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Forex Research - What Triggered the Major Volatility in FX and Equities?

What Triggered the Major Volatility in FX and Equities? Last Updated 10/10/2008 5:21:42 PM EST (GMT +5)

TODAY’S BIGGEST PERCENTAGE MOVERS

AUD/USD (-444 pips or -6.46%)

AUD/JPY ( -390 pips or -5.70%)

EUR/AUD (+1065 pips or 5.46%)

THE STORIES IN THE CURRENCY MARKET

  • USD: WHAT TRIGGERED THE MAJOR VOLATILITY IN CARRY TRADES AND EQUITIES?
  • EUR: EURO HITS LOWEST LEVEL SINCE MARCH 2007
  • GBP: BRITISH POUND: BIG WEEK AHEAD
  • JPY: CARRY TRADES TUMBLE AS VIX HITS RECORD HIGHS
  • CAD: RECORD EMPLOYMENT GROWTH FAILS TO HELP CANADIAN DOLLAR
  • AUD: BREAKS 0.65
  • NZD: FALLS 9.6% THIS WEEK

EXPECTATIONS FOR UPCOMING FED MEETINGS

 

** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

WHAT TRIGGERED THE MAJOR VOLATILITY IN CARRY TRADES AND EQUITIES?

The price action in the equity markets today was nothing short of impressive. We literally had a W shaped trading day where stocks opened down 600 points, rallied back into positive territory, sold off again by another 600 points before recovering most of its losses by the end day. The volatility that we have seen in the currency market is only an extension of the movements in equities. On an intraday basis, the Dow saw a 1000 point swing, with stocks up as much as 300 points in the last hour of trading. Two very different factors drove the sharp reversal - no one wanted to be short carry trades going into the G7 meeting and the money from the Lehman credit default swaps are coming back into the markets.

The Case for a Bounce Next Week

Even though the economy could still be in for more trouble over the coming months, there is a case for a major bounce next week. Many people are arguing that this week’s sell-off in stocks is tied to the need to raise cash to settle the Lehman Brothers’ credit default swaps. For those who bought protection against a bankruptcy on Lehman brothers, they are set to get 91.375 cents on the dollar. The sellers of the protection will now have to make cash payments of more than $270 billion to the buyers. As the money changes hands, those who have bought protection could now put their payments to work in the equity markets which could pave the way for a serious bounce.

Will the G7 Come Up With a Grand Plan?

There is big hope for this weekend’s G7 and G20 meetings. Unfortunately with expectations running very high, there is a chance that the G7 could disappoint. Unlike the weekend meetings in the US that led to the AIG bailout and the creation of the TARP program, the world’s largest economies are getting together to come up with a plan that could stabilize the financial markets. This could be the most significant G7 meeting since the 1985 Plaza Accord. The crisis has now gone global and a global response is needed. Unfortunately, investors have become increasingly desensitized to the groundbreaking measures introduced domestically and internationally, so it could take a lot to convince banks to start lending to each other. Grand plans are hard to come by and the G7 may just insist on tailoring solutions to their own countries which could be a big disappointment to the equity and currency markets. Italy has already said that the G7 draft is weak and needs to strengthen which confirms the possibility there could be a disappointment. In that case, there could be weakness for equities, USD/JPY and other Japanese Yen crosses. The EUR/USD and GBP/USD could come under pressure if there is aggressive selling in EUR/JPY and GBP/JPY just as we have seen today. If the G7 manages to come up with a grand plan, there is case a for a major relief rally in USD/JPY and other carry trades. Some ideas being floated around include bank recapitalization, equity or FX intervention and unsecured lending by central banks. Ultimately, it will be up to the market to decide if enough is enough with the aggressive selling because the flush that we have seen in the past week is no longer driven by economic fundamentals.

A Look at P/E Ratios: Are Stocks Becoming Good Values?

The Dow Jones Industrial Average has fallen more than 40 percent over the past year, leaving many investors wondering whether stocks have finally become cheap. Price to Earnings or P/E ratios has fallen to the lowest level in 23 years. With the S&P 500 trading at 860, the estimated P/E ratio according to the NY Times was just below 12. Over the past century, the average P/E ratio was approximately 15.5. According to a study by Yale Economics Professor Robert Shiller, the P/E ratios in the UK and Germany have fallen to levels that have only been seen 4 or 5 times in 150 years. From that perspective, P/E levels have fallen significantly but it is important to remember that earnings are expected to decline and P/E ratios always fall below the average in recessions. If economic conditions are as bad as the stagflationary period of the 1970s, then P/E levels could still fall to single digits. USD/JPY is due for a bounce, but in the long run, the prospect of further rate cuts from the US should continue to drive the currency pair lower. In addition to the G7 meeting, we are expecting US producer prices, consumer prices, retail sales, manufacturing and housing market reports next week.

BRITISH POUND: BIG WEEK AHEAD

It has been a brutal week for the British pound. The currency pair came under another round of selling that it took it below 1.70 against the US dollar to hit a low of 1.6781. It has since rebounded, but the intraday volatility has been significant. The market continues to be disappointed by the UK’s handling of the current economic crisis. After coordinated rate cuts by the UK, US, and Euro-zone, GBP/USD traders were still left with the idea that the British government has waited too long, and done too little, to prevent a disastrous recession. Even though this week’s major development was the rate cut and the bailout plan, the UK also saw an expanding trade deficit. Next week’s schedule is filled with many key economic reports, including the Employment Numbers, the Consumer Price Index and Producer Price Index. These reports could give a further gauge into how radically the BoE will be able to pursue further monetary easing.

EURO HITS LOWEST LEVEL SINCE MARCH 2007

After range trading for most of the week, the EUR/USD fell to the lowest level since March 2007. The coordinated rate decision earlier this week has given traders little reason to favor one currency against the other but the initial sell-off in stocks triggered a massive demand for US dollars. Like the UK, Germany and France are both expecting inflation numbers next week. Germany’s economic schedule also includes the ZEW Sentiment Survey, as well as further inflation barometers such as Producer Prices and Import Prices. The ECB has largely abandoned its inflation only viewpoint, adding growth concerns into its economic policy decision. Therefore the effect of rising inflation will be a limited concern due to the current market crisis. Monthly inflation expectations for both Germany and France are expected to be unchanged. It is likely that because of growth concerns and tame inflation we will see another rate cut within the next few months.

CARRY TRADES TUMBLE AS VIX HITS RECORD HIGHS

As the VIX reaches historical highs, there has been an extreme break-down of carry trades. Over the past 3months, the yen has had a 90% correlation with the volatility index and volatility is bad for carry trades. AUD/JPY has made itself the prime example of such a development, continuing this week’s losses by falling 6.25% or 420 pips. After hitting a low of 98.00, trading in USD/JPY has rebounded significantly, apparently due to marginal gains in US indices and the technical aspect of being extremely oversold. The recent rebound in the Dow has lifted the pair over 100 points on the day. Nevertheless, the Japanese economy has become almost the safe haven of risk aversion as we have yet to see a significant impact from the global economic crisis. It is safe to say the BoJ has little reason to cut rates as they are already at low levels. In the midst of a market that values currencies based on which one cuts rates the least, the yen has made a stand as one of the strongest. The most important releases next week are the Domestic Corporate Goods Price Index and the Trade Balance. The outcome of the G7 meeting will also play a big role in the price action of the Japanese Yen.

RECORD EMPLOYMENT GROWTH FAILS TO HELP CANADIAN DOLLAR

Canadian employment numbers, released this morning blew away expectations. The market was looking for 10k new jobs but instead, the country reported a record 106.9k job growth. The weakness in the Canadian dollar continues to stem from fears that a Canadian bank will collapse. In accordance with current trends, USD/CAD is up more than 7.0% this week. The economic calendar for the coming week is light for all 3 commodity producing currencies. The Australian dollar was the worst performing major currency with a 16 percent decline this week. According to Purchase Power Parity, the AUD/USD is now undervalued. Even though the validity of these numbers is often questioned, it is an interesting way to see how trends have progressed because the currency was still considered overvalued last week. Next week’s news releases do not hold any important new economic developments. Despite yesterday’s unchanged trading, the Kiwi is once again losing ground against the dollar, shedding more than 9% this week. A lack of news announcements has seen the Kiwi fall due to the overwhelming flight from the commodity currencies. Sunday, we expect New Zealand Retail Sales which may give us a sense into whether these losses are warranted.

GBP/USD: Currency in Play On Monday

GBP/USD will be our currency in play on Monday. The UK is expecting Producer Price Index figures Monday at 4:30 am ET or 8:30 GMT. Heightening inflation expectations could spell new problems for the BoE.

The currency pair remains in the sell zone as determined by Bollinger Bands. Today’s price action has been volatile in both directions, but has ended up near the day’s open with a modest gain. To find potential support it takes weekly and monthly charts, as opposed to daily ones. We found support levels by drawing a Fibonacci retracement from the lows in early 2001 to the high in early 2007. Support will be the 61.8% retracement at 1.6539. We will use the same Fibonacci retracement to locate resistance at the 50.0% retracement or 1.7421. The level is met with the one-standard deviation Bollinger band, further cementing the strength of the level.

 

About The Author

Lien has extensive knowledge within the interbank market, particularly in trading spot FX and options. She has written for numerous publications, is frequently quoted on financial media outlets, and is the author of several books, including Millionaire Traders. Read more >>

DISCLAIMER: This forum and the information provided here should not be relied upon as a substitute for extensive independent research before making your investment decisions. Global Forex Trading is merely providing this column for your general information. This forum and its information does not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision based upon this forum or any information contained within. In addition, any projections or views of the market provided by the author may not prove to be accurate. Global Forex Trading and Kathy will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained in this column. Global Forex Trading and Kathy do not render investment, legal, accounting, tax or other professional advice. If such advice is sought, or other expert assistance is required, the services of a competent professional should be sought.

 

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