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March 2009 Volume 6, No. 3

THE BRITISH POUND’S pounding p. 8

SWEDEN’S KRONA FACES familiar currency challenge p. 12

RISK AVERSION and the forex market p. 20

Strategies, analysis, and news for FX traders

WEEKLY BOTTOM PATTERN:

Time for a bounce? p. 16

CURRENCIES AND SOVEREIGN credit risks p. 28

CME READIES new Micro FX futures

p. 38

CONTENTS Contributors . . . . . . . . . . . . .

CONTENTS

CONTENTS Contributors . . . . . . . . . . . . . .

Contributors

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Global Markets

 

Has the bleeding stopped

 

for the pound?

 

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The British pound had backed off a bit from

its

once-in-a-lifetime sell-off in February, but

few are betting the currency will stage a dramatic recovery in the near future.

 

By Currency Trader Staff

 

Volatile times for krona

 

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Regardless of whether this Nordic currency can come out of its deep freeze, it is likely to have a bumpy ride in the coming months.

By Currency Trader Staff

 

Spot Check

Pound/dollar

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A look at what the British pound’s recent price

action hints about its future. By Currency Trader Staff

On the Money Rational fear and the forex market

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Analysis of several intermarket relationships suggests the role of risk aversion in the forex market is no cut-and-dried issue. By Barbara Rockefeller

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Advanced Strategies Sovereign credit risk and currencies

Government actions are perversely rewarding the guilty: As a nation’s credit rating deterio- rates, its borrowing costs fall and its currency, at least temporarily, rises.

By Howard L. Simons

and its currency, at least temporarily, rises. By Howard L. Simons continued on p. 4 2

continued on p. 4

and its currency, at least temporarily, rises. By Howard L. Simons continued on p. 4 2
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar

CONTENTS

CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar
CONTENTS International Markets Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar

International Markets

Numbers from the global forex, stock,

and interest-rate markets.

Global Economic Calendar

Important dates for currency traders.

Forex News Two exchanges, two approaches

to new FX futures

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The CME Group and ICE take different approaches in offering forex traders new ways to trade currency futures.

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Events . . . . . . . . . . . . . .

Events

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Conferences, seminars, and other events.

New Products & Services

Forex Journal

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A short trade in the USD/CAD pair.

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Looking for an advertiser?

Consult the list below and click on the company name for a direct link

to the ad in this month’s issue of Currency Trader.

CitiFX

dbFX

eSignal

FXCM

fxKnight.com

IG Markets

Institute of Higher Earning

InterbankFX

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ODL Securities

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The Wizard

Tsunami Trading

 

C O N T R I B U T O R S CONTRIBUTORS C O N T R I B U T O R S CONTRIBUTORS CONTRIBUTORS CONTRIBUTORS

C O N T R I B U T O R S CONTRIBUTORS A publication of

A

publication of Active Trader ®

For all subscriber services:

www.currencytradermag.com

Editor-in-chief: Mark Etzkorn metzkorn@currencytradermag.com

Managing editor: Molly Goad mgoad@currencytradermag.com

Associate editor: Chris Peters cpeters@currencytradermag.com

Contributing editor:

Howard Simons

Contributing writers:

Barbara Rockefeller, Marc Chandler

Editorial assistant and webmaster: Kesha Green kgreen@currencytradermag.com

Art director: Laura Coyle lcoyle@currencytradermag.com

Art director: Laura Coyle lcoyle@currencytradermag.com Howard Simons is president of Rosewood Trading Inc. and a
Art director: Laura Coyle lcoyle@currencytradermag.com Howard Simons is president of Rosewood Trading Inc. and a

Howard Simons is president of Rosewood Trading Inc. and a strategist for Bianco Research. He writes and

speaks frequently on a wide range of economic and financial market issues.

President: Phil Dorman pdorman@currencytradermag.com

Publisher, Ad sales East Coast and Midwest:

Bob Dorman bdorman@currencytradermag.com

Ad sales West Coast and Southwest only:

Allison Chee achee@currencytradermag.com

Classified ad sales: Mark Seger seger@currencytradermag.com

Volume 6, Issue 3. Currency Trader is published monthly by TechInfo, Inc., 161 N. Clark St., Suite 4915, Chicago, IL 60601. Copyright © 2009 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher.

The information in Currency Trader magazine is intended for educational pur- poses only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

Barbara

forex.com) is an international economist with a focus on foreign exchange. She has worked as a forecaster, trader, and consultant at Citibank and other financial institutions, and currently publishes two daily reports on foreign exchange. Rockefeller is the author of Technical Analysis for Dummies (For Dummies, 2004), 24/7 Trading Around the Clock, Around the World (John Wiley & Sons, 2000), The Global Trader (John Wiley & Sons, 2001), and How to Invest Internationally, published in Japan in 1999. A book tentatively titled How to Trade FX is in the works. Rockefeller is on the board of directors of a large European hedge fund.

Rockefeller (http://www.rts-

GLOBAL MARKETS Has the bleeding stopped for the pound? The UK’s concentration in financial services

GLOBAL MARKETS

Has the bleeding stopped for the pound?

The UK’s concentration in financial services has compounded the problems for its economy and currency.

BY CURRENCY TRADER STAFF

FIGURE 1 — HOW THE MIGHTY HAVE FALLEN A little more than a year after
FIGURE 1 — HOW THE MIGHTY HAVE FALLEN
A little more than a year after making a 26-year high above 2.1100, the
pound/dollar fell to a nearly 24-year low in January 2009.
Source: TradeStation

C oncerns over the global crisis remain the key driver in the foreign exchange market as

investors witness the continued dete-

rioration of economies around the industrialized world. In February, the British pound stabilized somewhat vs. the U.S. dollar after dramatic losses in recent months. Looking back to what seems now like a lifetime ago, in November 2007 the pound/dollar pair (GBP/USD) touched a high of $2.1159 (the highest price since 1981) and was still trading above $2.000 in July 2008 before plunging to a late-January 2009 low of $1.3500 (the lowest price since 1985), and more recently con-

solidating in the $1.4100- 1.5000 range (Figure 1). The British economy was especially hard hit during the fall months thanks to the UK’s strong reliance on bank- ing and other financial servic- es. Citing data from the British Consular Office, Charmaine Buskas, senior economic strategist at TD Securities in Toronto says, “10.7 percent of UK gross

BRITISH POUND/U.S. DOLLAR AT A GLANCE

Daily range (past 40 days):

Average: .0326

Median: .0329

Weekly range (past 26 weeks):

Average: .0828

Median: .0748

52-week high/low:

2.0395

   

1.3501

Prevailing interest rate, last change:

 

UK

 

U.S.

1%, -0.50%

 

0%, -0.50%

Next scheduled central bank meeting(s):

March 5

 

March 17-18

GDP (% annualized):

Q4 2008

Q3 2008

 

Q2 2008

 

UK

U.S.

UK

U.S.

UK

U.S.

-1.8

-6.2

0.3

-0.5

1.7

2.8

All data as of 2/27/09

domestic product (GDP) comes from financial services. It accounts for one in 30 jobs. They had the same troubles as everyone else, but amplified and magnified.” Like the U.S., the UK also suffered a crash in its over- leveraged housing market at the same time the global financial crisis began to hit. “The UK is suffering more than some because of its financial and housing sector exposure,” says Stephen Webster, chief European economist at 4CAST Inc.

2-percent contraction of the early 1990s, but less than the nearly 6-percent fall in the early 1980s following the ‘winter of discontent.’ The UK economy is about halfway through

continued on p. 10

The UK economy is about halfway through continued on p. 10 “The UK is suffering more

“The UK is suffering more than some because of its financial and housing sector exposure.”

— Stephen Webster, chief European economist at 4CAST Inc.

GDP freefall

Webster says the UK’s economic situation is “dire in every sense.” “Economically, the UK officially slipped into recession as of the fourth quarter 2008,” he says. “Credit conditions remain tight and confidence weak.” Ruth Stroppiana, chief interna- tional economist at Moody’s Economy.com adds: “The ongoing lending logjam and the associated adverse impact on the availability of credit to households and [corpo- rations] will take a heavy toll on the economy. Real GDP is expected to sink by almost 4 percent from peak to trough, almost double the

GLOBAL MARKETS continued FIGURE 2 — ALMOST, BUT NOT QUITE The Euro/pound’s run to parity

GLOBAL MARKETS continued

FIGURE 2 — ALMOST, BUT NOT QUITE The Euro/pound’s run to parity (1.00) came up
FIGURE 2 — ALMOST, BUT NOT QUITE
The Euro/pound’s run to parity (1.00) came up short late last year, and the pair
subsequently retraced more than 10 percent over the next six weeks.
Source: TradeStation

its deepest recession in three decades.” Moody’s Economy.com forecasts UK real GDP to con- tract by 2.9 percent in 2009, following a mere 0.6 percent rise in 2008. This compares with 4CAST Inc.’s projection of a

FIGURE 3 — TRYING TO STAY AFLOAT The pound/dollar has managed to stay above its
FIGURE 3 — TRYING TO STAY AFLOAT
The pound/dollar has managed to stay above its January low, but it has not
made a strong move to the upside.
Source: TradeStation

3.5-percent 2009 decline and TD Securities’ forecast of a 3.1-percent decline.

BOE action

The Bank of England (BOE) has aggressively stepped in to combat the financial crisis. Since early October, the BOE has slashed its key lending rate from 5 percent to the current record low of 1 percent. Analysts expect the BOE to pull the trigger on another rate cut at its upcoming March 5 meeting. Another 0.50-percent easing is widely expect- ed, which would take the key mone- tary policy rate to yet another record low of 0.50 percent. “With the monetary policy rate rap- idly approaching zero, Britain’s cen- tral bankers are running out of room to cut rates much further,” Stroppiana says. “Dysfunctional credit markets

have blunted the effectiveness of traditional monetary policy. “The government has granted the central bank unprece- dented powers to buy up to £50 billion

in corporate assets via the Asset Purchase Facility. The purchase of commercial paper and corporate bonds is currently being financed by the issue of Treasury bills rather than by the creation of money. The next step for Britain’s central bankers will likely be to adopt a quantitative easing policy — creating central bank money to boost money supply in a bid to increase the availability of credit to households and corporations.”

FX action

Into year-end, forex traders had focused on the parity level in the Euro/pound pair (EUR/GBP). On Dec. 30, EUR/GBP touched the .9800 level intraday but subsequently pulled back as far as .8600 in early February before rebounding to around .8860 later in the month (Figure 2).

“There was a speculative push to achieve parity in December,” says Michael Woolfolk, senior currency strate- gist at Bank of New York Mellon. “We saw a pullback in January from the speculative surge to buy the Euro vs. the pound.” However, analysts are increas- ingly bearish on the pair. “The UK has been more proac- tive than the Eurozone in battling the deteriorating economic condi- tions,” says Meg Brown, senior currency strategist at Brown Brothers Harriman. “We think the UK will follow the U.S. out of recession earlier than Europe. But we are not there yet.” On a relative basis, EUR/GBP could have more room on the downside, according Woolfolk. He and others highlight the Eurozone’s exposure to Eastern European banking woes. “Eastern Europe is imploding right now,” he says. “These coun- tries, such as Poland, the Czech Republic, and Latvia, are members of the European Union. They are in severe economic distress with no positive outlook for the foreseeable future.” The Eurozone’s exposure to these weak links could ultimately weigh on the Euro in the near future. Bank of New York Mellon forecasts a stiff decline in the Euro/dollar (EUR/USD) toward $1.15 in the months ahead. Into year-end, they see an 82.00 EUR/GBP target. In recent weeks, the $1.35 level has formed a minor bottom of sorts in the pound/dollar pair (Figure 3). But, the jury is still out on whether that will act as a strong floor in the weeks ahead. “Over the coming quarter, the U.S. dollar will not give up much ground and the pound will come under pressure,” Brown says. She

advises pound traders to “remain short or use pullbacks, to say, $1.50, to short the pound.”

For more analysis of the pound/dollar pair, see “Spot check.”

the pound.” For more analysis of the pound/dollar pair, see “ Spot check .” CURRENCY TRADER
GLOBAL MARKETS continued Volatile times for krona The Swedish krona, like many other smaller currencies,

GLOBAL MARKETS continued

Volatile times for krona

The Swedish krona, like many other smaller currencies, took a beating vs. the dollar and the Euro the past few months, but analysts are guessing the worst may be over.

BY CURRENCY TRADER STAFF

L ike Switzerland, Sweden has a long history of neutrality — the country has not participated in a military conflict in nearly two centuries. Nonetheless, the Nordic nation, with a popula-

tion of just over nine million citizens, has been unable to avoid the international financial crisis and global recession.

Swedish economic growth numbers plummeted toward the end of 2008 amid a sharp decline in exports, which include machinery, autos, paper products, and iron and steel products. At the same time, the Swedish currency, the krona (SEK), reversed a multi-year strengthening trend vs. the U.S. dol- lar in August 2008 and has deteriorated significantly into late February 2009 (Figure 1). In the third quarter of 2008 the Swedish growth rate turned negative, with a quarterly 0.1-percent gross domes- tic product (GDP) decline. Total 2008 GDP growth was forecast at 0.5 percent by Moody’s Economy.com, while Swedbank Markets estimated a final 0.3-percent annual rate for the year. The outlook for 2009 is much bleaker, though. The Swedish banking group SEB forecasts a 2.4-percent decline in Swedish GDP this year, which would represent the largest downturn since World War II. Moody’s Economy.com forecasts a 2.2-percent GDP decline.

“The financial crisis and a global slowdown have reduced demand for Swedish exports, while domestic con- sumption remained very weak,” says Moody’s Christine Li. And has been the case almost everywhere else, a wobbly housing market and nervous consumers are adding to domestic weakness. “Consumer spending has been contracting amid very

tight credit conditions and a weakening housing market,”

Li says. “Swedish house prices had been showing positive

annual growth rates during the first nine months of last year because of a cap on property taxes, but house prices are now contracting. The financial turmoil has kept credit

conditions tight and borrowing costs high, which has reduced household spending. “The labor market is also softening, with unemployment rising from 6.4 percent in December to 7.4 percent in January as Swedish companies slash their workforces to

battle the fallout from the global financial crisis and a weak-

er sales outlook,” Li adds. Sweden boasts an export-driven economy. During the

first three quarters of 2008, the volume of Swedish exports

of goods and services rose by about 4 percent annually

according to a recent report from Swedbank, in which ana- lysts wrote: “Foreign trade statistics for October and November show that exports of goods continued to weak-

en, for which reason we estimate that total export volume growth for the full year of 2008 to be only 2 percent. This is the weakest trend since 2002 and much lower than we forecast in the September forecast (4.5 percent).” Swedbank forecasts a 1.5-percent decline in Swedish export growth in

2009.

FIGURE 1 — THE FORMER TREND The dollar had been losing ground vs. the Swedish
FIGURE 1 — THE FORMER TREND
The dollar had been losing ground vs. the Swedish krona for the better part of
three years before the massive reversal that began in summer-fall 2008.
Source: ADVFN (http://www.advfn.com)

Banking and bailouts

Like many other countries, Sweden has put together a bailout package for its embattled banking sector, announcing a new $6 billion rescue plan in early February. “The Swedish banking sector

remains stressed,” Li says. “Following the demise of Lehman Brothers, the global wholesale funding market seized up and Swedish banks became reluctant to lend to each other. In response, the central bank has continued to pump massive liquidity into the sector, a total of SEK 300 billion of loans denominated in dollars and kronas. “Investors have recently been con- cerned about European banks’ exposure to emerging European markets,” she adds. “Swedish banks have a particular- ly high exposure to the Baltic region. Western European banks are believed to account for 90 percent of the value of all bank loans made to Central and Eastern European countries. Lehman Brothers’ September 2008 bankruptcy filing was a watershed event for both the Swedish economy and its currency. “The collapse of Lehman Brothers constitutes a turning point for the krona,” says Cecilia Skingsley, head of fixed income and foreign exchange research at Swedbank Markets in Stockholm. “The effect of the collapse was a sharp increase in financial market volatility. This turned out to be hugely detrimental to small currencies such as the Swedish krona as investors rushed into currencies such as the Japanese yen, U.S. dollar, and the Euro, which were perceived as huge and safe. On top of this, a small export-dependent country like Sweden has a disadvantage when the global business cycle turns down.”

The Riksbank

The Swedish central bank — the Riksbank — has been one of the more aggressive central banks in the world, according to Swedbank’s Skingsley. The Riksbank began an easing cycle in October 2008 and has made four cuts since then, bringing the bank’s overnight “repo” rate from 4.75 percent to 1 per- cent as of February 2009. Most Swedish analysts agree further rate cuts are possi- ble, with room for another 50 basis point

continued on p. 14

rate cuts are possi- ble, with room for another 50 basis point continued on p. 14
GLOBAL MARKETS continued FIGURE 2 — THE BIG TURNAROUND The dollar was pushing to new

GLOBAL MARKETS continued

FIGURE 2 — THE BIG TURNAROUND The dollar was pushing to new highs vs. the
FIGURE 2 — THE BIG TURNAROUND
The dollar was pushing to new highs vs. the krona in late February.
Source: ADVFN (http://www.advfn.com)

another few months, but will recover in the course of the second half of 2009. We look for EUR/SEK at 10.00 by year end.” Volatility will likely remain the name of the game in the near term. “The Swedish krona will remain volatile against the Euro this year given continued financial market turbulence,” Li says. “The Euro will weaken to 9.40 against the krona by mid-year as investors price in worsening Eurozone eco- nomic fundamentals and further aggressive Eurozone mon- etary policy easing. Moody’s Economy.com expects the Euro will finish the year at SEK 9.42 against the krona.” What does this mean in respect to the dollar? “The U.S. dollar will continue to benefit in this shaky global economic environment, partly due to continued repatriation flows, partly due to Euro problems stemming from heavy EMU exposure to Eastern Europe,” Skingsley notes. “We see USD/SEK at around 8.50 and the Euro will fall vs. both currencies.” SEB Trading expects USD/SEK at 8.75 in mid-2009. “The risks are clearly on the upside,” Javeus says.

FIGURE 3 — EURO/KRONA The krona also lost ground against the Euro, which, after a
FIGURE 3 — EURO/KRONA
The krona also lost ground against the Euro, which, after a pullback, pushed
above its December high in February.
Source: ADVFN (http://www.advfn.com)

cut to a 0.50 percent official rate in the second quarter of this year. Johan Javeus, chief forex strategist at SEB Trading offers a more aggres- sive outlook. “Our view is that the Riksbank will cut rates to zero at the April 21 meet- ing and keep the repo rate at zero until the end of 2010,” he says. The Riksbank has a 2-percent infla- tion target with a tolerance band of +/- 1 percent around that target.

While 2008 CPI inflation came in at 3.4 percent, inflation is not even on the radar screen this year — in fact, it has been plummeting. In December 2008, the CPI rose by 0.9 percent after hitting 4 percent in October 2008. But the Riksbank is forecasting a 0.5-percent decline this year in the nation’s consumer price index (CPI), and SEB forecasts a 0.9-percent CPI decline in 2009, followed by a modest rebound to a 0.4-percent rise in 2010.

The krona

Swedish citizens voted down entry into the European Union in 2003 and chose to maintain their own sovereign currency — the krona. For many years, the USD/SEK pair

was in a steady downtrend as the krona strengthened against the dollar, falling from from 11.06 in July 2001 to 5.81 in April 2008. After winding in a trading range for much of 2008, the krona made some explosive down moves against both the dollar and the Euro beginning in August

2008. Again, like most smaller currencies around the world,

the krona suffered as the financial panic unfolded. “Risk aversion has meant investors have been selling

risky assets such as the krona,” Li says. “The U.S. dollar has been strengthening vs. the krona as risk-averse investors have been mov-

ing into safe havens such as the dol- lar.” From the 6.04 level in August 2008, USD/SEK surged to 8.90 in late February 2009 (Figure 2), while EUR/SEK blasted higher from 9.48 to

11.40 in December 2008 before backing

off to 10.41 and then rallying again to a new high in late February (Figure 3). Although the krona is punished in times of financial risk aversion, according to Skingsley, “the trend is no longer falling, but rather stabilizing [with] continued high volatility. EUR/SEK will be range bound for

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SPOT CHECK Pound/dollar The British currency’s implosion makes it difficult to find historical comparisons, but

SPOT CHECK

Pound/dollar

The British currency’s implosion makes it difficult to find historical comparisons, but one unfolding pattern hints at higher near-term prices, barring a new dollar surge.

FIGURE 1 — GBP/USD, MONTHLY The pound plummeted to a nearly quarter-century low in January
FIGURE 1 — GBP/USD, MONTHLY
The pound plummeted to a nearly quarter-century low in January before
stabilizing somewhat in February.
Source: TradeStation
FIGURE 2 — GBP/USD, DAILY The pound continued to struggle after the initial September-November flush-out
FIGURE 2 — GBP/USD, DAILY
The pound continued to struggle after the initial September-November
flush-out in financial markets.
Source: TradeStation

BY CURRENCY TRADER STAFF

W hen, during the week

ending Oct. 24, 2008,

the British pound/U.S.

dollar pair (GBP/USD)

fell more than six percent below the pre- vious week’s low, it was the first time the pound had dropped that much in more than 16 years. To be precise, it had- n’t fallen that far, that fast since the week ending Sept. 18, 1992 — the week, in fact, when George Soros was credited with “breaking” the Bank of England with his massive short play against the British currency. That the pound has taken weekly beatings of this magnitude only four times in the past 20 years, and that three of them have occurred in the past five months (the weeks ending Oct. 24, Nov. 12, and Jan. 23), is a testament to the

extreme nature of the current market upheaval. (The market has fallen 3 percent or more on a weekly basis only 26 times in the past 30 years, and seven of those drops have occurred since August 2008.) Perhaps not coincidentally, reports surfaced in late January that Soros had been shorting the pound during the most recent sell-off, which saw the currency collapse from the 2.1159 high in November 2007 vs. the dollar to a 1.3501 low in January 2009 (Figure 1). Soros was quoted in The Daily Telegraph as saying he had foreseen the drop in sterling, but that after the fall from around $2 to $1.40, “the risk-reward balance is no longer compelling.” Although he hesitated to say the pound’s sell-off was definitively fin- ished, the news was widely interpreted as a sign the worst might be over, at least for the near future. But does that make it a buying opportunity? Has the bleeding stopped for the pound?reviews the economic and political challenges the British currency faces as it tries to rebound from its most dramatic devaluation in more

continued on p. 18

SPOT CHECK continued FIGURE 3 — GBP/USD, WEEKLY The two-week pattern that appeared in mid-January

SPOT CHECK continued

FIGURE 3 — GBP/USD, WEEKLY The two-week pattern that appeared in mid-January was a relatively
FIGURE 3 — GBP/USD, WEEKLY
The two-week pattern that appeared in mid-January was a relatively
rare event because of the size of the down move during the week
ending Jan. 16.
Source: TradeStation

than half a century. The price action itself is inconclusive. More so than most markets, the pound/dol- lar pair has struggled to find its footing since October-November, moving sideways to lower before falling to a new low in late January (Figure 2). Its subsequent run-up formed — from the week ending Jan. 16 to the week end- ing Jan. 23 — what likely caught the eye of many a chart watcher as a reversal pattern of some kind: A sharply lower weekly low that closed near the bottom of the week’s range, fol-

lowed by a week that bottomed around the same level but closed near the top of its range (Figure 3). Price initially bounced a little higher, then pulled back slightly over the next couple of weeks. However, several ways of modeling the pat- tern with any specificity produced too few examples from which to draw conclusions; the drop from the low of the week ending Jan. 16 to the following week’s low was, as men-

tioned, exceptionally large. Taking into account as many of the characteristics of the two-week pattern while avoid- ing optimization led to the following definition:

FIGURE 4 — POUND/DOLLAR WEEKLY PATTERN The pound/dollar pair outperformed the market’s overall bias during
FIGURE 4 — POUND/DOLLAR WEEKLY PATTERN
The pound/dollar pair outperformed the market’s overall bias during two
different periods, but results were choppy. Also, relaxing the pattern parameters
significantly produced a total of only 39 examples since 1979.

The evidence is scant, but the pattern analyzed here points to the potential for some limited upside action in the pound/dollar pair, given the market’s most recent move was in keeping with the pattern’s historical performance. However, as of Feb. 27, the market had concluded week four of its post-pattern move and had already rallied as much as .0448 above the Jan. 30 close, much more than the typical post-pattern move. Also, it’s important to remember the other half of this pair is the U.S. dollar, which, although it faces its own prob- lems, has proved it is still something of a safe-haven in times of turmoil. If the global markets begin to destabilize dramatically again, funds are likely to fly in the direction of the dollar, to the detriment of most other currencies.

1. Last week’s low is at least 1 percent lower than the previous week’s low.

2. Last week’s close was below last week’s open.

3. The difference between this week’s low and last week’s low is less than 0.05 percent.

4. This week’s close is above last week’s close.

5. This week’s close is in the upper 25 percent of the week’s range.

As loose as the parameters are, they produced only 16 previous examples

dating back to February 1999. Figure 4 compares the median price movement for the 12 weeks after the pattern (measured from the close of the pattern to the subsequent 12 weekly closes) to the median price action for all one- to 12-week periods during the 10-year analysis period. There is an upside bias to the post-pattern behavior, espe- cially through week 8, but the price action in the first cou- ple of weeks is flat to lower — which happens to be the path the pair took after the most recent instance. Going back another 20 years to 1979 produced 23 more examples, and the overall trajectory was roughly the same:

The pair outperformed the market by the end of the review period, but this time price meandered for seven weeks before turning higher.

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ON THE MONEY FIGURE 1 — EURO/DOLLAR VS. S&P 500, DAILY Prevailing wisdom holds that

ON THE MONEY

FIGURE 1 — EURO/DOLLAR VS. S&P 500, DAILY Prevailing wisdom holds that if risk aversion
FIGURE 1 — EURO/DOLLAR VS. S&P 500, DAILY
Prevailing wisdom holds that if risk aversion rises, the dollar goes up as
traders buy into the U.S. currency as a safe haven. If risk aversion falls, the
dollar falters.
Source: data — eSignal and Reuters Online; chart — MetaStock
FIGURE 2 — EURO/DOLLAR VS. S&P 500, WEEKLY It may seem as if the Euro
FIGURE 2 — EURO/DOLLAR VS. S&P 500, WEEKLY
It may seem as if the Euro led the S&P down in 1999-2001, but this
relationship has no basis in reality.
Source: data — eSignal and Reuters Online; chart — MetaStock

Rational fear and the forex market

Intermarket relationships aren’t always what they seem.

BY BARBARA ROCKEFELLER

T he explanation for

every market move in

recent months has been

“risk aversion.” If risk

aversion rises, as symbolized by declines in the Dow and S&P 500 stock indices, the dollar goes up as traders buy into the U.S. currency as a safe haven. If risk aversion falls because of some new government initiative to fix the financial sector or the economy, the dollar falters (Figure 1). While it’s true risk aversion is a powerful force, it’s really another way of saying “fear.” There was “irrational exuberance” on the way up, and now we have fear on the way down, with some people claiming this time the fear is rational and based on authentic risks of additional wealth destruction. In short, we haven’t come up with any new ideas about the behavior of markets beyond “fear and greed,” a phrase that surely has been around for centuries.

We haven’t come up with any new ideas about the behavior of markets beyond “fear and greed,” a phrase that surely has been around for centuries.

The problem with risk aversion as the explanation for everything is that it is being tossed around like confetti. One newspaper reports the Euro/yen pair has a strong correlation with the CBOE volatility index (VIX). A hedge- fund manager says he is very con- cerned about the Euro/yen crossrate being so strongly correlated with the S&P 500 stock index. European ana- lysts are tracking the relationship between the Euro/dollar and the Baltic Dry Index (BDI), a measure of shipping rates and thus a proxy for global economic activity.

Previously, we had the circular oil- dollar logic: the dollar is up “because” oil is down (on the theory that cheap oil is good for the U.S. economy), or oil is up “because” the dollar is down. Finally, we have the perennial dollar and gold relationship — gold rises when the outlook for the dollar is bleak. Gold is an alternative to money as a store of value, even if it can’t be used as a unit of account or a transac- tion medium (try paying for a quart of milk or a tank of heating oil with a chunk of gold). To all of this we say, “balderdash.”

FIGURE 3 — DOLLAR/YEN VS. S&P 500, DAILY The dollar/yen surging upward to nearly 100
FIGURE 3 — DOLLAR/YEN VS. S&P 500, DAILY
The dollar/yen surging upward to nearly 100 while the S&P 500 is still falling
is a divergence the risk-aversion scenario cannot explain.
Source: data — eSignal and Reuters Online; chart — MetaStock

Market prices may appear to be corre- lated, but correlation is not causation. Market prices are set by two things — fundamentals (such as corporate earn- ings for stock indices or jewelry demand for gold) and market senti- ment. When market sentiment is dom- inated by fear, rational or irrational, all prices will fall, but they fall in their own way and to their own extent because prices are set by human traders and each market has a differ- ent trader profile. Figure 2 shows the Euro and S&P 500 on a weekly basis. It appears the

continued on p. 22

2 shows the Euro and S&P 500 on a weekly basis. It appears the continued on
ON THE MONEY continued FIGURE 4 — EURO/YEN VS. S&P 500, WEEKLY Starting in 2003,

ON THE MONEY continued

FIGURE 4 — EURO/YEN VS. S&P 500, WEEKLY Starting in 2003, it looks like Euro/yen
FIGURE 4 — EURO/YEN VS. S&P 500, WEEKLY
Starting in 2003, it looks like Euro/yen has been highly correlated with the S&P
500, but neither currency has anything to do with the U.S. stock index.
Source: data — eSignal and Reuters Online; chart — MetaStock
FIGURE 5 — DOLLAR/YEN (INVERTED) VS. GOLD (WEEKLY) The yen and gold diverged dramatically in
FIGURE 5 — DOLLAR/YEN (INVERTED) VS. GOLD (WEEKLY)
The yen and gold diverged dramatically in the fall of 2008.
Source: data — eSignal and Reuters Online; chart — MetaStock

Euro led the S&P down in 1999-2001, but this has no basis in reality. The Euro was the least of the reasons the S&P fell in 2000. The real reason was the tech wreck and the bursting of the Internet bubble. The Euro was weak for its own reasons at the time, or rather we might say the dollar was strong for its own reasons, having lit- tle to do with stocks. We might say the Euro fell because Euro-holders were selling them to buy into the U.S. stock market, but the sums involved do not support the thesis, tens of bil- lions in portfolio investment vs. hun- dreds of billions in actual Euro/dollar positions. The tail does not wag the dog. We need to downplay the seeming correlation for two reasons. First, we want to avoid knee-jerk trading deci- sions inspired by developments in only marginally related markets. This is called keeping your eye on the ball and it’s a basic tenet of good manage- ment. As management guru Stanley Drucker advised, “Stick to your knit- ting.” If you follow the dollar/yen and your trading P&L depends on the dollar/yen, you should not be look- ing at the gold-oil relationship. A corollary is that if the rest of the mar- ket is bedazzled and befuddled by events in another market, you may be able to take advantage of it. At some point they will wake up to the empti- ness of their presumption, and if you can predict their exit, you can get there first. The second reason is that you want to have a clear head, uncluttered by extraneous factors against the day when your market really does make a

When market sentiment is dominated by fear, rational or irrational, all prices will fall, but they fall in their own way and to their own extent because prices are set by human traders, and each market has a different trader profile.

move. For example, the yen was said to be a safe haven for the Japanese. Risk aversion was causing retail investors to pull back from positions in foreign assets. In the past year, Japanese investors in overseas invest- ment trusts saw a pullout of $118 bil- lion. Despite Japan having the worst economic performance among G7 countries, with GDP falling 12.7 per- cent year-over-year in 2008, the yen is

the home currency for the Japanese and thus their safe haven. Besides, a new tax law coming into effect in April waives corporate taxes on repatriated profits, possibly as much as ¥10-20 tril- lion. This scenario supposedly supports the inverse correlation of the yen and the U.S. stock markets. As the Dow and S&P fall, the yen goes up on repa- triation. This sounds plausible and

FIGURE 6 — DOLLAR/SWISS VS. GOLD/OIL (WEEKLY) The rise in gold and decline in oil
FIGURE 6 — DOLLAR/SWISS VS. GOLD/OIL (WEEKLY)
The rise in gold and decline in oil forms a spike, but the Swiss franc fails to
follow.
Source: data — eSignal and Reuters Online; chart — MetaStock

indeed the yen strengthened from 110.67 in August 2008 to 87.13 in January 2009, or more than 21 percent (Figure 3). But now suddenly we have the dol- lar/yen surging upward to nearly 100 while at the same time the S&P 500 is still falling — a divergence the risk- aversion scenario simply cannot explain. Logically, if world equity assets are falling, risk aversion should be higher and the safe-haven yen should be rising, not falling. Golly, maybe the dollar is the safe haven, after all.

continued on p. 24

falling. Golly, maybe the dollar is the safe haven, after all. continued on p. 24 CURRENCY
ON THE MONEY continued FIGURE 7 — DOLLAR/YEN VS. NIKKEI 225 STOCK INDEX, DAILY The

ON THE MONEY continued

FIGURE 7 — DOLLAR/YEN VS. NIKKEI 225 STOCK INDEX, DAILY The yen/Nikkei stock index relationship
FIGURE 7 — DOLLAR/YEN VS. NIKKEI 225 STOCK INDEX, DAILY
The yen/Nikkei stock index relationship is logical, because when the yen is
weak Japanese companies can sell more overseas.
Source: data — eSignal and Reuters Online; chart — MetaStock
FIGURE 8 — DOLLAR/YEN VS. NIKKEI 225 STOCK INDEX, WEEKLY The yen/Nikkei relationship is weaker
FIGURE 8 — DOLLAR/YEN VS. NIKKEI 225 STOCK INDEX, WEEKLY
The yen/Nikkei relationship is weaker on a weekly basis.
Source: data — eSignal and Reuters Online; chart — MetaStock

Or maybe it’s a mistake to forecast the yen based on what stock markets are doing. Starting in 2003, it looks like Euro/yen has been highly corre- lated with the S&P 500 (Figure 4). Huh? Neither currency has anything to do with the U.S. stock index. Maybe we could torture U.S. corpo- rate earnings and get them into the picture somehow, but the operative word is torture. What about currencies vs. oil and

If the rest of the market is bedazzled and befuddled by events in another market, you may be able to take advantage of it. At some point the rest of the market will wake up to the emptiness of their presumption, and if you can predict their exit, you can get there first.

gold? Figure 5 shows the yen against gold, which is denominated in dol- lars. Note the giant divergence in the fall of 2008. Another chart that shakes confidence in intermarket correlation is the Swiss franc vs. the gold/oil composite (Figure 6). Here we see the

rise in gold, coupled with the fall in oil, delivering a spike while the Swiss franc fails to follow. The Swiss franc is regarded as a safe haven in times of market turmoil and uncertainty — and the spike in gold/oil must spell “uncertainty” in capital letters — but it would have been a mistake to buy Swiss francs on this evidence. One intermarket relationship that is consistent and reliable is the one between the yen and the Nikkei stock index (Figure 7). This has logic behind it, because when the yen is weak Japanese companies can sell more overseas. This is the only time you can use an intermarket correlation to your trading advantage — but you have to be nimble. Figure 8 shows the same relationship on a weekly basis. The correlation is weaker, because there are other, separate factors at work in both markets, like actual earnings over expected earnings. You can’t dawdle with this one. Next, consider the Baltic Dry Index as a proxy for true economic growth. The BDI, which has been around since 1744, measures the price of shipping raw materials on various routes around the world. It takes a long time to build a ship, so when demand for shipping rises compared to the supply of ships, we assume economic growth is good (Figure 9). The Euro seems to track the index very closely to the May 2008 spike when the index hit a record high. By December 2008, the index had lost all its 2005 gains. So why did the Euro spike up in December to nearly 1.4600 when the index was still down in the dumps? Logically, there is no reason for the Euro to be more highly

correlated with world growth than any other currency. The BDI fell for many reasons, but

an important one was the loss of cred- it that started last July and remains in

continued on p. 26

was the loss of cred- it that started last July and remains in continued on p.
TRADING STRATEGIES continued FIGURE 9 — EURO/DOLLAR VS. BALTIC DRY INDEX WEEKLY There is no

TRADING STRATEGIES continued

FIGURE 9 — EURO/DOLLAR VS. BALTIC DRY INDEX WEEKLY There is no reason for the
FIGURE 9 — EURO/DOLLAR VS. BALTIC DRY INDEX WEEKLY
There is no reason for the Euro to be more highly correlated with world growth
than any other currency. The BDI fell for many reasons — notably, the loss of
credit that started last July.
Source: data — eSignal and Reuters Online; chart — MetaStock
FIGURE 10 — COMMODITY PRICE INDEX VS. BALTIC DRY INDEX, WEEKLY The correlation of raw
FIGURE 10 — COMMODITY PRICE INDEX VS. BALTIC DRY INDEX, WEEKLY
The correlation of raw material prices to the BDI is more impressive than the
relationship between the Euro against the BDI in Figure 9.
Source: data — eSignal and Reuters Online; chart — MetaStock

It’s okay to consider that one market influences another, like raw materials prices influence the BDI. But it’s risky and a bit silly to trade the Euro/dollar by looking at the BDI chart.

effect today. Shippers, shipbuilders, and producers of raw materials couldn’t get credit as the financial markets seized. Finally, raw materials prices fell dramatically. The correla- tion of raw material prices (represent- ed by the Commodity Price Index in Figure 10) to the BDI is more impres- sive than the relationship between the Euro against the index. Finally, if we think fear is behind all markets these days, let’s measure fear itself. That is achieved with the VIX, which measures the implied volatility of S&P 500 index options over the upcoming 30-day period (Figure 11). A high VIX means fear is really high and the market is likely to go up, on the theory that an excess of fear will exhaust itself. VIX spiked to its high- est level in October 2008, crashed, and then spiked again. As we know, the S&P itself failed to deliver a rally (Figure 1) while at the same time, the Euro is diverging from VIX. Well, if fear is what is dominating the curren- cy market, the Euro should be lower

— much lower. Evidently, risk aver- sion in stocks is quantitatively and qualitatively different from risk aver- sion in currencies. Context counts. It’s okay to consid- er that one market influences another, like raw materials prices influence the BDI. But it’s risky and a bit silly to trade the Euro/dollar by looking at the BDI chart. Don’t trade one thing while looking at something else. Trade the thing you’re looking at.

For information on the author see p. 6.

FIGURE 11 — EURO/DOLLAR (INVERTED) VS. VIX (DAILY) The VIX spiked to its highest level
FIGURE 11 — EURO/DOLLAR (INVERTED) VS. VIX (DAILY)
The VIX spiked to its highest level in October 2008, crashed, and then spiked
again — without a big rally in the S&P. At the same time, the Euro is diverging
from VIX.
Source: data — eSignal and Reuters Online; chart — MetaStock

Other Barbara Rockefeller articles:

“Competitive devaluations, the EMU, and the yen” Currency Trader, February 2009. Currency devaluation never works in the long run — just ask Japan — but that doesn’t mean panicky governments won’t use it to try to stem the flow of blood in the near term.

“The Euro: Prosperity or perdition?” Currency Trader, January 2009. The belief the Euro sell-off has ended may be based on some false assumptions about how the U.S. and Europe are handling the economic crisis.

“The six Ds of depression” Currency Trader, December 2008. The buck has gotten a bounce from the recent financial panic, but the longer-term picture isn’t quite as bullish.

“Euro and dollar at parity?” Currency Trader, November 2008. A few short months ago the world was contemplating Euro $2. Now, the talk is all about Euro $1. What are the odds it will happen?

“Crisis of confidence,” Currency Trader, October 2008. As Wall Street and Washington prove themselves equally inept, the dollar suffers.

“The dollar-oil connection” Currency Trader, September 2008. As oil broke, so did the Euro/dollar pair. What can we learn from analyzing bursting bubbles?

“Horizontal patterns in foreign exchange” Currency Trader, August 2008. The Euro’s price action lends itself well to dissection with the Darvas Box.

“Are the summer doldrums here?” Currency Trader, July 2008. If market myth is true, the season will bring a sideways market. But the myth warrants some analysis.

“Manias and crashes: Where will oil lead the dollar?” Currency Trader, June 2008. Although some analysts argue a falling dollar is helping to push up oil prices, it might be the other way around. The question is, when will the bubble-go-round stop?

“Is the Euro going to the moon?” Currency Trader, May 2008. A look at the Euro’s recent gravity-defying performance.

“What’s really driving the dollar?” Currency Trader, April 2008. Signs of a potential turnaround in the buck can be found in an unexpected place.

“Why is the yen trending higher?” Currency Trader, March 2008. The yen’s rise seems to defy logic. Find out what’s behind it.

You can purchase and download past articles at http://store.activetradermag.com.

ADVANCED STRATEGIES Sovereign credit risk and currencies The policy failures of 2007-2008 are likely to

ADVANCED STRATEGIES

Sovereign credit risk and currencies

The policy failures of 2007-2008 are likely to lead to greater government intervention.

BY HOWARD L. SIMONS

FIGURE 1 — FIVE- AND 10-YEAR CDS COSTS ON U.S. AND GERMAN BONDS VS. NORMALIZED
FIGURE 1 — FIVE- AND 10-YEAR CDS COSTS ON U.S. AND GERMAN BONDS
VS. NORMALIZED YIELD SPREAD
The credit crisis was global and clearly affected German bunds as much if not more
than American bonds.

O ne witticism circulat-

ing about the Internet

endlessly — and by

fax previously, for

those of you old enough to remem- ber when the fax machine was très chic — is the six phases of a project. These are, in chronological order:

enthusiasm, disillusionment, panic, search for the guilty, punishment of the innocent, and praise and honors for non-participants. This process must be scale-inde- pendent, for it applies to global cen- tral banks and finance ministries, operating both as separate entities and in coordination with each other, as well as to small groups within companies. How else can we explain the phe- nomenon — increasingly observ- able in 2008 — that once a country’s sovereign credit rating deteriorates, its borrowing costs fall and its cur- rency, at least temporarily, rises? If this is not a perverse rewarding of the guilty, then what is?

Sovereign credit risk

Credit default swaps (CDS) are insurance contracts wherein the writer agrees to pay the investor the full (“par”) value of the bond in the event of a default. Think of them as put options on bonds. They are quoted in basis points, or 0.01-percent units of the dollar amount being insured, usually a minimum of $10 million. The com-

FIGURE 2 — CREDIT RISK OF JAPANESE FIVE- AND 10-YEAR BONDS REMAINS ELEVATED This parallel
FIGURE 2 — CREDIT RISK OF JAPANESE FIVE- AND 10-YEAR BONDS
REMAINS ELEVATED
This parallel example observed for American and Japanese bonds confirms an
emerging principle of sovereign credit risk: Governments are being rewarded with
lower borrowing costs as investors flee risk.

ative real short-term interest rates, acceptance of all hard-to- value securities as collateral, implicit backstops of rescue plans for entities such as Bear Stearns, the de facto nation- alization of Fannie Mae and Freddie Mac, and the creation of a bewildering array of lending facilities managed by some combination of the Treasury and the Federal Reserve. Each one of these steps reduced, in the case of the Federal Reserve, the quantity of Treasury securities on its balance sheet. Central banks’ portfolios held securities of increas- ingly dubious quality, so much so the Federal Reserve has refused to disclose the garbage it has accepted as collateral despite a Freedom of Information Act inquiry. All this chicanery produced higher inflation and, ironi-

continued on p. 30

bination of a risky bond plus a CDS, therefore, is a synthetic call option on the bond. The arbitrage is conceptu- ally simple: A holder of a risky bond should be willing to pay as much as the spread over Treasury or other sovereign yields in CDS protection. What happens when the underly- ing bond itself is a sovereign credit risk, such as a U.S. Treasury, a German bund or a Japanese govern- ment bond (JGB)? The default risk of

Restated, as credit risks increased in general, investors fled riskier assets for the perceived safety of sovereign debt — a flight-to-quality only if you assume “quality” and “printing press” are interchangeable.

any of these instruments involves something pretty apocalyptic, on the

order of the issuing government ceasing to exist and honor its obligations. That happens, as anyone who dabbles in Tsarist or Confederate bonds in any- thing other than the scripophily market can attest. And if that event comes about, it would be pretty pointless to receive payment for a defaulted U.S. Treasury bond in U.S. dollars. Therefore, the CDS quotes here always are in units of another currency; Euros for U.S. bonds and dollars for German and Japanese bonds. Rising CDS costs on various sovereign credit risks became an increasing fact of life after the onset of the cred- it crunch in 2007. Governments everywhere (in the U.S. and UK in particular) felt the appropriate response to banks reaping the consequences of their own bad bets and risk management was to bail them out by a combination of neg-

ADVANCED STRATEGIES continued FIGURE 3 — YEN VOLATILITY ROSE WITH SOVEREIGN CREDIT RISK Yen implied

ADVANCED STRATEGIES continued

FIGURE 3 — YEN VOLATILITY ROSE WITH SOVEREIGN CREDIT RISK Yen implied volatility jumped during
FIGURE 3 — YEN VOLATILITY ROSE WITH SOVEREIGN CREDIT RISK
Yen implied volatility jumped during the August 2007 panic, well ahead of any increas-
es in CDS costs, and peaked simultaneously with these costs in the January, March,
and September-October 2008 panics. Yen volatility remained elevated along with
these CDS costs.

cally, higher credit costs for both corporate borrowers and for resi- dential mortgages without the off- setting benefit of rising asset prices. As far as complete failures with catastrophic long-term conse- quences go, you would be hard- pressed to beat this. Praise and honors for the non- participants might be a Pyrrhic victory given the damage pro- duced by the participants. Did we mention Timothy Geithner, pres- ent (as the president of the New York Federal Reserve) at the destruction of Lehman Brothers and the draconian “rescue” of AIG, was rewarded with the Treasury Secretary? It’s important to remember the government’s AAA credit rating derives from 1) its taxation author-

Secretary? It’s important to remember the government’s AAA credit rating derives from 1) its taxation author-

ity and 2) its printing presses, not necessarily in that order. While the federal government can tax 100 percent of your money (true statement: under the due process clauses of the fifth and 14th Amendments, all that is required is for Congress to pass a law), it is unlikely to do so, and we saw by the dollar’s collapse early in 2008 that international creditors might issue a collective cease-and-desist order on the printing presses. If the markets sense the govern- ment’s balance sheet consists of defunct mortgage securities, a credit deterioration will occur.

Trans-Atlantic trade

Let’s map two different CDS costs, those for German bunds

continued on p. 32

FIGURE 4 — YEN STRENGTHENED AS SOVEREIGN CREDIT RISK ROSE Over the past year, the
FIGURE 4 — YEN STRENGTHENED AS SOVEREIGN CREDIT RISK ROSE
Over the past year, the yen and five-year CDS costs have moved in tandem. Higher
credit risk leads to both lower funding costs and a stronger currency for the govern-
ment — at the expense of higher funding costs for everyone else.
funding costs and a stronger currency for the govern- ment — at the expense of higher
ADVANCED STRATEGIES continued priced in dollars and those for American bonds priced in Euros, at

ADVANCED STRATEGIES continued

priced in dollars and those for American bonds priced in Euros, at two different maturities, five and 10 years (Figure 1). The jump in CDS

costs for the U.S. during various phas-

es of the 2008 credit crisis and the gov- ernment’s response thereto is quite apparent, as is the ratchet nature of

their climb: Once the market priced in

a lower credit rating for the U.S., it remained elevated until the next jump.

Moral hazard: Banks learned they can force governments’ hands by failing on a grand scale, and governments learned their power rises and their funding costs fall when they extend the full faith and credit of their national treasuries to wayward financiers.

What about the CDS costs for the German bunds priced in dollars? While they are at lower basis-point levels than their American counter- parts, their path has paralleled U.S. CDS costs. The credit crisis was as a global affair and clearly affected the German bunds as much if not more than it did the American bonds. Let’s overlay the normalized yield spreads between the German and American bonds; this is the yield dif- ferential between the German and American bonds, divided by the

Related reading:

Other Howard Simons articles

“Minor trends make minor friends” Currency Trader, February 2009. Do minor currencies offer trading opportunities the majors don’t? Find out what the numbers say.

“Let the trend be your friend: The majors” Currency Trader, January 2009.

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performance? This and other questions are answered in this study of currency trends.

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“Nordic currency confusion” Currency Trader, November 2008. Get a handle on the dynamics of the Northern European currencies.

“The Swiss franc’s commodity connection” Currency Trader, October 2008. How can the Swiss currency be, of all things, a commodity currency?

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“The short, awful life of the dollar carry trade” Currency Trader, August 2008. The implications of the weak-dollar policy and the dollar’s roles as a funding currency.

“Currencies and commitments” Currency Trader, June 2008. Find out what COT data conveys about forex price action.

“Getting carried away with the kiwi” Currency Trader, July 2008. What’s driving the New Zealand dollar, and how long is it likely to last?

“Currencies and stock index performance” Currency Trader, April 2008. Find out how stock indices relate to the performance of their currencies.

“What’s down with the Australian dollar?” Currency Trader, March 2008.

Traders have many assumptions about the nature of the Australian dollar, but only one

of these preconceptions appears to have any impact on the currency.

“Currencies and U.S. stock-sector returns” Currency Trader, January 2008. This exhaustive analysis challenges some common assumptions about the relationship between currency moves and stocks.

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American yield itself. This normalized yield spread began to move strongly lower in mid-July 2008, but then shot higher into December 2008, especially at the five-year horizon, as investors fled into U.S. Treasuries. This was a rather bizarre phenome- non; as the U.S. abandoned all pre- tense of fiscal and monetary sobriety and began to borrow $100 billion chunks as if they were $5 bills, U.S. Treasury yields collapsed. By December 2008, four-week Treasury bills were yielding 0.0000 percent at auction and three-month bills were actually being sold at a premium to par for a negative yield to maturity. Restated, as credit risks increased in general, investors fled riskier assets for the perceived safety of sovereign debt. It is a flight-to-quality only if you choose to use “quality” and “printing press” interchangeably. Yes, it was time to punish the inno- cent with rising costs for mortgages and corporate debt, and reward the guilty with declining funding costs for sovereign debt even as the sovereign was trying desperately to inflate its way out of every problem, real and imagined. The expansion of moral hazard was complete; banks learned they can force the hand of government by failing on a grand scale, and governments learned their power rises and their funding costs fall when they extend the full faith and credit of their national treas- uries to wayward financiers.

Trans-Pacific trade

One of the downsides of the U.S.- German example is its short life; the CDS series for the Treasuries begins in April 2008, and that simply is too small of a data sample to draw any mean- ingful conclusions between credit risk and currencies. However, if we look across the Pacific to Japan, we can find CDS on JGBs trading back to 2003. Let’s see whether these instruments confirm the principle suggested here — that

money flows into mismanaged gov- ernment coffers. Five- and 10-year CDS costs on JGBs priced in USD exploded higher between November 2007 and the March 2008 Bear Stearns panic low (Figure 2). They retreated between March and June 2008 and hit a reaction low in early June, marked on both charts with a green vertical line, and then rose sharply during the September-October crisis. The normalized yield spread between Japanese and American five- and 10-year bonds started to rise after June 2008. Japanese yields fell faster than American yields even though the credit risk for Japanese bonds rose at a faster rate and the yen weakened against the dollar. This was a temporary phenomenon, however. By the time the FOMC announced its “anything goes” mone- tary policy on Dec. 16, 2008, the yen was at a thirteen-year high, and short- term American rates were below their Japanese counterparts in what some may regard as a violation of the laws of financial gravity. This is completely parallel to the phenomenon observed for American and European bonds and thus con- firms an emerging principle of sover- eign credit risk: Governments are being rewarded with lower borrowing costs as investors flee risk.

Impact on the yen

Now let’s turn this longer history toward the Japanese currency. If we map the implied volatility on three- month non-deliverable forwards on the yen against five-year CDS costs, we see how this volatility jumped dur- ing the August 2007 panic, well ahead of any increases in CDS costs (Figure 3). It peaked simultaneously with these costs in the January, March, and September-October 2008 panics (yes, there are a lot of panics to enumerate). Volatility on the yen remained elevat- ed along with these CDS costs. If we strip out the intermediary of

volatility and substitute the yen itself, we see this principle emerge quite clearly (Figure 4). Over the past year, the yen and five-year CDS costs have moved in tandem. The circle has been closed: Higher credit risk leads to both lower funding costs and a stronger currency for the government at the expense of higher funding costs for everyone else. We have to consider another, grim- mer scenario. If the Great Depression was prolonged and deepened by poli- cy errors, did the world move away from greater centralized planning? No, the opposite occurred. The era initiat- ed a half-century of ever-greater gov- ernment interference in the economy. Past performance does not predict future results, but what else can we use? Expect the massive policy failures of 2007-2008 to lead to greater govern- ment intervention.

For information on the author see p. 6.

lead to greater govern- ment intervention. For information on the author see p. 6. CURRENCY TRADER
INTERNATIONAL MARKETS CURRENCIES (vs. U.S. DOLLAR)     Current            

INTERNATIONAL MARKETS

INTERNATIONAL MARKETS CURRENCIES (vs. U.S. DOLLAR)     Current            

CURRENCIES (vs. U.S. DOLLAR)

INTERNATIONAL MARKETS CURRENCIES (vs. U.S. DOLLAR)     Current            
INTERNATIONAL MARKETS CURRENCIES (vs. U.S. DOLLAR)     Current            
   

Current

           

price vs.

1-month

3-month

6-month

52-week

52-week

Previous

Rank*

Country

Currency

U.S. dollar

gain/loss

gain/loss

gain/loss

high

low

rank

1

British pound1 1.45017 4.99% -3.19% -21.76% 2.0397 1.3501 10

1.45017

4.99%

-3.19%

-21.76%

2.0397

1.3501

10

2

 

South African rand2   0.09981 1.66% 3.29% -23.87% 0.1391 0.0841 12

0.09981

1.66%

3.29%

-23.87%

0.1391

0.0841

12

3

 

Hong Kong dollar3   0.12898 0.02% -0.03% 0.66% 0.129 0.1279 5

0.12898

0.02%

-0.03%

0.66%

0.129

0.1279

5

4

Chinese yuan4 0.14645 0.02% -0.17% -0.05% 0.1466 0.1395 3

0.14645

0.02%

-0.17%

-0.05%

0.1466

0.1395

3

5

5 Swiss franc 0.85894 -0.97% 4.26% -5.69% 1.0375 0.813 15

Swiss franc

0.85894

-0.97%

4.26%

-5.69%

1.0375

0.813

15

6

6 Australian dollar 0.64528 -1.40% 1.64% -25.56% 0.9849 0.6005 11

Australian dollar

0.64528

-1.40%

1.64%

-25.56%

0.9849

0.6005

11

7

7 Canadian dollar 0.80105 -1.42% 1.03% -16.16% 1.0297 0.768 4

Canadian dollar

0.80105

-1.42%

1.03%

-16.16%

1.0297

0.768

4

8

8 Indian rupee 0.02001 -1.57% 0.30% -13.34% 0.03974 0.01843 8

Indian rupee

0.02001

-1.57%

0.30%

-13.34%

0.03974

0.01843

8

9

9 Singapore dollar 0.65432 -1.69% -0.35% -7.62% 0.7434 0.6489 13

Singapore dollar

0.65432

-1.69%

-0.35%

-7.62%

0.7434

0.6489

13

10

10 Euro 1.27509 -1.86% 0.48% -13.83% 1.6038 1.2329 14

Euro

1.27509

-1.86%

0.48%

-13.83%

1.6038

1.2329

14

11

11 Taiwanese dollar 0.02881 -2.93% -3.81% -9.69% 0.03335 0.02865 9

Taiwanese dollar

0.02881

-2.93%

-3.81%

-9.69%

0.03335

0.02865

9

12

12 Brazilian real 0.41999 -3.35% -0.07% -32.14% 0.6414 0.3751 2

Brazilian real

0.41999

-3.35%

-0.07%

-32.14%

0.6414

0.3751

2

13

13 New Zealand dollar 0.51066 -3.55% -4.94% -28.01% 0.8214 0.4959 16

New Zealand dollar

0.51066

-3.55%

-4.94%

-28.01%

0.8214

0.4959

16

14

14 Thai baht 0.02825 -4.98% -1.60% -4.85% 0.03373 0.0262 6

Thai baht

0.02825

-4.98%

-1.60%

-4.85%

0.03373

0.0262

6

15

15 Japanese yen 0.01047 -7.10% 0.19% 15.18% 0.01148 0.00904 1

Japanese yen

0.01047

-7.10%

0.19%

15.18%

0.01148

0.00904

1

16

16 Swedish krona 0.11294 -7.25% -7.92% -28.54% 0.1718 0.1111 7

Swedish krona

0.11294

-7.25%

-7.92%

-28.54%

0.1718

0.1111

7

17

17 Russian ruble 0.02786 -10.01% -23.42% -32.08% 0.04334 0.0271 17

Russian ruble

0.02786

-10.01%

-23.42%

-32.08%

0.04334

0.0271

17

As of Feb. 25

*based on one-month gain/loss

 

ACCOUNT BALANCE

 

Rank

Country

2007

Ratio*

2006

2008 +

Rank

Country

2007

Ratio*

2006

2008 +

1 Singapore

41.395

27

36.288

42.208

13 Mexico

-6.368

-0.7

-2.425

-10.588

2 Switzerland

65.534

15.8

58.708

64.106

14 France

-39.363

-1.6

-27.712

-48.885

3 China

379.162

11.7

249.866

453.146

15 India

-23.131

-2.1

-9.503

-32.301

4 Hong Kong 22.796 11.2 20.586 20.456 16 UK -96.687 -3.5 -77.236 -105.144

4 Hong Kong

22.796

11.2

20.586

20.586

20.456

16 UK

16 UK

-96.687

-3.5

-77.236

-105.144

4 Hong Kong 22.796 11.2 20.586 20.456 16 UK -96.687 -3.5 -77.236 -105.144
 

5 Netherlands

55.891

7.4

8.6

6.7

17 Australia

-50.816

-5.7

-41.49

-52.988

6 Taiwan

25.402

6.8

24.661

28.365

18 U.S.

-784.341

-5.7

-811.483

-788.293

7 Sweden

25.903

6

27.707

25.584

19 South Africa

-18.495

-6.7

-16.608

-19.237

8 Russia

72.543

5.9

95.322

49.181

20 Spain

-138.916

-9.8

-106.399

-154.849

9 Germany

175.371

5.4

147.134

174.137

Totals in billions of U.S. dollars *Account balance in percent of GDP

 

10 Japan

195.904

4.5

170.437

195.145

+Estimate

11 Canada

25.603

1.8

20.792

17.909

Source: International Monetary Fund, World Economic Outlook Database, October 2008

 

12 Brazil

10.253

0.8

13.276

4.299

NON-U.S. DOLLAR FOREX CROSS RATES

 

Currency

1-month

3-month

6-month

52-week

52-week

Rank

pair

Symbol

Feb. 25

gain/loss

gain/loss

gain/loss

high

low

Previous

1

Pound / Yen

GBP/JPY

138.564

13.07%

-3.38%

-32.08%

215.863

118.782

15

2

Pound / Euro

GBP/EUR

1.13748

6.94%

-3.67%

-9.24%

1.3304

1.0195

4

3

Franc / Yen

CHF/JPY

82.08369

6.58%

4.07%

-18.13%

105.071

74.698

20

4

Aussie $ / Yen

AUD/JPY

61.65867

6.07%

1.44%

-35.39%

104.448

55.1876

17

5

Canada $ / Yen

CAD/JPY

76.5369

6.04%

0.84%

-27.25%

108.96

70.6656

13

6

Euro / Yen

EUR/JPY

121.84

5.62%

0.29%

-25.19%

169.958

112.045

19

7

Real / Yen

BRL/JPY

40.12818

3.96%

-0.26%

-41.12%

69.3981

36.0109

10

8

Franc / Euro

CHF/EUR

0.67369

0.90%

3.75%

9.44%

0.6992

0.6106

12

9

Franc / Canada $

CHF/CAD

1.07277

0.42%

3.16%

12.44%

1.1583

0.9135

18

10

Aussie $ / Euro

AUD/EUR

0.5061

0.39%

1.15%

-13.67%

0.6268

0.4725

7

11

Canada $ / Euro

CAD/EUR

0.62829

0.39%

0.54%

-2.76%

0.6785

0.5799

2

12

Aussie $ / Canada $

AUD/CAD

0.80592

-0.02%

0.57%

-11.26%

0.9833

0.7568

14

13

Aussie $ / Franc

AUD/CHF

0.75145

-0.50%

-2.52%

-21.13%

1.0095

0.712

3

14

Real / Euro

BRL/EUR

0.32941

-1.58%

-0.55%

-21.29%

0.4197

0.2941

1

15

Real / Canada $

BRL/CAD

0.52455

-1.99%

-1.12%

-19.10%

0.6719

0.4726

9

16

Real / Aussie $

BRL/AUD

0.65112

-2.09%

-1.71%

-8.90%

0.7391

0.5991

5

17

Franc / Pound

CHF/GBP

0.59238

-5.67%

7.67%

20.51%

0.661

0.4658

16

18

Aussie $ / Pound

AUD/GBP

0.44509

-6.13%

4.97%

-4.89%

0.4902

0.3786

11

19

Canada $ / Pound

CAD/GBP

0.55253

-6.15%

4.34%

7.12%

0.5918

0.4874

8

20

Real / Pound

BRL/GBP

0.28969

-7.99%

3.21%

-13.29%

0.339

0.2441

6

 

GLOBAL STOCK INDICES

 
 

1-month

3-month

6-month

52-week

52-week

Rank

Country

Index

Feb. 25

gain/loss

gain/loss

gain/loss

high

low

Previous

1

Brazil

Bovespa

38,232.00

-0.72%

9.82%

-29.82%

73,920.00

29,435.00

1

2

India

BSE 30

8,902.56

-1.13%

2.38%

-38.39%

18,137.30

7,697.39

8

3

Hong Kong

Hang Seng

13,005.08

-1.14%

0.98%

-38.38%

26,387.40

10,676.30

14

4

Japan

Nikkei 225

7,461.22

-2.88%

-10.36%

-42.07%

14,601.30

6,994.90

12

5

Australia

All ordinaries

3,281.50

-3.27%

-8.22%

-35.53%

6,059.50

3,201.50

4

6

South Africa

FTSE/JSE All Share

18,817.56

-6.64%

-7.13%

-29.53%

33,232.89

17,814.42

7

7

Mexico

IPC

18,200.70

-7.06%

-5.68%

-31.10%

32,292.90

16,480.00

15

8

Canada

S&P/TSX composite

7,932.30

-8.37%

-6.05%

-40.31%

15,154.80

7,566.32

2

9

Singapore

Straits Times

1,616.79

-8.45%

-2.21%

-93.95%

3,269.88

1,473.77

3

10

UK

FTSE 100

3,849.00

-8.55%

-7.73%

-29.64%

6,377.00

3,665.20

6

11

U.S.

S&P 500

764.90

-8.57%

-10.79%

-39.62%

1,440.24

741.02

5

12

France

CAC 40

2,696.92

-8.75%

-15.97%

-38.09%

5,142.10

2,662.73

11

13

Germany

Xetra Dax

3,846.21

-11.11%

-15.66%

-38.92%

7,231.86

3,790.79

13

14

Italy

MIBTel

12,494.00

-11.92%

-18.90%

-42.01%

26,458.00

12,349.00

10

15

Switzerland

Swiss Market

4,702.50

-13.19%

-14.16%

-33.42%

7,802.60

4,660.90

9

 

GLOBAL SHORT-TERM INTEREST RATES

 

Country

Interest rate

Rate (%)

Last change

Aug. 08

Feb. 08

U.S.

Fed funds rate

0-0.25

0.5 (Dec. 08)