Forex Investment and Currency Trading

Yesterday’s price action suggested high levels of stress and continued deleveraging across many financial markets.

Money market spreads widened to levels rarely seen. Interest rates on short dated US Treasury bills dropped sharply with the 3 month bill yielding only 0.2% at one stage. The equivalent Libor rate fixed at 3.06%.

FX was quite volatile with some EM currencies under pressure, in particular the BRL and later in the session some clear Dollar weakness as well. The price action in recent days has been dominated by unwinding of carry trades, while no other macro theme appears to have displayed a clear trend.

The main price action, however, was in equity markets, where the Fed liquidity injection into AIG calmed nerves only until European lunchtime. After the US open, stocks declined rapidly with weakness in financials particularly pronounced. The S&P future traded a 5.8% intra-day range and ended the day on a low, at minus 4.7%. The VIX index closed on a high above
36%. The SEC imposed fresh short-selling restrictions.

The massive, co-ordinated injections of Dollars by the major central banks announced this morning should contribute to allay prevailing fears, particularly against the backdrop of extensive liquidity backstops now put in place by the US authorities.

How can we explain the relative Dollar stability in the last few weeks? Firstly, the equity allocation flows in September appear to have become much smaller in either direction and broadly neutral.

The assumed hedging flows may have gone through the market by now as well. Valuation looks much less attractive at these levels after the USD has moved more than half way back to fair value from its lows. This is particularly true given the economic situation in the US has also deteriorated again. Rate differentials have moved strongly against the Dollar and while these FX-rate correlations have become much less relevant they may highlight why investors have become more reluctant to buy more Dollars.

In fact one could argue that more neutral flows, negative growth and financial news, combined with sizable long USD positions could lead to a weaker Dollar at least in the short term.

However, the extreme tightness in money markets also seems to have an impact. Some investors appear to use EUR denominated funding converted into USD through spot exchange transactions to cover USD denominated liabilities. This at least would be the logical conclusion of the different levels of liquidity in USD and EUR money markets. If and when these USD funding issues get resolved, the implication may be a weaker USD as well. Overall, there is a Dollar negative bias in the short term.

Regardless of these shorter term flow dynamics, the longer-term Dollar picture remains quite positive, mainly because the trade balance in the US continues to narrow rapidly in real terms and lower oil prices will likely help narrow the nominal import bill as well.

Therefore, even if the US continues to experience slow growth and further financial stress (and a weaker Dollar in the meantime) the current account funding needs keep declining. Yesterday’s release of the Q2 BBoP showed a deficit of only 2.9% of GDP compared to 5.0% in Q1.

US Dollar is forecasted to strengthen again early next year after a temporary bounce back up to EUR/$1.50.