The world’s financial markets are on the verge of a collapse that rivals the Asian Financial crisis of 1997/98, the Savings and Loans crisis of the 1980’s and 1990’s, and some say even the Great Depression. As market risks balloon and traditional assets begin to break down, we now look to the Forex market to identify those currencies and strategies to avoid and those to hold through the turmoil.
In this article, we will tally the market destruction so far and review the potential triggers for the next leg of the market plunge. Then, we will cover the dangers in dollar and carry trade exposure. Finally, we will offer FX alternatives that will lower risk and may even bring us out on top of the market.
The News So Far
This morning, few markets escaped the panic that was borne out of a series of events that, in the end, may spell disaster for the global financial system. Assessing the damage, we can see that equities plummeted through all time zones. The primary risk asset for most investors, the benchmark Dow Jones Industrial Average tumbled over 500 points to close below 11,000 for the first time since July 17th. A better view of the panic was read in the S&P Volatility Index (VIX) which surged above 30 percent for the first time since the March. Elsewhere, the yield on the two-year Treasury note fell a staggering 51 basis points on speculation the Federal Reserve will join its global counterparts by entertaining interest rate cuts; and the even crude dropped below $94 per barrel on speculation curbed growth would dry up demand.
Tracking the general deterioration of conditions over the past year, we can trace the roots of this specific market crunch back to the sub-prime meltdown. Back in July and August of 2007, only a few hedge funds with heavy exposure to mortgage-backed securities were suffering from a jump in defaults encouraged by the resetting of adjustable rate mortgages. Since then, major lenders have collapsed, defaults have jumped to their highest level in 30 years, a mortgage-based crisis has turned into a credit crisis, financial institutions have racked up over $500 billion in write downs and a few major firms have flirted with collapse. Today, we saw that stakes were raised once again. Lehman Brothers, the world’s third largest securities firm filed for bankruptcy after a drain on capital and liquidity left the venerable company with no alternatives.
What Could Be Worse?
So far this week we have witnessed the largest bankruptcy filing on record; however, that may only be the beginning for this round of the ongoing financial crunch. Of far greater consequence for the markets (especially after Lehman’s downfall) could be a failure of AIG – one of the largest insurance firms in the world. Representing the next step of the sub-prime contagion, insurance for investors and for citizens is now threatened by a lack of liquidity in the credit markets. Should this giant go under, the market will be inundated with unmovable assets that would further depress prices which in turn forces downgrades that starts the cycle all over again with additional bankruptcies.
Looking out over the next few months, after this leg of the financial crisis has already been priced into the market, the real deterioration will begin. With credit markets frozen, investment evaporating and jobs being lost, an economic depression is the natural next step. We have already seen the UK, Euro-Zone and Japan report contractions through the second quarter. The true global proxy though will be the US economy – the world’s largest. Speculation of a recession through the second half of the year is starting to take root; and as conjecture gives way to data, there will be little regulators or investing powerhouses can do to turn things around. With the pain of severe losses haunting traders, a general lack of return not compensate for the level of risk that could linger for many months.
What To Avoid
Carry Trade – In the currency market, there was once strategy that was used exclusively to take advantage of the broad bull market through 2007 – the carry trade. With yields on the rise and risk dwindling in the steady bull market, there was no rival to this international trade. However, since the subprime problems first began to show up on the radar, the highly sensitive strategy has been under the gun. As can be seen in the chart below, conditions have gotten exponentially worse just in the past six weeks as banks have actually failed (as opposed to Bear Stearns which was bailed out) and there is evidence that the credit crisis has spread to critical points. As efforts to control the unfolding crisis fail and the potential for returns fall, interest in this index will push to new two-year lows.
The US Dollar – In the past few months, the US dollar has rallied nearly 13 percent on a trade-weighted basis. However, to understand where the currency is going, we need to understand where the strength has come from. Ushered down to a record low, the world’s most liquid currency has bounced on the outlook that the Federal Reserve was going to hike (where other central banks were now looking at cuts) and that the dollar’s counterparts were too highly valued in fundamental terms. In the long-term, the comparative value point may still hold water. With the UK, Japan and now Euro-Zone economies looking at potential recession, the US dollar is still severely depressed in comparison to highs seen in 2005 and especially those from 2002. On the other hand, in the short-term, the US is still the epicenter of the credit crisis. What’s more, hope that the US economy was on the upswing has been quickly dampened and the positive rate expectations for the FOMC have quickly turned into speculation of rate cuts by the year’s end.
Alternatives
While it may seem like the market turmoil has infected every corner of the global financial markets, there are always options in the currency market. For the next few weeks to months, capital the world over will seek out liquidity and safety. This doesn’t mean the markets will go only for those economies that are looking at positive growth though. Instead, the market will play a rating game, going for those currencies that have the best balance of liquidity, relative growth, and low exposure to the ebb and flow of risk appetite. As both the carry trade and US dollar are already flagged for risk, the market will be using these two assets to sell against. Therefore, a long carry currencies (Japanese yen and Swiss franc) and short dollars against comparatively strong currencies will find at least short-term interest. And, while it seems that all economies are suffering from the global downturn, it is easy to see that some are holding up better than others. Canada, Switzerland and the Euro-Zone have all seen comparatively lighter shocks to their economy.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>.