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What Defines Risk in Currencies!
By Mike Conlon | October 28, 2009
As I mentioned earlier this morning, today’s trading in the currency market is all about risk aversion. JPY and USD continue to strengthen against the commodity currencies (AUD, NZD, CAD). By looking at these numbers, I would expect the US equity markets to be down A LOT more. Yet at this writing, the Dow is down 17 points, the S&P 500 down 8 points, and the Nasdaq down 25 points. What gives?
Usually, a strong move in JPY and USD will accompany a larger sell-off in the equities indices, and vice versa. Yet the stock market “sell-off” is well within its normal daily trading ranges. The charts on the Aussie look like its poised to go down further, so could this be foreshadowing the stock market sell-off everyone seems to now be predicting?
One of the strange “ironies” about the currency market is the difference between risk-taking and risk-aversion. Take the current market, for example. When trading currency pairs, you are essentially trading one currency in relation to another. So in this regard, you typically want to own the stronger pair and sell the weaker pair. Usually the stronger pair is paying higher interest than the weaker pair, so you actually earn interest in this type of situation, otherwise known as a carry trade.
So let’s take a look at two “hypothetical” countries and their respective currencies.
Currency A: This country’s currency is very weak, yields almost no interest (ZIRP), its banks are questionable as to solvency, its economy is teetering on the brink of disaster, it is taking on debt like its going out of style, and confidence is near an all-time low.
Currency B: This country was largely unaffected by the credit crisis and the Great Recession, just raised its benchmark rate 25 bp to 3.25%, is currently worried about too fast a recovery and inflation, and appears to have its fiscal house in order.
So which currency is “riskier”, A or B? If you said ‘A’, then you are WRONG!
In this example, Currency A is the US dollar and Currency B is the Aussie. So it sometimes seems comical that in order to avoid risk, you would sell a higher yielding currency from a financially sound country in favor of a declining wreck with no interest from the country with possibly the worst fiscal situation on the planet!
Yet that’s how it goes. For now. Obviously its because of the status of USD as the world’s reserve currency that makes this “flight to safety” trade happen, but I wonder at what point people start to realize that earning interest in Australia is the real “flight to safety”.
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Topics: What To Look At In The Market |