at least level off due to decreased exports. It could get worse if the scenario of a Chinese real estate crash turns out to be the case. Then there is the issue of social and political unrest. The Arab world is not the only place where people have grown tired of heavy handed autocracies. People often put up with bad government when they can put food on the table and rise up when the economy turns bad.

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The European Central Bank rate of interest on loans to client banks may fall in the coming year. The new European Central Bank president, Mario Draghi, is expected resemble US Federal Reserve Chairman, Ben Bernanke, in his actions, more so than his predecessor, Jean-Claude Trichet. Draghi, like Bernanke, studied at the Massachusetts Institute of Technology. With Greek debt default still a strong possibility the EU has given the bank broader powers to prop up banks as well as governments. There are two problems that leaders of the EU and the Central Bank face. One is that governments across the continent need to spend less. We see this in the recently announced French austerity plan. The other is that decreased spending could well drive the continent back into a recession. It appears as though Draghi may follow Bernanke’s lead in driving interest rates lower in an attempt to avoid recession and increased unemployment by cutting the European Central Bank rate among other measures.

There is, indeed, speculation that Draghi could find himself following the Fed example of buying government bonds as well. The new bank president has already surprised many by issuing 1% interest loans amounting to over $600 Billion USD to prop up ailing European banks. The end result of all this could well be a yearlong decline in the Euro. Currency traders and others can heartened by the prospect of the EU getting a handle on the debt crisis. Over the long term, a solution to the continental sovereign debt dilemma can only mean good things for the EU. However, it may well be a bumpy and somewhat downward ride for the Euro until the EU gets its house in order. Volatile foreign currency rates were the hallmark of last year and may well continue into 2012. A reduced European Central Bank rate may well lead to a long term solution but at the price of declining Euro in the year or years to come.

If the Euro does decline it will probably not fall all at once or at a steady rate. Trading options on the falling Euro may be the best trading bet. When the trader buys calls or puts on one currency with the other he limits his investment risk to the price of the options contract. Traders will be able to decide upon trades based upon solid fundamental and technical analysis. By purchasing options the trader will be able to avoid substantial losses if his analysis is faulty. On the other hand he will be able to leverage his investment by purchasing options as the cost of an options contract is substantially less than the cost of the underlying currency. As always we are not predicting that the Euro will fall but offering a thought process for traders to follow in developing and executing currency trades. If the impression that Mr. Draghi gives of following in the steps of Mr. Bernanke is correct that will give traders useful insight into the likely direction of the Euro in 2012.

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There does not seem to have been a huge Forex response to Persian Gulf tension, yet. The US and its Western allies have been ratcheting up pressure on Iran to submit its nuclear program to inspections. In fact Iran is under pressure to dump its nuclear program as international agencies believe the purpose of Iran’s program is to develop nuclear weapons. As Iran has become increasingly cut off it has responded with threats to close the Straits of Hormuz. A third of all oil shipped by sea and a fifth of all oil traded in the world passes through the 34 mile wide straits every year. Currency traders are right to look for a Forex response to Persian Gulf tension. However, the economic worries and Europe, Asia, and North America seem to have taken precedence. The Euro rallied briefly as stronger than expected economic data came out of Germany and China. Over the longer haul, however, the Euro is not expected to do especially well. Austerity measures such as the French austerity plan and similar measures throughout the continent will likely lead to stabilization of the Euro Zone economy but will be a distinct drag on economic growth in the coming year or years.

The may be a greater Forex response to Persian Gulf tension if Iran takes any steps to impede traffic through the straits. The US aircraft carrier USS John C. Stennis and its battle group are stationed in the area and, in fact, passed through the straits recently during Iranian military exercises. Iran recently captured a US stealth drone that was allegedly sent to gather data about Iranian nuclear development. Iranian scientists have been assassinated as well. Israel is especially concerned as Iran has never admitted the nation’s right to exist. For Forex traders the concern would be that the fourteen or so tankers a day that pass through the straits would be impeded and the effect such would have on the world economy. Persian Gulf oil states, led by Saudi Arabia, have promised to increase production in Iran shuts down production. However, if these nations cannot ship their oil, prices will likely go up worldwide. Skyrocketing oil prices could well drive up prices of commodities and manufactured goods throughout the world and lead the world back into the depths of recession. Foreign currency rates would likely change as well. Think of who imports the most oil and then image their currencies falling as a Forex response to Persian Gulf tension.

Confidence in the dollar has risen over the last three years. Many believe that this is only because the Euro, especially, has done so poorly. But, in regard to a blockage of the Straits of Hormuz, or outright hostilities, the US is in better shape than just a few years ago. The US had reduced oil imports to 40% of consumption and, in fact, receives the vast majority of its imported oil from Mexico and Canada. Many would look to Europe, China, and Japan as large economies more likely to suffer from a cut off of oil coming out of the Persian Gulf. Thus a Forex response to Persian Gulf tension could well start with not only nations more dependent upon oil imports but also with nations in their supply chains.

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Will 1% loans from the European Central Bank to struggling European banks result in stabilization of the European banking system or a Euro carry trade? The European Union has been in a sovereign debt dilemma for a couple of years. The Southern tier of EU nations, plus Ireland, has become the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) group. These nations, most notably Greece, would have been unable to finance their national debts without aid from lenders, the IMF, the European Central Bank and other EU nations in particular. The possibility of a breakup of the European Union or at least the departure of Greece and a couple of other nations loomed over the continent for the last few months. Just recently EU leaders met in Paris and agreed to amend the EU treaty to allow closer financial integration. (Read this as putting a cap on politically motivated pork barrel spending to buy local votes.) In addition EU members gave the European Central Bank greater authority and autonomy in dealing with the overall debt situation as many banks were weak and many considered a run on French banks a distinct possibility as many had invested heavily in bonds from Greece, Italy, and the others. But, just what does this have to do with a Euro carry trade?

The expression, carry trade, is usually associated with the Yen and not the Euro. Japan has had extremely low interest rates for two decades. Investors holding Yen can engage in foreign exchange trading and obtain US dollars or other international currencies in search of better returns on investment. Then the investor buys US Treasuries if he now has dollars or, perhaps, Italian or Greek national debt bonds if he has turned in Yen into Euros. Anyone who bought dollars before the rally last fall and then purchased treasury bills before rates fell did doubly well.

On the other hand many Japanese repatriated offshore assets to pay for the destruction of the worst earthquake and tsunami in their history. This Yen repatriation sent the currency up dangerously fast. The rise in the Yen was only halted by threats of the G7 ministers to intervene in strength. Anyone who held offshore assets in a Yen carry trade did poorly at that point. The point of the Yen carry trade is to have or borrow assets in a nation where interest rates are low, convert to another currency, and invest where interest rates are high. The point is also that a change in currency rates does not erase all profits. This is the connection to a so called Euro carry trade.

A concern of some is that struggling European banks that have received 1% interest loans may be tempted to invest in high risk, potentially high return, debt. Whether this would be European debt or to use foreign currency trading in order to practice a Euro carry trade debt elsewhere in the world the potential for profits could be great, providing that the global economic picture brightens. On the other hand the loans could amount to throwing good money after bad if anyone tries such an aggressive and risky strategy. The good news for those fearful of such a scenario is that overnight deposits at the European Central Bank are at an all-time high. Apparently many of the European banks that needed bailouts have learned their lesson. They are avoiding any semblance of a Euro carry trade and putting their short term money in the most secure location available, even at low overnight interest rates.

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Will an increase in China foreign investment limits lead to a wave of Chinese acquisitions worldwide? If the relevant Chinese authority gives the go ahead individual Chinese investors will be able to purchase and use increased amounts of foreign currencies. Considering the country’s mammoth currency reserves an increase in China foreign investment limits could greatly widen the range of investments available to wealthy Chinese. As Chinese exports decline Forex traders expect less upward pressure on the Yuan. The Euro crisis and the US debt dilemma are far from resolved. Continued slow economic growth in North America and a new recession in Europe are likely to further reduce demand for Chinese exports although trader surpluses are likely to continue into the far distant future. While there threatens to be a run on French banks and a Moody downgrade of European nation debt ratings China may be extending its foreign investments and internationalizing the Yuan.

China has been under increasing pressure to let the Yuan float versus other currencies. The rationale of both European and North America leaders is that if allowed to float to its true value the Yuan will go up significantly in price. The rationale continues that a higher priced Yuan will make Chinese products less competitive and those of the EU, USA, and other nations more competitive. The goal of leaders in the West is to staunch the perpetual red ink in their balances of payments with the Chinese. For the Forex trader deciding how China foreign investment limits fit into the picture may spell the difference between profit and loss. It may be with an eventual increase of the Yuan that China is talking about allowing more of its citizens to convert Yuan to US dollars, Euros, Yen, and other major currencies in order to diversify the wealth of the nation. However, China has done spectacularly well in the last forty years since opening up to the rest of the world and done so under a very strictly controlled regime. It can be argued that they would have done better with less control. However, things as they are, China’s financial leaders may be concerned about too much capital escaping their direct control. Thus any moves to increase China foreign investment limits may be slow. Of course, if recession returns to Euro and North America, Chinese exports will suffer and in the Forex markets one may need to trade a declining Yuan.

In order to make purchases of foreign products, parts, or services, Chinese companies must purchase foreign exchange from the Central Bank and other institutions. A measure of Chinese foreign trade is the net value of foreign exchange sold by banks in a given month. When companies make a profit in a foreign currency that must sold back to the Central Bank or other financial institutions. Most recent available figures show $4.4 Billion US dollar value in sales of Yuan. This is the highest in four years. China has the world’s largest foreign currency reserves valued at over $3 Trillion USD. Because the Central bank recently sold more foreign currency that it has purchased it appears that there has been a net exit of capital from China in the last month or so which has also been seen in a diminished China current account surplus. All of this is pertinent in sorting out the end Forex result of increased China foreign investment limits.

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Will an upcoming review result in a Moody downgrade of European national debt ratings? If Moody downgrades the debt rating of every nation in Europe will it make a difference? Remember that Moody, Fitch, and Standard and Poors were roundly criticized for not picking up on the sorry state of bank finances running up to the 2008 market crash. The fact that the US and other nations had to ante up trillions of dollars in stimulus payments and money to keep credit flowing has been often blamed on Moody and the others. Now, as the European debt dilemma drags on Moody’s Investors Service has announced that it will review the debt rating of every nation in the European Union. This has to do with the need for bailout money to avoid debt defaults by Greece and the other nations in the so called PIIGS group. If everyone depletes their national treasury in order to bail out the southern tier nations of the EU, and Ireland, will someone else be next in line for bailout or debt default? An up and down stock market and the threat of a run on French banks has kept investors as well as currency traders concerned. The Euro has taken its hits due to possibility of a partial EU breakup. Will a Moody downgrade of European national debt ratings be the next step and, if so, what will be the difference.

In a perfect world of debt rating Moody’s and other merely restate the obvious. If a company or government has poor cash flow and little cash it may not be able to pay its debts. It may, in fact, see its debt rating reduced from AAA to junk. If investors are paying attention they will not need the review of a debt rating agency to tell them the obvious. The recent European debt summit resulted in an agreement by 17 nations to revise the EU treaty giving more power to the European Central Bank. The prospect of more fiscal discipline by EU members has many feeling good about an eventual resolution to the debt dilemma. In the short term there are still problems despite the promise implicit in the new treaty agreement and Fitch Ratings remarked to the effect that the summit did not really fix anything in the short term, a restatement of the obvious. Beside efforts by the EU at large, each nation of the European Union will need to tighten its belt as seen in the new French austerity plan, whether there is a Moody downgrade of European national debt ratings or not.

The proof is in the pudding, they say. The efforts of European nations to exert more control over local finances fix the Greek debt crisis and avoid other calamities, can be successful with sufficient attention to detail. But, once the EU is out of the global spotlight, will efforts to clean up the EU fiscal mess proceed or be swept under the rug? Assigning a number to the likelihood that a company or a nation will not follow through and pay its bills is the business of Moody and others. Although the EU has increased the power of the Central Bank to deal with this crisis there are those who believe that giving more power to the bankers is an effort to let the politicians off the hook. In the case of EU politicians it is the old Walt Kelly saying that “We have met the enemy and he is us.” It will take a lot of insight and honesty for all relevant politicians throughout Europe to forego buying votes with programs when that has been the way to do business since they sent Napoleon to Elba, the second time. Maybe a Moody downgrade of European national debt ratings is the best choice, to keep the politicians honest, another oxymoron.

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Could there be a run on French banks if credit agencies downgrade their debt ratings? A bank run is when many customers of a bank simultaneously wish to withdraw funds. They do this, commonly, because they believe that the bank might go into bankruptcy and that they, the customer, will lose money. If a sufficiently large number of customers decide to withdraw their money for fear of the bank becoming insolvent it can become a self-fulfilling prophecy. A possible run on French banks is of concern because the large deposits that many nations, including Germany and the US have in these banks. It was the run on many US banks in the early 1930’s that helps create the Great Depression. The prospect of a Greek debt default is especially worrisome for French banks as they hold substantial amounts of Greek debt. As with other bank runs it is the prospect of losing money that drives depositors to withdraw funds.

There are a number of ways that banks attempt to prevent a run. An old and often successful procedure is to close the bank temporarily. Such a “bank holiday” stems the flow of capital out of the bank while other measures are instituted to protect the bank. Deposit insurance helps protect depositors but the amounts of deposit insurance are useful for individuals and not for nations. The interconnectedness of banks and other financial institutions is such that damage from a run on French banks and subsequent collapse could spread to North America and Asia. It is a measure of how seriously investors take this situation that when news of a possible resolution to the European debt dilemma emerged this last week socks soared in the US and worldwide. Varying foreign currency rates have been a hallmark of this situation.

Nations throughout the world have been trying to get a hand on the degree to which their banks are exposed to this situation. The US Federal Reserve announced that it is analyzing the books of the six largest US financial institutions for European, especially French, debt. It is pertinent that Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Wells Fargo have deposits equal to two thirds of the US GDP which comes to a little under $10 Trillion USD. The concern of the Fed is the currency swaps in which these folks have engaged. In a currency swap two parties exchange currencies or interest payments on currencies on a fixed future date. These are Forex transactions. Speculators use these in search of profits. Central banks may use these to keep currencies stable. The concern of the Fed is that US banks may have excessive exposure to the Euro and the risk of a Euro collapse if the European debt dilemma becomes unsolvable. This combination of Forex and sovereign debt has plagued the markets for over a year and may, indeed, produce a run on French banks. As credit agencies such as Moody’s appraise the situation Forex traders are wary of movement of the Euro and the US Federal Reserve is pumping dollars into Europe in order to forestall a global financial disaster.

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If a beginning trader wishes to profit from fluctuations in the US Dollar, Swiss franc or Euro versus other currencies he will need to develop a Forex trading system. Although it is possible to let a team of traders and programmers develop a Forex trading system for you it is important that any foreign currency trader understands the ins and outs of the system. Even if you plan to purchase a trading system it is an excellent exercise to think through the various aspects of foreign currency trading in order to put things in perspective. So, if you are going to develop a Forex trading system or purchase one “off the shelf” what are the important parts?

Which Currency Pair and When

People trade foreign currencies for two basic reasons. Companies doing business internationally need to exchange currencies in order to make and receive payment for goods and services. These folks follow fundamentals and use Forex technical strategies in order to hedge the risk of currency fluctuation between the signing of a contract and final payment. Currency speculators simply seek to profit from price changes between any given pair of currencies. To a degree it is easier to develop a Forex trading system for hedging currency risk because the trader is only interested in one pair of currencies and one specific time frame. On the other hand a currency speculator will commonly keep his eye on a number of currency pairs in order to trade the most profitable pair at the most profitable time. Thus a speculator will need to allot time to seeking the most profitable pairs to trade and may subscribe to an alert service in order to trade when price action is potentially most profitable.

Which Market to Trade and What Time of Day

The major Forex exchanges are London, New York, and Tokyo. The sum total of their business hours allows a trader, in theory, to trade around the clock. However, humans need sleep. Traders also need prep time to scout out trading opportunities, learn more about trading strategies, review results, and modify their trading system. In order to develop a Forex trading system that works for people, time of day, available hours and organization of work flow are crucial. Folks wishing to trade the post tsunami Yen versus other currencies may wish to work during Tokyo business hours while those trading the British Pound may wish to work London business hours. For a trader living in Miami, Chicago, Denver, or San Francisco this will require other arrangements in order for the trader to have a personal, social, or family life.

How Much Do You Want To Risk and How Do You Protect Your Money?

Success is never guaranteed in Forex trading. Traders typically trade using a margin account. Then they leverage their trades which can greatly magnify profits but can also magnify losses. Smart traders also use trailing stops in order to lock in gains and avoid disastrous losses. Smart day traders get out of all of their trades at the end of the trading session to avoid getting caught in a big gap when the market opens the next day. Smart traders never put all of their money into one trade and smart traders never look upon what they are doing as gambling. And good traders review their results whether they are trading the Euro and the Greek debt crisis or are knowledgeable about commodities and trading the AUD, and if their system does not work they develop a Forex trading system that does.

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