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 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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The China current account surplus is down roughly forty percent from last year. The US would like to see this shrink even further as America constantly runs a deficit due to more imports from China than exports to China. The US argument is that the China current account surplus is because of an artificially low exchange rate on the Chinese currency, the Yuan. The US and the EU would both like to see the Chinese allow their currency to float freely versus other currencies in order to make US and EU exports more competitive in the Chinese market and elsewhere. The Chinese, however, are merely following the example set years ago by Japan and Taiwan. By constantly purchasing US dollars to use as foreign currency reserves these nations are able to force the dollar higher and their own currency lower in currency pair trading. As the specter of a Greek debt default occupies the attention of the Forex world Western leaders are looking to the future and one of the reasons for the degree of debt in Europe, the China current account surplus.

In recent discussions as well as in pronouncements in the media, Chinese leaders cite the reduced China current account surplus as evidence that China is investing more heavily on infrastructure as a means of driving its currently export driven economy. They state that China is moving at a reasonable speed in increasing the value of its currency and that moving any faster is not necessary. On the other hand world leaders like US president Obama make the argument that China needs to let its currency float and do it more rapidly. With the US and EU debt burdens on the front burner for the West it is understandable that these economies look for relief in the form of more nearly balanced foreign trade with China and other Asian nations. Meanwhile China states its intention for internationization of the Yuan. The goal of China is, by the end of the decade, to add the Yuan to the small of group of currencies that nations hold as foreign currency reserves.

Currently the dollar as a safe haven currency is rising due to the EU debt crisis and pronouncements out of Europe that nations can voluntarily leave the European Union. This could well mean the entire southern tier of nations, Greece, Italy, Spain, and Portugal whose sovereign debt issues have occupied currency traders for over a year. If the Chinese are successful in internationalizing the Yuan it could become a so called safe haven currency along with the Yen, Swiss franc, US dollar, and, in better times, the Euro. Much of this will depend upon continuing a China current account surplus but not to the degree that the US and EU engage in a trade war as a means of last resort in order to deal with their own debt crises. The bottom line for China is to move to a more balanced economy in which their citizens buy products from around the world as well as being the new workshop of the world and only being an export driven economy. Many experts feel that the planned economy approach that China is using to create jobs in the interior does not solve the balanced economy issue and simply continues an eventually unsustainable China current account surplus.

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The recently announced French austerity plan reminds us that it is not only the so called PIIGS nations in the European Union that need to cut expenses. In announcing the French austerity plan Prime Minister Francois Fillon forecasted that the French austerity plan needs to save 100 billion euros. President Nicolas Sarkozy and his government would like to avoid a downgrade of their credit rating (as seen in the USA) and is thus cutting budgets and looking to raise taxes. With the Greek debt crisis ever so painfully in the news Italy is seen as the next, and worse, problem confronting the EU. The news the other day carried a telling item. The very Catholic nation of Ireland will no longer have an ambassador to the Vatican. It appears that everyone is cutting something in their budget.

French growth forecasts have been cut in half. Analysts say the French austerity plan will certainly reduce debts but may not be sufficient to avoid a cut in the nation’s credit rating. This issue is a little like looking at Illinois or California within the USA. It has to do with a member of the EU and not the EU itself. But, maybe not. In order for the bailout plans of the various nations in the EU to work the two largest economies must grow. Italy, the third largest EU economy is in trouble. France is looking to reduce debt which will likely reduce economic growth. That leaves Germany whose economy is recovering from the recession more slowly than desired. How does all of this affect the seemingly continuous downward direction of the Euro? Europe, for all of its current problems, is either the first or second largest economy in the world, depending upon whether they or the USA are in the lead for the year. However, the value of the Euro versus other currencies will adjust based upon the economic strength of the EU in relation to other economies.

French officials are cautioning the nation that sacrifices may be required as the idea of a European nation going bankrupt is no longer an abstraction. With Greece, Spain, and now Italy in danger of debt default it is altogether possible that one or more nations might leave the EU. How this new reality will affect the Euro versus the dollar is uncertain. A national bankruptcy could cause a cascade of defaults in weaker European economies. This could lead to nations leaving the EU. On the other hand it could end up with a stronger and more economically viable union. As with all Forex trading the issue of the French austerity plan requires continual fundamental and technical analysis of the currency involved, the Euro. Obviously a true global economic recovery would speed the recovery of the major nations of Europe and help stave off the wave of defaults that trouble world markets. As always traders need to watch two economies and two sets of data at once in Forex trading as traders trade one currency against the other.

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New headlines about a government collapse indicate that a Greek debt default is very possible despite herculean efforts by the European Community at large to prevent this very scenario. This story goes back a couple of years to the 2008 stock market crash and onset of the worst recession in three quarters of a century. Nations throughout the world borrowed heavily, or simply printed money, to avoid a banking collapse and a much dreaded freeze in credit worldwide. This strategy has been criticized by some as likely bankrupt many nations and lauded by some as having avoided a second Great Depression. The result in a number of nations in the European Union is that banks stayed open and governments engaged in various economic stimulus plans in efforts to jump start their economies. However, the end result for several nations was that they simply ran out of money and credit. The looming Greek debt is not the only sovereign debt issue plaguing Europe. Five nations have been in the spotlight for the last years. Portugal, Ireland, Italy, Greece, and Spain have become known as the PIIGS group in financial circles. As things worsen Forex risk aversion has driven the Euro down.

News reports tell us that austerity measures demanded by lenders in return for writing of large portions of Greek national debt and securing the rest have evoked street demonstrations and riots in Greece. The Prime Minister recently called for a popular referendum on the painfully cobbled together debt deal offer to Greece. The reaction of many lawmakers is that they will call for a no confidence vote. If this vote passes there will have to be new elections in Greece and all of nearly two years of work putting together a rescue package may indeed go down the drain. A possible result of a Greek debt default would be Greece leaving the European Union and more pressure on other members of the PIIGS group, starting with Italy. The Yen and Swiss franc will likely be under pressure rise farther and the dollar as a safe haven currency will likely go up as well.

What effect will a Greek debt default have on the Euro? What effect will a Greek debt default have on the situation in Italy, Ireland, Portugal, and Spain? How about stock markets throughout the world and other currencies? Many fear a domino effect of debt defaults if the Greek situation is not contained. Certainly markets throughout the world are concerned as every time there is bad news about European debt, stocks go down. Experts are especially concerned that Italy will be next if Greece defaults, with other PIIGS nations to follow. The Euro will likely fall in this case and traders buying puts in Forex trading the Euro will likely prosper. Many choose to buy options in such a situation and avoid trading currencies directly. By doing so the trader limits his risk to the cost of the options contract and enjoys the leverage of trading options as well. Using a strategy known as a long straddle a trader buys calls and puts on the same currency with the same expiration date. He will profit if the currency rises or falls and if the currency rate does not change he will lose only the prices of the options contracts whether there is a Greek debt default or not.

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