Lessons from the Pros

The Fear is Falling, and the Tide is Turning

Throughout the recent U.S. Dollar rally, it has been my contention that the main driver for the greenback has been fear. Fear of an equity market crash has sent money out of stocks and into U.S. Treasuries, causing the USD to skyrocket to multi-year highs against the Euro, the British Pound, the Australian Dollar, and many other currencies. Now that fear is subsiding, and as it fades, the USD is fading right along with it.

Since we are in the midst of a credit crisis, our chosen indicator for gauging fear in the current environment is the Ted Spread (click here to learn more about this indicator). The Ted Spread represents the difference in yield between a three-month U.S. Treasury and three-month LIBOR (London Interbank Offered Rate), one of the rates at which banks lend dollars to one another. This indicator was hovering around 1% in August and early September, then shot higher in mid-September, rising above 4.5% as the collapse of Lehman Brothers became imminent and banks became reluctant to lend to one another. Now that the U.S. and other governments have essentially nationalized their banks, the fear is ebbing once again and the Ted Spread has fallen from its peak to about 2.25% (see figure 1).

Figure 1: Ted Spread falls from its peak, indicating an easing of the credit crunch. Source: Bloomberg LP

Another famous "fear gauge", the CBOE’s Volatility Index (VIX), is also reflecting this slightly more relaxed environment. The VIX is created from a variety of options on the S&P 500 Index (SPX), and I’d like you to think of some of those options as insurance policies against a crash in the SPX. As fear grows, the insurance policies become more expensive, causing the prices of the options – and the VIX – to climb. Now that concern about the credit crunch is subsiding, the VIX is beginning to ebb. Notice the similarities in the charts of the VIX and the Ted Spread, as both have recently spiked and are now receding (see figure 2).

Figure 2: The CBOE’s VIX indicates that options traders are becoming less fearful. Source: MSN Money

Of course as currency traders, our main concern is the effect of this change in attitude on the U.S. Dollar. If I’m correct in stating that the recent USD rally was based on fear, then a reversal of that fear should lead to a reversal in the greenback. A glance at the daily chart of EUR/USD shows that the pair has stabilized after its recent plunge. EUR/USD has bounced nicely off of its lows, even briefly regaining its 1.30 handle after falling into the 1.23 area (see figure 3).

Figure 3: As fear eases, the EUR/USD currency pair has put its plunge on pause. Source: Saxo Bank

It’s important to understand that the USD was not going up because of an improvement in the fundamentals of the U.S. economy. The U.S. is going into a recession just like everyone else, so there is nothing intrinsically better about the U.S. economy in relation to Europe or Great Britain; however, the U.S. Federal Reserve is dealing with the situation in a more proactive manner. Everyone is going down the tubes together, and we will all come out of this together sometime next year, starting a period of new growth. Recessions don’t last forever, they are a part of a business cycle and a reality of economics. Companies tend to grow fat during the good times, and a recession forces them to become lean if they want to survive. Then when the recovery portion of the cycle kicks in, they are more efficient and therefore able to grow rapidly, enhancing their own bottom lines, creating new jobs, and spurring increased economic growth. This boom and bust cycle is not new, it has always been with us and it isn’t going to go away, but if we at least understand it we may be better equipped to deal with it on both a personal and professional level.

Recessions in the U.K. and Europe may run deeper than the one the U.S. is experiencing because of the inexplicable reluctance of the Bank of England and the European Central Bank to do more to spur growth. While the U.S. Fed Funds rate has been cut to the bone, currently residing at 1%, the Bank of England’s benchmark rate is 4.5% as of this writing, and the European Central Bank rate is 3.75%. The respective heads of these central banks, Mervyn King and Jean Claude Trichet, claim that they are fighting inflation by keeping rates at these lofty levels. While keeping inflation in check is an excellent policy during normal times, we are clearly in an abnormal environment and rates need to be chopped drastically to prevent an even deeper recession. When the price of oil has been halved and GDP has turned negative, inflation has a tendency to take care of itself. When the ECB and the Bank of England get serious about growth and cut rates more deeply, expect to see these currencies recover.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.

Ed Ponsi