The Forex Nitty Gritty

Things seem to have gone from bad to worse in Greece and the contagion of debt default worry seems ready to spread across Europe and elsewhere. It appears as through the Greek debt write off requirements were too strict. At least that is what Greek voters believe as they voted for widely different political parties and not so much for the folks that negotiated the debt relief deal that was supposed to protect against debt default. It turns out that Greece was not alone having this opinion. France elected a socialist who thinks that too much fiscal restraint will drive France and Europe into a recession and worsen its debt dilemma instead of improving it. At this point Forex traders may be thinking that the germane question really is how many Drachmas to a dollar? The situation is Greece is as follows:

Greece is a parliamentary democracy. It has many political parties with widely different views. For a party to govern it needs to get a majority of the vote. If it fails to do so the leading vote getter is asked to try to form a coalition with another party or two. This usually is a matter of picking a party or two with fairly close views on how to govern. Then the parties in the coalition pick a Prime Minister everyone gets a say in how things will be run. Unfortunately for Greece the major parties lost a lot of votes in the most recent election and parties on the far right and far left gained strength. To avoid a Greek debt default these parties need to agree to form a government that can go ahead with the agreed upon requirements of a EU sponsored bailout by the middle of June. If they do not, there will an election later in the month, too late deal with the issue. The next thirty billion or so (in dollars) installment is necessary to pay off bonds that are coming due. If they are not paid off the likely outcome will be a run on banks in Greece and the exit of Greece from the EU. Then, how many Drachmas to a dollar will be a valid question.

Besides wondering just how many Drachmas to a dollar, traders are driving the Euro down in expectation of an exit of Greece from the EU and the loss of loans made by the EU to Greece. The question of how many Drachmas to a dollar will be a side issue if Italy is next to default and the Euro goes into free fall. Underlying this drama is the question of whether the strict austerity measures chosen as a route to solvency are too strict. If these measures serve to choke off growth they will defeat their purpose. Voters in two countries have voted strongly for growth. If that is the way things go Greece could default, leave the EU, reestablish economic growth and the answer to how many Drachmas to a dollar might that the Drachmas is increasing in value. For the EU and the Euro the problem is that a Greek default will threaten other economies and require that the EU print more Euros in further enlarge its bailout fund. That will likely drive the Euro further down. That is part of why we post the question how many Drachmas to a dollar instead of to a Euro as the Euro will likely fall either way. Options on the falling Euro may well be the best choice in hedging risk as this situation plays itself out.

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When investing overseas be aware of the potential Forex benefits of foreign stock trading. The idea Forex benefits of foreign stock trading are to profit from the stock and profit from changes in the rate of exchange. It is also possible to use the Forex market to move assets out of one currency simply to invest at a higher rate of return and then to return assets to the original currency after a profit has been made. This is what is commonly done in the Yen carry trade. Investors convert their strong Yen into dollars, for example, and invest in US treasury bills, stocks, or other investments in the USA. When they have made a sufficient profit these investors cash out of their investments, convert their dollars back to Yen and count their profits. If they time the Forex market accurately these investors also enjoy Forex benefits of foreign stock trading, Treasury purchases, and the like. As looser Chinese currency controls become the norm a carry trade with currency profits may be possible with the Yuan as well.

The seemingly eternal Euro Zone debt crisis may offer the best example of Forex benefits of foreign stock trading. The recent elections in both Greece and France have shown that voters disagree with the austerity measures agreed upon to bail out Greece and other countries. The Greek debt write-off requirements have now resulted in a nearly sure defeat for the party and individuals instrumental for the Greek side of the deal. The strict austerity measures in place across Europe are likely to take the EU into a recession this year. Now, if the various parts of the bailout deals in place in Europe unravel the situation could be even worse. Many expect the EU to come apart. If this is so the Euro will fall and, probably, so will European stocks. However, remember that a major part of the problem for Europe, as well as the USA, is the value of the Euro (or dollar) against the Yuan, Yen, Taiwanese dollar and other Asian currencies. A falling Euro will make European products more competitive on world markets. A falling Euro Zone stock market will very likely result in a number of very fairly priced stocks. If this scenario holds an investor could wait for the Euro to fall and buy Euros with dollars. Then, buy cheap Euro Zone stocks with his Euros. Then, when the situation finally rectifies itself, sell the stocks for a profit in Euros and sell the now-more-valuable Euros for dollars. Think Forex benefits of foreign stock trading.

Other nations that are currently hurting in the slow recovery from the recession include the BRIC group, Brazil, Russia, India, and China. Chinese exports are down and there as real possibility of a Chinese real estate crash. India and Brazil have each seen a marked drop off in their rates of growth. Russia is still struggling with the bureaucratic mindset of Communism as it tries to leverage its natural resources to build currency reserves and revamp its technology and industry to compete with Europe, the USA, Japan, and China. The same argument made for Europe can fit here and reap Forex benefits of foreign stock trading. As always the trader needs to research his investments and trade currency at the most opportune times.

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Some still contend that the Vietnam War was all about oil in the South China Sea. Today there are new oil and gas finds in the Spratly Islands in the South China Sea and perhaps a threat of armed conflict. Our concern is the Forex response to oil and gas disputes in the South China Sea. Although the United States is no longer engaged in a ground war in Indochina its navy patrols the South China Sea. Toward the south of this region lie over seven hundred and fifty islands, cays, atolls, in islets called the Spratly Islands. This has long been a productive fishery with its many reefs. In the modern era the area promises to become important for extensive oil and gas deposits. The Spratly Islands lie off the West coasts of Malaysia, Brunei and the Philippines and the East Coast of Southern Vietnam. Mainland China and Taiwan are two and three times the distance from the islands. Our concern about a Forex response to oil and gas disputes in the South China Sea is similar to our concern about the Forex response to Persian Gulf Tension. It has to do with the militarization of this cluster of islands.

Just Who Owns the Spratly Islands?

Disputes over sovereignty in the Spratly islands go back years to when the French governed Indochina as a colony and pre-communist China under Chang Kai Shek argued over a French presence in the islands. Today Taiwan and mainland China each claim all of the South China Sea. Malaysia, Brunei, Vietnam and the Philippines claim parts of the islands. Mainland China, Taiwan, Vietnam, and the Philippines all have small troop garrisons in the islands. Brunei does not have troops to back up its claim. Tensions have recently risen as a Philippine company has found a new and large gas deposit. The Philippines already take natural gas from the area and pipe it to the island of Luzon. The Forex response to oil and gas disputes in the South China Sea could manifest themselves in a number of ways, both in direction and foreign currency trading volume.

Forex Response to Oil and Gas Disputes in the South China Sea

How Forex markets respond to disputes in the region will largely depend upon just how hot the situation gets. Last year a Chinese military vessel attempted to ram a Philippine oil exploration vessel. The US military has increased its presence in the area. In fact, the Philippines and other nations have sought closer ties with the USA in response to the perceived threat from China. Who gets to use the estimated twenty trillion cubic feet of natural gas just discovered could make a difference as well. When China’s industrial machine recovers from the recession and starts building again the rights to the energy wealth of the South China Sea could support their economy and the Yuan. On the other hand, overt military conflict, especially involving the USA and China could wreak havoc on the Yuan and US dollar. Some analysts expect the rhetoric to cool down once the Chinese leadership changes this year and lower level functionaries no longer feel the need to posture and appear decisive or strong. Then concern about a Forex response to oil and gas disputes in the South China Sea might diminish as well. Then traders can go back to concerns about such things as the China current account surplus or deficit and not the actions of the People’s Liberation Army.

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Beware of Forex price markups when having someone else manage your Forex trading account. That seems to be the take home message as legal action proceeds against the Bank of New York Mellon Corporation and others. These banks are being sued for alleged foreign exchange fraud by pension funds and others on whose behalf they traded Forex. It is good Forex advice to always know what you are doing when you trade currencies. If someone else is trading on your behalf it is better advice to make sure that you know what the charges, fees and commissions are.

There is the matter of Forex trading and foreign currency risk and there is the matter of the cost of doing business. Long term investing requires that one keep track of how one’s investments are doing on at least a weekly basis. Trading stocks, options, futures, commodities, and currencies requires that one keep up to day on a daily basis. It is all too easy for a currency trader to get into trouble and start acting like a gambling addict, doubling down on his “bets.” Anyone who has fiduciary responsibility for someone else’s money needs to be aware of Forex price markups and up to the minute trading results. The individuals and pension funds who are suing a number of banks apparently allege that they were swindled. Advice the rest of us is to beware of Forex price markups just as the old Roman saying, “Let the buyer beware.” Sometimes the rush for profits gets too intense, and even the best of money managers forget to beware of Forex price markups and other costs of investing.

The banks in this case deny that they overcharged their clients. Some of this goes back to contractual agreements between the banks and their pension fund clients. Some goes back to marketing literature used by the bank/Forex trader to entice pension funds to become clients. The job of the pension fund manager in order to beware of Forex price markups is to demand to see every single cost involved in a Forex transaction. This includes the Forex rates quoted in the transaction. Were the rates quotes the real up to the second quotes at the time of the trade? Or, were the rates given to the pension fund rates from different times during the day? A bad situation to be in is when the market is trading sideways and your account is absorbing the commissions, fees, and other costs of repeated trading.

It is certainly common for a Forex trader to open a trade, see it go a little bad, and wait for it to correct itself later during the day. Second guessing the trader is really not fair. The fund manager does not need to be steeped in Forex technical strategies but he needs to pay attention to results. There are two issues for the fund manager. One is if the trader is really successful in making money for the fund. The other is if the pricing is fair. A sad fact is that when an investor is making money he too often forgets to check the cost of his investments, he too often overlooks hidden costs, and neglects to beware of Forex price markups.

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What is the best minor currency to trade? The economies of Brazil and Mexico, India and China, as well as Russia are growing. Increasing commerce will result in increasing currency exchange. Choosing the best minor currency to trade will depend upon a number of factors including potential profits, high volume markets, liquid markets, and evolving Forex market sentiment. In general, a prosperous economy will result in a more valuable currency. That having been said, nations such as China are accused of currency manipulation. To the extent that a nation manipulates its currency it might not be the best minor currency to trade. Such thoughts need to be part of how to develop a Forex trading system for minor currencies.

Mexico

The Mexican peso (MXN) is the 12th most traded in the world and the third most traded in the America’s after the US and Canadian dollars, both classified as major currencies. An exception for the Mexican Peso is that it can be traded against the New Zealand dollar as well, NZD MXN. Mexico had a growth rate of 3.8 percent in 2011. A strong advantage to picking the Mexican Peso as the best minor currency pair to trade is its relatively high trading volume, especially against the US dollar. Mexico’s proximity to the USA may also be helpful in looking at the fundamentals that drive Mexican currency exchange rates.

Brazil

Despite the strength the emerging Brazilian economy the real commonly trades only against the US Dollar, USD BRL. Brazil’s economy grew 2.7 percent in 2011. The long term direction for this currency will probably be up as Brazil emerges as the super power of Latin America. How fast the rise occurs will decide if this is the best minor currency to trade.

India

The Indian Rupee, INR, trades against all major currencies. The country had a 7.8 percent growth rate in 2011. The same argument used for Brazil works for India. The world’s largest democracy is growing rapidly which will likely drive the rupee upward as well. The openness of India’s society makes where to get important Forex news less of a problem than with countries such as Russia and China. The twin factors of transparency and growth may well make the Rupee the best minor currency pair to trade.

Russia

The Russian Ruble (RUB) trades against the US Dollar and the Euro, USDRUB and EURRUB. Russia’s economy grew by 4.3 percent in 2011. More effective development of its natural resources is Russia’s trump card and a vote for the Ruble as the best minor currency pair to trade.

China

China’s currency, the Yuan, does not float freely in an open market and the country is under repeated pressure from the European Union and the United States to let its currency rise to a market driven level. China’s economy grew by 9.2 percent in 2011. Although the China current account surplus is reduced such fundamentals may still have less to do with the value of the Yuan than decisions by the Chinese hierarchy. This may not be the best minor currency pair to trade unless you have a crystal ball that tells you what the Chinese hierarchy is about to do.

As usual we offer this discussion in order to stimulate thought and not as explicit advice. Do your own fundamental and technical analysis and never trade when you do not understand what the markets are doing.

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A higher Euro Zone current account surplus is good news for those concerned about a possible downward direction of the Euro. According to press reports, the higher Euro Zone current account surplus is largely because of increased exports or goods and services. This indicates a stronger economy that many anticipated in light of austerity measures being put in place across the continent. The Euro Zone’s current difficulties started with the 2008 market crash which ushered in the worst global recession in three quarters of a century. Many Euro Zone budgets were dependent upon continued strong growth as debt levels were high throughout the Euro Zone.

A couple of years ago it came to light that five members of the European Union, Portugal, Ireland, Italy, Greece, and Spain were, to varying degrees, at risk to default on their national debts. They were nicknamed the “PIIGS” group. Greece became the focus of international attention as the worst case scenario. After receiving more than $100 Billion in funds two years ago the country was at risk for being unable to pay for expiring government bonds in March of 2012. The drama leading up to this date drove the Euro up and down depending on if the news for a successful bailout was positive or negative. In general the order of the day was how to short the Euro.

Along the way to a successful bailout by other members of the Euro Zone, the European Central Bank, and the International Monetary Fund, there were riots in Greece over lost pension and health care benefits. Countries across the Euro Zone agreed to reduce their national budgets and abide by austerity measures in order to avoid a spread of the Euro Zone debt dilemma from the Southern tier of nation to the more prosperous economic core of the Euro Zone. The austerity measures are likely to cause a recession in the European Union, according to many economic forecasters. The recently higher Euro Zone current account surplus, therefore, is excellent news for an economy wracked by doubt and debt as it tries to claw its way out of what has come to be called the “Great Recession.” The issue of the day may well become how invest in Euro.

For those Forex trading the Euro a higher Euro Zone current account surplus indicates a stronger Euro, but that is not all there is to the story. The price of the Euro is driven by whether more folks want to acquire Euros or more folks want to get rid of Euros. The current account surplus for the Euro Zone could have been if not for outflows of investment as many have avoided putting their money in the Euro Zone. For example, those who received payment for their maturing bonds in Greece may have taken a fifty percent hit on capital. Those folks may well have moved their money out of Euros and into, what they may feel to be, a stronger currency. Although the Euro Zone may be producing products to sell throughout the world, worldwide investors may well not trust either European banks or many European countries when it comes to paying their debts. A higher Euro Zone current account surplus does not necessarily mean that there will be no new recession in Europe. If, for example, European imports of products from China and other parts of Asia drop off substantially, a higher Euro Zone current account surplus could be maintained even with a shrinking economy.

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As the Greek debt dilemma finds resolution, currency traders wonder if there will be similar Euro Zone support for Portugal debt relief. Both Greece and Portugal are part of the so called PIIGS group. Portugal, Italy, Ireland, Greece, and Spain all have been in danger of defaulting on their national debts. The situation was sufficiently bad in Greece that it required the largest government bailout in history, cobbled together by the various solvent members of the Euro Zone, the European Central Bank, and the International Monetary Fund. In addition, private investors in Greek bonds took a fifty percent reduction in bond value and gave Greece longer to repay in return for the country not simply refusing to pay. The problem for the remaining PIIGS nations will be getting credit at reasonable rates. Anyone buying Portuguese bonds may be thinking that in return for a few percent interest each year they will be running the risk of having their bonds written down by fifty percent or losing their investments completely. Euro Zone support for Portugal debt relief will be important in the country is to avoid the debt default that many feared for Greece. Then traders will want to consider what the Euro Zone debt resolution will mean for the Euro.

Portugal, Recession, and Its Debt Burden

The country of Portugal has a continuing recession with a one percent drop in GDP in 2011. It is expected to have as much as a four percent drop this year and perhaps another two percent in 2013. With the Greek scenario as a backdrop, Portugal will have trouble finding any private lenders to help it out. Although economists expect Portugal to emerge from its recession within five years, that does not encourage investors at this point. Thus Euro Zone support for Portugal debt will be critical in the coming years. If the solvent so called core group of European Union nations are willing to support Portugal in the coming years it will likely emerge more fiscally sound. In addition, the austerity measures taken on by nations across Europe may well lead to slower than expected European growth in the year or so to come. This would simply make things worse for Portugal and the other nations struggling with their debt burdens.

Trading the Euro

It appears that the European Union is not going to break up, as some feared a year or more ago. However, fears of a “domino effect” of debt defaults from Italy to Spain to Portugal to Ireland and back to Greece still concerns traders and investors. The answer for the currency trader, in this situation likely lies in how the European Central Bank is dealing with the generalized debt dilemma. The European Central Bank seems to be following the lead of the United States Federal Reserve in that they are printing money in order to pay off debts, prop up banks and the credit system, and stimulate the various economies. This approach may well pay off in pulling the Euro Zone out of its economic funk. However, the cost could well be a devalued Euro. However, if you expect to see a downward direction of the Euro look at who else is printing money to stimulate economies these days. The dollar and Yuan could fall as well. As always don’t trade currencies unless you understand what you are doing and always do your homework.

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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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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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Currency and stock traders have been hoping to see tangible signs of a global economic recovery. When the largest heavy equipment manufacturer in the world, Caterpillar, reported better than expected earnings it also predicted growth in the three percent range through the end of 2012. Stock markets reacted positively and currency traders are looking to see which currencies will profit the most. A lot of the construction spending coming this next year has to do with the ongoing reconstruction efforts in Japan following the worst earthquake and tsunami in the history of the island nation. Construction in Japan as well as in the USA are expected to help lead global economic recovery this next year. Does that mean that the YEN and USD will rise as well? Investing in the US dollar was a good bet recently as the dollar rose against most currencies and falling interest rates on T bills made assets held in dollars and T bills doubly valuable.

Traders recognize, however, that the Japan and Switzerland have been selling their currencies recently to avoid high priced Yen and francs. Traders also recognize that for a global economic recovery to really gain steam the European Union needs to follow through with promises and its more prosperous members need to ante up somewhere in the neighborhood of €2 Trillion in order to resolve the continuing debt dilemma. If this happens most traders expect to see a rally of the Euro which could lead to a falling dollar. Although many see the dollar as a safe haven currency a rising Euro could compete as a secure currency to park assets in time of economic distress. Likewise, if the Swiss and Japanese stop dumping their currencies they could rise as well. Smart traders are using options to hedge currency risk.

A positive factor pointing to a continued global economic recovery, as opposed to a second dip of the worst recession in three quarters of a century, is the fact that many US companies are flush with cash. Many, in fact, have substantial sums offshore. If legislation meant to encourage a repatriation of these assets goes through it could bring a lot of dollars back to the USD and also drive the dollar higher. This would be a situation similar to the Yen repatriation scenario earlier this year when Japanese investors divested themselves of investments denominated in dollars and other currencies and converted these currencies back into Yen. These investors had been engaged in the so called Yen carry trade. They were able to move assets out of Japan with its low interest rates and convert to currencies where interest rates were higher. When the earthquake and tsunami wreaked havoc on the nation many needed assets back home in Japan to finance reconstruction efforts. The resulting wave of purchases of YEN drove the currency up very rapidly and only a threat of unified intervention by the combined financial ministers of the G7 served to stabilize exchange rates. As a continuing global economic recovery seems more likely there will very likely be substantial cash flows for investment and well as asset repatriation. Currency traders are well advised to follow fundamentals and technical aspects of their currency pair of choice in the coming months.

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