Forex Investment and Currency Trading

Is the global financial system healing…or getting worse? In one sense there are multiple signs of reduced stress in the global banking system, a slowing in cross-border capital flows and, as a result, signs of a reduction of volatility in currency markets. At the same time, global equity markets remain weak, consistent with ongoing uncertainty about the breadth and depth of the global economic slowdown.

The signs of stabilization emanate from the major source of stress during the late summer – basic funding in the financial system. Commercial paper (CP) outstanding has jumped about $150bn in the first 10 days of the Fed’s CPFF (Commercial Paper Funding Facility), with a healthy jump of $113bn issued by financial companies; the latter gain represents a 40% recovery of the contraction from mid-August (when the turmoil worsened) to the week ended October 22. Moreover, prime money market funds continue to receive modest inflows following the sharp outflows through mid-October, another stabilizing force in the demand for commercial paper and for the money market system. Indeed, the two periods of sharp falls in CP outstanding coincided with the surge in LIBOR funding spreads and the stabilization of core funding in the financial system is contributing significantly to improved USD funding in the short-term money markets. In this context, the liquidity demand for USDs appears no longer to be a currency market issue.

Coincident with the stabilization of the USD funding markets there are clear signs that currency volatility, particularly for the major USD crosses, is moderating. Indeed, it is noteworthy that despite the ongoing volatility in global equity markets the realized volatility for USD/JPY has collapsed recently.

What is interesting, however, is that the continued uncertainty in the global economic outlook, reflected in ongoing stress in equity markets, appears to be impacting the EUR, and EUR/USD, more than USD/JPY, the typical currency pair most impacted by equity price movements. In fact, while USD/JPY realized volatility over the last 10 days has fallen to just under 15%, realized 10-day volatility in EUR/USD remains over 21%. In this context, the key driver in major currency markets may not be the USD crosses but, instead, the EUR crosses, suggesting that US-based “explanations” for recent USD performance are misplaced. In particular, the argument that the USD remains strong because markets may be discounting an earlier US economic recovery appears completely out of sync with the ongoing strains in the economy. With the EUR holding a 57.6% weight in the USD Index, recent USD Index performance can be as much a function of EUR activity (particularly EUR/JPY movements) as US economic/market fundamentals.

There are other factors that point towards ongoing capitulation of EUR positioning as the driving force in USD Index performance. Market sentiment in EUR/JPY appears to be unusually strong, with the risk-reversal skew in favor of EUR/JPY puts holding just under 10, more than 6 times the average since the introduction of the EUR in 1999.

Moreover, while we have noted before that recent USD gains are “excessive” compared to the modest improvement in US interest rate prospects relative to the rest of the world, the shortfall in the trade-weighted EUR (TWI) appears even more extreme.

There are numerous signs that the core of the US financial system appears to be functioning more effectively, with government central bank action helping to stabilize cost and availability of funding. This, in turn, has contributed to a reduced shortage of USDs in the global system, sharply reducing one source of support for the USD. Instead of US economic optimism, however, the persistent strength of the USD versus core European currencies appears more related to the unwinding of long positions in the EUR (and GBP) versus the JPY, USD and CHF, leaving the USD (perversely) inversely correlated with US equity market performance. While that process can persist for a while longer, deteriorating growth and economic momentum are not the foundations for a strong currency over a more extended period, with USD gains increasingly at risk entering the yearend period.