Cliff Wachtel's  Instablog

May 24, 2012

Most Markets May Plunge When EU Anxiety Is High-But In Forex There's Always A Bull Market Somewhere

Here In Part 1 We Cover Key Background Information: The Distinction Between Risk & Safe Haven Currencies

Any prudent investor now needs a basic grasp of foreign exchange (forex) markets. Economic policies are eroding the value of most major currencies and anything denominated in them. The following is an excerpt from The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start. In this excerpt we cover some forex basics that all investors can use right away to improve their returns, even if they never trade forex.

While it sounds strange to think that there could be any winners from the ongoing deterioration and possible end of the EU and EUR as we know it, in forex there are always winning and losing currencies, because currencies always trade in pairs, with one always rising and one always falling versus the other. In forex, unlike other asset markets, there's always a bull market somewhere.

Even better, you don't have to be an active trader to exploit these markets. As we showed in Forex markets produce some of the most stable long term trends that are perfect for passive long term investors. The basic reason why forex produces more and better long term trends than other markets like stocks is:

Currencies endure far longer than the average publicly traded company

While the fundamentals of a company can change within a matter of months, fundamentals of national economies change much more slowly. The relative competitiveness of an entire nation or economy, its growth and employment rates, etc, can take years or decades to change. Currencies tend to behave like the shares in an economy, so if one economy is doing better than another, that situation tends to persist for years or even decades. While long term market trends that favor risk or safety currencies can influence the trend of a currency pair, secular bull or bear markets also take years to play out, and so long term expansion and contraction cycles can also reinforce certain long term forex trends.

The most basic criteria to understand about each of the major currencies is

• whether they are risk or safe-haven currencies
• how that determines their performance and correlation to other types of assets
• how to profitably exploit that knowledge

The following article is a summary from the book's more detailed coverage of this topic, and provides the needed background information to understand Part 2 of this series.

Definition of Risk vs. Safe Haven (Or Safety) Currencies

Here's the basic distinction between risk and safe haven currencies.

• Risk currencies behave like other risk assets, such as stocks or industrial commodities (oil, gas, copper, etc); they rise when markets are feeling optimistic, and fall when markets are nervous.

• Safe haven or safety currencies behave in the opposite manner, like other safe haven assets (investment grade bonds and commercial paper, short term money market funds, etc), rising in times of fear and falling in times of optimism about economic growth.

NB: These classifications have NOTHING to do with how safe a given currency may be as a store of value. Rather these names refer ONLY to whether the currency generally behaves like other risk or safe haven assets.

For example, although the CAD is considered a "risk" currency, Canada's low debt/GDP, strong economy and healthy banking system makes it one of the safest currencies as a long term store of value in which to have your savings.

The Risk Ranking

Here's the traditional ranking of currencies in order of risk, that is, which ones benefit most when markets are feeling optimistic, going from left to right:

This means that when risk assets are rising (aka a "risk on" market), traders typically are:

• Long pairs that have a base currency that is higher on the risk scale than their quote currency, like the AUDJPY or EURUSD

• Short pairs that have a base currency that is lower on the risk scale than their quote currency, like the GBPAUD or EURNZD

When risk assets are falling (aka a "risk off" market), traders typically do the opposite. Remember, currency pairs move in the direction of the base currency, rising when it rises relative to the quote currency, and vice versa.

The ranking rarely works perfectly over a matter of days or weeks but is a useful generalization that works in the longer term.

Currency-specific news items regularly cause currencies to behave out of order from this ranking in the short term. For example:

1. Even if markets are feeling very pessimistic, if there is news that is bad for the JPY, it may not be strong that day despite the market being in "safe haven" mode.
2. Even in times of optimism, the AUD could underperform the other risk currencies due to specific events or conditions influencing:
   1. Australia, like slowing growth or sinking expectations about interest rate increases.
   2. Bad news about the economy of its biggest export customer, China

In descending order these are: the JPY, USD, and CHF. Thus when markets are nervous, the JPY is usually the strongest, followed by the USD and CHF, and all 3 of these to gain against the above risk currencies. During times of great pessimism, most traders would try to short the following pairs by buying puts on them: AUDJPY, AUDCHF, AUDUSD, NZDJPY, NZDCHF, NZDUSD, etc.

Again this ranking is a generalization.

Currency specific events can cause currencies to perform in ways contrary to their risk or safety ranking. For example, over the past years the CHF has in fact been the preferred safe haven due to Switzerland's stronger economy and lower debt levels relative to those of the US and Japan. However when there is great fear about Europe's economy, the CHF may weaken, because most of Swiss exports would suffer. Also, the Swiss National Bank, like other central banks, periodically intervenes to keep the CHF low in order to protect Swiss exports.

While there are other factors that we cover in the book, here's a quick look at the most important ones.

There are a number of factors, the strongest of which is the currency's benchmark short term yield. Those currencies with higher short term interest rates, or those expected to have higher rates in the future, tend to move with risk assets due to their use in carry trade (buying of higher yield currencies funded by selling of lower yielders and profiting on the difference in rates while you hold the long and short positions).

Closely related to the above are market expectations about whether a given currency's yield will be rising, falling, or flat in coming months. While interest rate differentials may determine longer term risk ranking, its expectations about those differentials that can determine how performs against another over a given period. For example, let's say that 2 central banks A and B both announce a 0.25% rate increase on the same day. If the rate hike for A is believed to be the last one, and the hike for B is believed to be one of more increases still to come, then A is likely to sell off on profit taking. Meanwhile B is likely to enter a sustained uptrend, certainly against A, as traders see the increase as confirmation of the anticipated chain of coming rate increases.

Thus if interest rates for a given currency are expected to rise dramatically relative to those of other currencies (typically due to rising growth expectations for that nation) it's possible for a formerly low yielding safe haven currency to evolve into a high yielding risk currency. The opposite can also happen.

While current and expected future yields are crucial, they're not the only determinants of risk ranking. For example, currencies of export based economies that prosper or decline with global growth logically behave like other risk assets and hence are considered risk currencies. For example in recent years the yield on the CAD was equal and often lower than that of the EUR, yet the CAD was overall higher on the risk spectrum than the EUR.

Now that you've got the above background information on risk and safe haven currencies, we can move on to Part 2 -their correlations and how to use them, that's already up. After that, you're ready for Part 3- finding the profit opportunities in forex markets from the EU crisis. It should be up within the coming week.

While forex markets are typically associated with high risk, complex, time consuming short term trading, there are many safer, simpler ways that conservative investors or traders with limited time and skills can tap forex markets for currency diversification and currency diversified income. To learn more about how to improve your returns through conservative forex trading and investing, take a look at The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start.

It's the only book specifically written to show mainstream investors how to survive and hedge currency risk posed by unprecedented money printing by most major central banks, and how to prosper by safer, simpler ways to exploit forex and commodity markets, either as conservative traders or income investors, for lower currency risk and better returns. It's essential reading for all investors, because a good investment in a bad currency is a bad investment. Click here for a description of the book, and here for advanced reviews. It's due out in September 2012, reserve your copy by clicking here.

Disclosure: For informational purposes only. No positions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

May 23, 2012

From Seeking Alpha's Global & FX Market Currents (paraphrased & summarized)

1. Details of Papademos comments: In the full interview, clear the former PM isn't predicting a euro exit, but warns of nuclear winter in the event of an exit as a way to push Greeks into voting for the establishment parties.
2. "46 hours. That's the amount of time from a Friday NYC close to Monday's Wellington, NZ open - the amount of time Greece's (and Europe's) leaders will have to handle the issues surrounding a Greek exit from EMU. From calming civil unrest to recapitalizing the banks to getting a new currency going, "leaving is messy," says a former ECB member"
3. The ECB has set up a working group to focus on worsening financial conditions due to Greece, reports Die Welt, citing sources. Further market deterioration is likely to instigate new anti-crisis measures from ECB
4. Eurogroup Working Group (EWG):Each EZ country must prep contingency plan should Greece leave EMU-It's a significant step as nothing like this has previously been ordered for fear of leaks. Among the elements to consider are what support the EU/IMF should give.

In the end - most governments of the most widely held currencies are likely to prefer to print money rather than raise taxes, cut benefits, or at least use money printing to minimize the short term pain of voters -at the expense of future inflation & loss of purchasing power. EU already moving that way as France, Italy, Spain & rest of periphery push for Euro bonds (likely to be paid back with printed money as funding nation taxpayers will object to more donations to GIIPS).

Learn how to protect your assets against widespread money printing as Fed, ECB, other central banks seek to inflate away debt, devalue their currencies-and anything denominated in them-including your savings. Click here to read about the only solution for mainstream investors from our own Chief Analyst. For advanced reviews see here.

Disclosure: no positions

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

If most of your assets are denominated in one or two of the most widely held currencies, it's time to be thinking about ways to hedge that exposure and diversify into assets denominated in or connected to currencies that aren't about to be threatened by massive, potentially inflationary money printing that risk killing purchasing power.

Want proof? We need only look at what's happened in the first three days of this week.

The following are paraphrased from seekingalpha.com's Global & FX Market Currents from May 21 to 23.

May 21

1. The Telegraph: Hollande, Monti, & Rajoy seek halt austerity
2. ECB should buy unlimited amounts of sovereign debt if Greek exit from EMU-Polish finance minister Rostowski.
3. Even EZ-wide deposit guarantee plan may not halt the Club Med bank run because depositor fear is less bank failure risk and more redenomination risk
4. China may announce stimulus actions in the near future, reports official Xinhua News Agency

May 22

5. Jeremy Siegel: ECB's best hope of saving EMU is to trash the currency upon which it is built. A devalued EUR will bring some relief to periphery by boosting trade& pumping more inflation into German economy - a small price to pay to save the union. - A PRICE TO BE PAID BY ALL THOSE WITH SAVINGS PORTFOLIOS IN EUR, JEREMY!
6. Speaking to reporters on the release of an IMF report urging the U.K. to print more money, agency head Lagarde calls for eurobonds.
7. Fitch downgrades Japan to A+, outlook negative. "The country's fiscal consolidation plan looks leisurely relative even to other fiscally-challenged high-income countries, and implementation is subject to political risk."
8. China to fast-track approvals for infrastructure projects to combat an economic slowdown, according to the state-backed China Securities Journal.

May 23
9. Dow Jones: Italy's Mario Monti has joined France's Hollande advocates eurobonds. If so, he would join Spain's Rajoy who has also offered guarded support for same and establish a solid bloc to counterbalance German opposition to jointly issued bonds. Given the limited support that German, Dutch, Finnish, and other funding country tax payers would be willing to offer, we suspect this debt would printed away.
10. Eurogroup Working Group (EWG): Each EZ nation must prepare a contingency plan should Greece leave EMU. This is announcement is the first public admission of the possibility by an official EU body. Indeed, such talk was considered taboo for fear of leaks and ensuing panic. However with even the Greek PM admitting to the possibility, the topic is out in the open Among the elements to consider are what support the EU/IMF should give. With taxpayers of both EU funding nations and the US (IMF's chief paymaster) unlikely to be supportive, and the US in an election year, we suspect the funds will be printed rather than allocated from other programs or from spending cuts.
11. Bank of Japan maintains monetary policy, leaving rates in the 0-0.1% band, keeping asset purchases level at a total of ¥70T ($880B). Analysts expect an increase in asset purchases to come soon. This means in essence more Yen printing to fund purchases of Japan bonds to keep their price up and yield (and so Japanese interest rates) low.

Of course, these items are just from the past three days. There are more reasons, and more currencies, likely to face the threat of diluted purchasing power through excessive money printing that quietly taxes savers to fund spenders.

12. It's well known that the Reserve Bank of Australia is in easing mode, and that the Fed is ready to begin more quantitative easing if needed.

13. If the EU crisis starts to overheat, expect the Fed to take further measures to make more cash available to ease EU banking liquidity. Of course, the real cause of the EU's crisis isn't liquidity, its actual solvency. The short term liquidity crunch is just a symptom of the world refusing to lend to it because so many EU banks and governments may already be technically insolvent. Still, the Fed is likely to do as it did last year and at least ease liquidity problems in Europe to buy more time to avoid a likely market panic and collapse.

It's possible that widespread money printing may help avoid recessions - but it's far more likely that it will kill ultimately reduce (possibly severely) the purchasing power of the above mentioned currencies.

Yes, the so called coming "fiscal cliff" of an end to tax cuts and certain spending programs may reduce the monetary expansion in the US, but remember, this is an election year. It's unlikely any politician will want to hit voters' wallets before the November elections. We believe talk of fiscal responsibility will outweigh any real action on it.

The key lesson here is that we all must diversify our liquid assets - here's the guide to the easiest, safest way to do it, The Sensible Guide To Forex. It shows how you can easily achieve this, without opening accounts all over the world, or engaging in the high risk, demanding kind of short term trading typically associated with forex.

Click on this here for a description and here for advanced reviews.

We don't have to accept whatever diluted currency Bernanke, Draghi, King, and other central bank heads decide to serve up. We can vote with our feet and wallets and move get more exposure to assets of nations that respect our rights to keep what we've earned and saved without imposing the stealth tax of excessive money supply.

Does anyone know which firm(s) dominate the market for printing presses used to print currencies? The coming years should be great for those who manufacture, sell, and service the hardware behind the wave of loose monetary policy.

Disclosure: no positions or plans to open new ones in any asset mentioned above in the coming days.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.