Forex Investment and Currency Trading

• The last few months have seen historic volatility in currencies, including one of the biggest Dollar rallies ever. Many of the links between currencies and fundamentals that we normally rely on have broken. This has certainly been the case for the Dollar. The initial Dollar rally during July and early August was arguably consistent the macroeconomic news flow, which saw large negative surprises in economic data outside the US, in particular in the Euro-zone. But the later, and more violent, Dollar rally from mid-August to today has happened against a macroeconomic backdrop that would normally be seen as Dollar-negative.
• First, the link between rates and FX has broken: While we have seen monetary easing on a
  global scale, we have also seen the Fed deliver more easing than expected, and interest rate
  differentials, including forward differentials, have generally not moved dramatically in the
  Dollar’s favour. As such, the Dollar has overshot relative to what simple interest rate models
  would have predicted.
• Second, the link between macroeconomic news flow and FX has broken. This has been particularly clear in October. While much of the focus has been on weakening growth outside the US, it is important to note that the US data itself has deteriorated sharply and has come in
  substantially worse than already pessimistic expectations.
• Third, the link between key balance-of-payments flows and FX has broken.

We have seen improvement in money markets on the back of dramatic government intervention. We have seen shortdated spreads between Libor rates and central bank rates narrow, both in the US and in Europe. We have seen the Fed provide liquidity directly to the commercial paper market and, as a result, we have seen outstanding amounts of paper increase. And, lastly, we have seen the Fed provide swap lines to central banks around the world in an effort to bring Dollar liquidity to the places where it is most needed. Most recently, the Fed extended these swap lines to four countries with emerging market status, namely, Korea, Mexico, Brazil and Singapore.

Nevertheless, the deleveraging process that has been set in motion will be hard to stop quickly, especially since it is now starting to feed on economic weakness, making it self-reinforcing to some degree.