Forex Investment and Currency Trading

Despite the substantial measures the US authority has been taking over the last few months to increase liquidity in the system, US financial conditions have been tightening. These tensions are partly related to the broader stress in financial markets and partly driven by cyclical factors. And in addition, there are elements of tighter credit quantities that the indicator may not be capturing. However, on a broader basis it does highlight the notion that the US financing environment is not growth supportive yet. And it is this tightness in financial conditions that underlines the discussion of a potential
liquidity trap and the quantitative measures that can be taken to avoid it.

The USD kept on appreciating in a very abrupt way throughout October with the need for USD funding dominating dollar demand.

FX derivative markets became very illiquid and arbitrage opportunities between the FX forward markets and interest rate markets became very hard to take advantage of.

Even more importantly, the USD appreciation revealed fragilities in emerging markets space relating to foreign currency liabilities and brought forward issues relating to FX mismatches in the EM private sector.

Finally, the correlation between USD upside and risky asset downside intensified to the extent that risky assets like the SPX were trading according to financial woes.

More recently, the USD has been trading range bound, albeit in a volatile fashion. This has coincided with the successful launch of the commercial paper facility by the Fed and the establishment of swap lines with key EM and G10 central banks and with the reduction in money market tensions.

To the extent that USD strength is driven by pressures relating to the de-leveraging process, following USD trends will also be key in terms of observing (indirectly) the progress in the Fed’s efforts to effectively supply the market with the necessary amounts of liquidity.

As it may take a while until funding tensions and related risks abate, analysts forecast that the USD will likely strengthen towards 1.20 in 3 months. However, once the Fed manages to create enough of a monetary stimulus in order to ease broader funding strains, the dollar should shift back to trading cheaper relative to fair value (at about 1.30 in 6 and 12 months time).

At that point we could even see a declining correlation between the USD and risky assets as the former starts to stabilize due to the effective US monetary expansion, while risky assets continue to trade based on cyclical risks.

The analysis above implies that an extended period of dollar stability could signal/ coincide with an effective relaxation in funding strains related to the de-leveraging process. That, however, would not necessarily mean that volatility is set to decline in FX markets more broadly.

Risky assets could remain under pressure as financial tensions give way to broader cyclical pressures. In a similar fashion, FX volatility could remain at elevated levels because of cyclical pressures as well.

It has been discovered that there are strong cyclical forces driving high volatility regimes and that volatility tends to increase when the cycle matures and to decline after the cycle reaches its trough. In that sense a sustained reduction in volatility could have much richer implications in signaling broader cyclical tensions (even though some stabilization of funding pressures can reduce volatility to still elevated levels).