Yesterday, both the European Central Bank (ECB) and the Bank of the UK cut their benchmark interest rates to record lows. This is especially incredible in the case of the UK, whose Central Bank over 300 years old! You can see from the following chart that both Central Banks have more than made up for their respectively slow starts in easing monetary policy by effecting several dramatic rate cuts, following the example of the Federal Reserve. The baseline UK rate now stands at .5%, only slightly higher than the Federal Funds rate, and slightly lower than the 1.5% ECB rate.



Given that they have essentially reached the terminus of their monetary policy options, all three Central Banks are exploring further options aimed at pumping money into their respective economies. The Fed has already “announced a program to buy $100 billion in the direct obligations of housing related government sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac and the Federal Home Loan banks — and $500 billion in mortgage-based securities backed by Fannie Mae, Freddie Mac and Ginnie Mae.” As I wrote in a related article, “this was quickly followed by repurchase programs, lending facilities, investments in money market funds, and option agreements, all of which were designed to supplement its ‘traditional open market operations and securities lending to primary dealers.’ The Fed’s efforts also worked to ease the liquidity shortage in credit markets abroad by entering into swap agreements with several foreign Central Banks suffering from acute Dollar shortages.”

In conjunction with the rate cut, the Bank of the UK, meanwhile, will pump £150bn directly into UK credit markets through liquidity support, buying public and private debt, and asset purchases. “The main purpose of quantitative easing is not to send the money supply into orbit but to stop it from crashing…the broad money held by households has risen at a worryingly slow rate over the past year, and holdings by private non-financial firms have actually been dropping.” In contrast to the monetary programs of the UK and US, the ECB has thus far refrained from the kind of liquidity support that would necessitate printing new money. Instead, “the central bank will continue offering euro-zone banks unlimited loans at the central bank’s policy rate until at least the end of this year.”

The interest rate cuts were announced simultaneously with a spate of macroeconomic data, which collectively paint a bleak picture. Eurozone growth is projected at -2.7% for 2009 and 0% for 2010. The current unemployment rate at 8.2% and climbing. The thorn in the side of the EU is represented by eastern Europe, where growth is falling at an alarming pace, dragging the EU down with it. While EU member states have pledged to intervene if one of their own falls into bankruptcy, it’s unlikely that they would intervene similarly if a non-EU member state went bust. The UK economy is similarly desperate, having contracted at an annualized rate of 5.8% in the most recent quarter. The wild cards are the real estate and financial sectors, the fortunes of which are increasingly intertwined.

So what do the forex markets have to say about all this? Economists have used the dual phenomena of risk aversion and deflation to explain the interminable weakness in the the Pound and Euro. Everyone is surely familiar with the notion of the US as “safe haven” during periods of global financial instability. The deflation hypothesis, meanwhile, suggests that the ECB (and to a lesser extent, the Bank of UK), fell behind the curve when easing liquidity. The ECB, especially has harped on inflation as a reason for cutting rates more quickly. Given that investors are now more concerned with capital preservation than price inflation, it follows that they would prefer to invest where Central Banks were more vigilant about deflation (i.e. the US).

Personally, I think that the continued declines in both currencies, in spite of steep interest rate cuts, indicates that the deflation hypothesis is bunk, and investors remain fixated on risk aversion. By no coincidence, the temporary rebound in US stocks that took place in January was also accompanied by a bump in the Euro. (See chart below).



I think this mindset is reasonable, but only in the short-term. Given the current economic environment, I don’t think investors (and currency traders) can be faulted for ignoring the possibility that quantitative easing and liquidity programs will have to be funded with the printing of new money, which would be inherently inflationary. Many comparisons are being made with Japan, whose ill-fated quantitative-easing program succeeded only in inflating a bond-market bubble and vastly increasing Japanese public debt. According to one columnist, “it’s hard to argue that quantitative easing ended deflation; high oil prices did that. Meanwhile, the economy cured on its own most of the structural problems such as excess capacity and too much debt associated with the deflationary environment.”

In short, with a medium and long-term investing horizon in mind, I think the ECB’s approach to dealing with the credit crisis is more conducive to monetary stability. Thus, when investors grow weary of the idea of US as safe haven, they will no doubt focus instead on fundamentals. At which point, the ECB will likely be rewarded for fulfilling its anti-inflation mandate, in the form of a stronger Euro.

Since touching a fresh 24-year low in the beginning of March, the British Pound has recovered strongly, rising 5% against the USD in a matter of days. Analysts are at a loss to explain the sudden strength of the Pound, outside the confines of the safe-haven hypothesis: “The risk premium that sterling has taken on works both ways, and you can see sterling outperforming whenever risk appetite picks up.”
As another analyst points out, however, ascertaining the role of risk aversion in the markets has become somewhat circular: “Observers…draw this assessment purely from price action. Rising equities means the market is less risk averse. And the way we know there is less risk adversity is that the stocks have rallied.” Applying this argument to forex, softening risk aversion is contributing to a stronger Pound. At the same time, observers point to the rising Pound as a signal that risk aversion has softened. In short, the safe-haven trade is surely not the most convincing explanation.

In fact, by all accounts, the Pound should be falling. The latest data shows that retail sales plunged by 1.9% on a monthly basis. GDP is projected to fall to such an extent that “in 2009 Britain will slip to 12th place (from 7th in 2007) among the 15 ‘old’ members of the European Union, behind all except Spain, Greece and Portugal.” Meanwhile, the Central Bank of the UK has warned that Britain’s government finances have become so fragile that the government will have difficulty carrying out new spending plans. Investors have taken note, and demand for the latest auction of UK government bonds is believed to be the “lowest in history.”
Given all the bad news, perhaps the Pound’s recent rise can be best attributed to technical factors. “The $1.45 level represents so-called resistance on a descending trend line connecting the January high of $1.5373 and the February peak of $1.4986.” Given that the Pound has since sunk back below $1.45, it can be reasonably discerned that a cluster of sell orders were executed at this level.
Over the longer-term, the prognoses for the UK economy generally, and the Pound specifically, are not good. Thanks to a low exchange rate, inflation is actually rising. It is perhaps a welcome development, since it indicates that the UK was (temporarily) averted deflation, but it could also be a product of the quantitative easing plan announced earlier this month, whereby the Bank of England will flood the banking system with newly minted money. “Such a tactic can dilute the currency, and the perception that such dilution is about to occur is dragging the Pound down right now.”

Only last year, the idea that the Australian Dollar would ever reach parity with the USD was laughable. Then, earlier this year, it became plausible. Now, according to an informal poll of analysts, it is not only possible, but likely. AUD bulls should look no further than the rapid surge in commodity prices, which may boost the total value of Australian exports by 20%, including a 30% rise in its commodity exports. In short, the Australian economy has boomed, and inflation is slowly creeping up. The consensus among economists is that the Royal Bank of Australia will leave its benchmark lending rate unchanged at 7.25% for the duration of the year. At the very least, it won’t lower rates, which is all analysts need to believe in order to get behind its currency. Bloomberg News reports:
"There could be some parity parties going on,” said a currency strategist in Sydney at RBC, a unit of Canada’s largest bank. "The RBA…[has] given a green light for the market to push the currency higher."

After a brief hiatus, the Australian Dollar has resumed its upward march against the Dollar; its next milestone will be a 25-year high against the Greenback. Of course, its continued strength is due to a combination of high domestic interest rates and high commodity prices. In fact, its performance seems to mirror the price of gold, which is no coincidence since gold may be Australia’s most valuable export. In addition, gold has value as a monetary instrument, which means an appreciation in gold can give the Australian Dollar a double-boost by lifting it while simultaneously punishing the US Dollar. With regard its domestic monetary policy, Australian inflation recently passed the 4% mark, which means interest rates (already at 7.25%) are likely to stay high for a while. The countdown to parity continues, reports Bloomberg News:
The local dollar rose to its highest since 2000 against the New Zealand currency before an inflation report tomorrow that may support the case for the Reserve Bank of Australia keeping interest rates at a 12-year high.

By one measure, the US Dollar has lost 33.8% of its value under President George Bush, its worst performance by far under any one administration. The burgeoning twin deficits, lackluster economic performance, as well as the current environment of stagflation have all contributed to a dramatic and unprecedented loss of confidence in the Dollar. While investors are understandably optimistic about the prospect of a new President, come January, they are ambivalent as to whether it is Barack Obama or instead John McCain that is ultimately elected. Since the Dollar seems to have bottomed out anyway, the new President stands to preside over a recovery of the Dollar. Reuters reports:
"We look at the dollar as a brand and any change from Bush will help benefit the dollar."

Is the "parity party" on or off? That is the question on the minds of currency traders following the Australian Dollar. Last week, analysts indicated that the party had been postponed, if not cancelled entirely. This week, there are signs that perhaps some of the bearishness surrounding the AUD is overblown. To be sure, the Australian economy is slowing, and the Central Bank will almost certainly lower interest rates. At the same time, some analysts believe that commodity prices have fallen too far, and will recover in time, as the long-term fundamentals that have underlied their rise still remain in place. Besides, the currency’s losing streak is already the worst since 1980, which suggests investors have gone too far. The most likely scenario is a bumpy 2008 for the currency, followed by a strong 2009. News.com.au reports:
[One analyst] said a recovery in global commodity prices could give the currency a much-needed bounce over the next few months. Citigroup has also forecast that the global markets have turned "too bearish" on commodity prices.

I won’t lie; the Forex Blog is admittedly Dollar-centric, in that developments in forex markets are usually assessed relative to their projected impact on the US Dollar. Sometimes, we forget that their are other currency pairs that move irrespective of the Dollar. Take the Australian Dollar and New Zealand Kiwi, for example. As both currencies are backed by high interest rates, they have benefited equally from the carry trade and as a result, they behave quite similarly. Combined with the fact that they are practically neighbors, it’s easy to forget that there are unique circumstances that weigh separately on them.
Over the next 12 months, both countries’ Central Banks are expected to significantly lower their benchmark interest rates as a result of slowing economic growth. However, as New Zealand does not have a large stock of natural resources to depend on in times of economic turmoil, it is projected to lower rates quite sharply, compared to Australia. Accordingly, the Australian Dollar may represent a buying opportunity against the Kiwi in the near-term. Bloomberg News reports:
New Zealand’s dollar is likely to fall 8.7 percent to NZ$1.33 versus Australia’s by year-end as the nation’s economic slowdown accelerates, boosting prospects the RBNZ will lower borrowing costs…according to RBC Capital Markets.

It would seem as if the world is conspiring against the Australian Dollar. In the last couple months, the currency has plummeted nearly 20% from the 25-year high it had reached against the US Dollar. A combination of global economic weakness, falling commodity prices, and a trend towards risk aversion have turned the tables in favor of currencies perceived as more stable in times of crisis. To add insult to injury, the Central Bank of Australia decided to cut its benchmark lending rate, narrowing the interest rate differential that had been partially responsible for the Australian Dollar’s multi-year appreciation. Bloomberg News reports:
"In the near term, the question will be do we hold here or go down a bit more on interest rates?” said [Central bank Governor Glenn] Stevens.

Over the last two months, the South African Rand has plummeted, losing nearly 20% of its value against the US Dollar en route to a five-year low. It seems the currency has become the latest victim of the credit crisis and the resulting widespread risk aversion. The sudden exodus away from the carry trade, for example, has affected the Rand disproportionately, as many foreign investors had come to South Africa over the last few years to take advantage of the country’s 12% interest rate. Now, the country is facing a horrible crisis, and is worrying about its ability to finance its current account deficit, which already exceeds 7% of GDP. Accordingly, analysts predict the Rand will continue to drop. Bloomberg News reports:
"The portfolio flows we have seen over the past couple of years are going to dry up and we will not be able to fund the deficit with the portfolio flows." The rand may slide to 9.20 rand by the end of the year…

The Australian Dollar has lost nearly 1/3 of its value (relative to the USD) over the last few months, as the credit crisis continues to drive investors away from areas perceived as risky. In other words, the best (and perhaps the only reasonable) explanation for its fall has very little to do with Australian economic fundamentals. Then again, the rise in the currency that took place over the last decade was also rooted in technical and financial trends, although rising commodity prices were also a factor. The Australian Dollar (as well as the New Zealand Kiwi) was one of the prime beneficiaries of carry-trades, due to unusually "generous" interest rate levels. Now that investors are chasing stability/capital preservation instead of yield, however, the currency has seriously fallen out of favor. The Australian reports:
Equity markets would continue to drive currency markets, while being influenced by the ongoing financial crisis. "These are unprecedented times in volatility for the Australian dollar and currencies," said [one analyst].

On the basis of technical factors, the Australian Dollar had halted its precipitous decline against most major currencies. As a result of an unbelievable 100 basis point interest rate cut, however, the currency has resumed its fall. That the rally was short-lived is not a mystery. The yield advantage enjoyed by Australia over the last few years has almost completely evaporated. Combined with lackluster Australian equity performance and tanking commodity prices, foreign investors have little reason to maintain capital in Australian holdings. On the plus side, the rate cut showed investors how serious Australian economic policy-makers are in dealing with the credit crisis. Unfortunately, diligence doesn't always translate into efficacy.

While the Australian Dollar and New Zealand Kiwi technically started 2009 in the black, most analysts believe that both currencies will continue their record declines that began in 2008. All economic indicators continue to point downward, due to the adverse conditions created by the worldwide recession. The economies of Australia and New Zealand are extremely dependent on exports of raw materials and dairy products, respectively. Unfortunately, due to a contraction in demand and a decline in speculation, the prices for both types of commodities appears unlikely to erase even a fraction of the losses suffered last year. The death blow into the heart of both currencies will likely be delivered by their respective Central Banks, which are expected to make additional interest rate cuts. This will further erode the rate differential with the US/Japan, that previously signaled the currencies as attractive investments. Bloomberg News reports:
The average forecast is for the currency [AUD] to reach a low of 62 cents in the first quarter before recovering to 66 cents by the end of 2009. New Zealand’s dollar…will bottom at 52 U.S. cents in the second quarter and recover to 55 cents by the end of the year…

The Swiss Franc is in the same boat as the US Dollar and Japanese Yen, benefiting from an increase in risk aversion and an unwinding of carry trade positions. In other words, the currency rising on the back of the sound monetary policy of the National Bank of Switzerland, with its low rate of inflation and proportionately low interest rate. Despite the fact that the Swiss economy is poised to contract in 2009, its economy is in better shape than its rivals, and its current account balance is still in surplus. As a result, the consensus among analysts is that investors will continue to flock to the Franc, as Switzerland is sill perceived as a relatively low-risk place to invest. Especially compared to the Euro, which has risen against the Dollar of late, the Swiss Franc remains undervalued. Bloomberg News reports:
Investors are drawn to the franc in times of international tension and economic upheaval because of the country’s history of neutrality and political stability.

By offering high leverage, the market maker encourages traders to trade extremely large positions. This increases the trading volume cleared by the market maker and increases his profits, but increases the risk that the trader will receive a margin call. While professional currency dealers (banks, hedge funds) never use more than 10:1 leverage, retail clients are generally offered leverage between 50:1 and 200:1[2].
A self-regulating body for the foreign exchange market, the National Futures Association, warns traders in a forex training presentation of the risk in trading currency. “As stated at the beginning of this program, off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.“ [17]

The foreign exchange market is a zero sum game[7] in which there are many experienced well-capitalized professional traders (e.g. working for banks) who can devote their attention full time to trading. An inexperienced retail trader will have a significant information disadvantage compared to these traders.
Although it is possible for a few experts to successfully arbitrage the market for an unusually large return, this does not mean that a larger number could earn the same returns even given the same tools, techniques and data sources. This is because the arbitrages are essentially drawn from a pool of finite size; although information about how to capture arbitrages is a nonrival good, the arbritrages themselves are a rival good. (To draw an analogy, the total amount of buried treasure on an island is the same, regardless of how many treasure hunters have bought copies of a treasure map.)
Retail traders are - almost by definition - undercapitalized. Thus they are subject to the problem of gambler's ruin. In a fair game (one with no information advantages) between two players that continues until one trader goes bankrupt, the player with the lower amount of capital has a higher probability of going bankrupt first. Since the retail speculator is effectively playing against the market as a whole - which has nearly infinite capital - he will almost certainly go bankrupt.
The retail trader always pays the bid/ask spread which makes his odds of winning less than those of a fair game. Additional costs may include margin interest, or if a spot position is kept open for more than one day the trade may be "resettled" each day, each time costing the full bid/ask spread.
According to the Wall Street Journal (Currency Markets Draw Speculation, Fraud July 26, 2005) "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.' "[15]
Paul Belogour, the Managing Director of a Boston based retail forex trader, was quoted by the Financial Times as saying, "Trading foreign exchange is an excellent way for investors to find out how tough the markets really are. But I say to customers: if this is money you have worked hard for – that you cannot afford to lose – never, never invest in foreign exchange." [16]

A forex (or foreign exchange) scam is any trading scheme used to defraud individual traders by convincing them that they can expect to gain a high profit by trading in the foreign exchange market. Currency trading "has become the fraud du jour" as of early 2008, according to Michael Dunn of the U.S. Commodity Futures Trading Commission. [1] But "the market has long been plagued by swindlers preying on the gullible," according to the New York Times [2]. "The average individual foreign-exchange-trading victim loses about $15,000, according to CFTC records" according to The Wall Street Journal. [3] The North American Securities Administrators Association says that "off-exchange forex trading by retail investors is at best extremely risky, and at worst, outright fraud." [4]
“In a typical case, investors may be promised tens of thousands of dollars in profits in just a few weeks or months, with an initial investment of only $5,000. Often, the investor’s money is never actually placed in the market through a legitimate dealer, but simply diverted – stolen – for the personal benefit of the con artists.”[5]
In August, 2008 the CFTC set up a special task force to deal with growing foreign exchange fraud.”[6]
The forex market is a zero-sum game[7] , meaning that whatever one trader gains, another loses, except that brokerage commissions and other transaction costs are subtracted from the results of all traders, technically making forex a "negative-sum" game.
These scams might include churning of customer accounts for the purpose of generating commissions, selling software that is supposed to guide the customer to large profits, [8] improperly managed "managed accounts", [9] false advertising, [10] Ponzi schemes and outright fraud. [4] [11] It also refers to any retail forex broker who indicates that trading foreign exchange is a low risk, high profit investment. [12]
The U.S. Commodity Futures Trading Commission (CFTC), which loosely regulates the foreign exchange market in the United States, has noted an increase in the amount of unscrupulous activity in the non-bank foreign exchange industry.[13]
An official of the National Futures Association was quoted [14] as saying, "Retail forex trading has increased dramatically over the past few years. Unfortunately, the amount of forex fraud has also increased dramatically..." Between 2001 and 2006 the U.S. Commodity Futures Trading Commission has prosecuted more than 80 cases involving the defrauding of more than 23,000 customers who lost $350 million. From 2001 to 2007, about 26,000 people lost $460 million in forex frauds. [1] CNN quoted Godfried De Vidts, President of the Financial Markets Association, a European body, as saying, "Banks have a duty to protect their customers and they should make sure customers understand what they are doing. Now if people go online, on non-bank portals, how is this control being done?"