THE INFLUENCE OF FUNDAMENTAL ANALYSIS IN THE WORLD OF FOREX
For anyone directly experiencing the recent roller-coaster ride in currency markets, turmoil and volatility have been the rule. Fundamental economic data abounds, as do statements from politicians or government officials, but all seem to have minimal market impact since a larger fundamental, a financial crisis, has trumped all others soundly. News of the debt crisis in Europe surfaced late last year, but no one got excited until February, and even then, the predictability of the global reaction was woefully underestimated.
Foreign currency traders were not oblivious to the potential impacts. The forex market had already begun to reflect a weakening Euro versus the Dollar four months ago, and Gold had begun its steady rise to new record highs. Contrary to the belief that currency traders are fierce day-traders with time horizons amounting to minutes and hours but rarely months, long-term economic fundamentals play a large role in determining the capital flows between countries, the essence of forex when boiled down to its essential principles.
Relativity is paramount in this world. Einstein never traded currencies, but he would have appreciated the search for underlying laws for profiting from relative differences between the economies of two separate countries. The value of a currency, in the absence of any Gold standard, is always relative to its trading pair opposite. One major fundamental factor affecting this relativity is the rate of interest paid in each market. The currency “carry trade”, one of the most popular longer-term forex strategies, preys upon these market differences to generate short-term gains.
An Internet dictionary defines a currency carry trade as:
“A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.”
A global bank or hedge fund will typically borrow a large amount from a low-interest rate market, for example Japan, and then invest the funds where yields are higher. For the past year or more, the “base” currency has been the Yen or the Dollar, and the destination currency investment has been Australia, New Zealand or even India. Return margins can range from 5% to 10%, depending on your appetite for risk, and with leverage, multiples of these returns can be earned.
All sounds fine and good so far, but when a crisis occurs, there is always a predictable rush of capital to “safe havens”, which tend to be U.S. Treasuries or Gold bullion or stocks. Today’s crisis was par for the course. Cautious forex traders would have hedged their “carry trade” bets, but the greedy were caught unaware and rushed with paranoid fright back to their trading desks to unwind their trades which may have turned unprofitable. The “carry trade” strategy can be incredibly profitable, as long as the “base” currency stays flat or weakens. A sudden strengthening of the Dollar tends to unwind “carry trade” overhang. This time around, the Aussie Dollar fell 15% versus the greenback, even with a strong economy and equally strong fundamentals.
Estimates of “carry trade” overhang volume range between $1 and $2 trillion at a point in time. This strategy used to be the private “playground” of large banks and other financial institutions, but today, an individual forex trader can have an “open carry” account with the broker of his choice and get in on the action. He also can get wiped out, too, like many hedge fund managers of late!