part0030

At last we have arrived at the fourth of our major capital markets which is, forex. The markets that ultimately display the flow of money around the world.

But where to start explaining the forex market is a difficult question, and in this chapter what I do not intend to cover are the basic mechanics of exchange pairs. This is a all explained in another of my books Forex For Beginners. You can find details in the back of this book or on Amazon.

The purpose of this chapter is to try to give you a different perspective, a deeper view, an historical view, as to how this market has evolved and why. Also how it has changed over the last 50 years, and what are some of the changes we are likely to see in the future.

By doing this I hope to provide a broader perspective for you as a trader, a framework if you like, against which to trade.

The forex market is one of the most difficult both to understand and trade as it is driven by so many internal and external influences. These combine to create what appear to be random, sudden changes in price and direction. And the reasons for this are as follows.

First, the forex market is the most influenced and manipulated politically, both by governments via their central banks. This is the market where global politics meets money in one glorious melting pot. Second, it is the primary market which offers central banks a small degree of control over the economic landscape as the international powers battle for supremacy. Third, it is the market where international politics meets economics, and I cannot stress this point too strongly.

As forex traders you really do have to understand the above and the extent to which this market is subject to political intervention, coupled with false and misleading data from individual countries, all overlain with jealousy, trade wars, sanctions and political manoeuvring.

Earlier in the book I considered the relationship between the US dollar and gold and, as I stated there, as a forex trader you do have to understand the US dollar and its role as the lynch pin for the entire monetary system. Furthermore, you also have to understand how this role also impacts the currency markets.

Over the past half century, there have been a variety of attempts to control currency exchange rates, both overtly and covertly, and this is a feature of the market that will continue for decades to come, as central banks and governments set self preservation of their own markets and economies, well ahead of any concerns for any fellow members of the G7 or G20.

The principal reason for this is that there is simply too much at stake for the politically appointed officials and government representatives who put their own political appointments and opinion ratings first, and other countries second.

Central banks have a remit to provide economic stability which encourages growth, controls inflation and is a stimulus for jobs. If a country is largely dependent on exports, the central bank will do everything in its power to ensure its currency is kept artificially weak, thereby protecting its overseas markets.

In short, all the various parties involved will always do what is in the best interest for themselves, and their country, and not necessarily in that order. This is what you are confronted with as a forex trader, which is why it is such a complex but fascinating market.

Other features to consider are the issues of pegging and why it still continues today, free floating currencies, and finally intervention and why it happens. However, before looking back historically to the 1970s I want to start with 2007 and explore the ramifications of the last few years.

2007 saw the onset of the worst financial crisis in the last 100 years, probably only eclipsed by the stock market crash of 1929.

The ramifications of the near collapse of worldwide banking infrastructures, coupled with the virtual bankruptcy of entire countries will remain for years, if not decades to come. Some would argue the fractures in the credit markets may never heal, and that we could still be subject to some aftershocks, once the dust has settled.

In fact we need look no further than the so called BRIC countries of Brazil, Russia, India and of course China who having been the principle beneficiaries of the credit bubble and explosion, are now beginning to worry about the long steady decline of the US dollar.

At this point you might ask why these countries should be so worried about this decline. The reason is what is known as the “dollar peg”. In simple terms this means a currency is 'pegged' to the US dollar, and does not free float like other currencies. In other words, the currency follows the US dollar as it strengthens or weakens accordingly.

Of the BRIC countries, those which have been, or indeed still are, pegged directly or indirectly to the US dollar, are the Chinese yuan, the Russian Rouble and the Indian Rupee. In addition, the currencies of the Gulf States too are pegged to the US dollar. The last of these is primarily pegged to minimise any currency fluctuations due to their dependency on selling oil,which is priced in dollars.

This list changes all the time, as countries around the world first adopt, and then modify or abandon the peg, as a mechanism for managing currency exchange rate fluctuation. But what is pegging? Why is it used? What are the advantages and disadvantages and how is the current pegging system likely to affect the currency markets in the next few years?

As rational, logical beings you would think we would learn from the lessons of history. Sadly, this is not the case, as we only have to look back to the Bretton Woods agreement and the Marshall plan of the 1950’s and early 1970‘s. This is when the dollar was established as the 'de facto' global reserve currency, following the collapse of these agreements and the removal of the gold standard.

The gold standard was an attempt to peg currencies to gold, and on its demise ushered in the free floating currency model which has been more or less adopted across the globe.

As forex traders it's vital we understand the issues with pegging, and in particular how this mechanism affects the floating currencies, particularly when major economic nations are pegged to the dollar. For the Gulf states of course, pegging makes sense, since their primary income is derived from oil which is priced in US dollars, and as such, their oil reserves are not subject to the usual exchange rate fluctuations which would otherwise apply.

But why do countries adopt a currency peg and what are the benefits? But perhaps a supplemental question is why is this important even to a scalping forex trader? And the answer is the Euro.

When a currency is primarily pegged to the dollar, most trade and transactions are by default executed in US dollars. This is fine in a stable economic environment where currency stability is the norm.

However, in the last few years this has most certainly not been the case with central banks such as the FED creating artificial debt markets with their fiscal and monetary stimulus, whilst simultaneously creating an artificially weak dollar.

It is no surprise therefore the problems with pegging have become more exaggerated as a result. And this is precisely where we were at the start of the new decade.

In simple terms a US dollar peg does two things to those countries who have opted into this arcane system. First, the pegged countries are forced to issue new money in order to re-balance the peg which is like a see saw, so the printing presses are turned on in the base currency which in this case is the US dollar.

Second, this has the effect of driving up the cost base for manufacturers on a domestic basis and driving inflation into the economy. The side effect is monetary policy has to remain tight to combat the inflationary pressure created by the peg with the pegged currency’s economy slowing as a result.

The country with the pegged economy is then locked in a no win situation unable to tackle its domestic issues or to devalue its own currency to rebalance the economy. This was the primary reason why the Bretton Woods agreement failed. The peg had the effect of stimulating inflationary pressures into the pegged currencies. This made domestic manufacturing uncompetitive in world markets and led to a protracted period of recession for the pegged currency exceeding that of the base currency.

Whilst there are parallels between the Bretton Woods collapse of forty years ago, and the pegged currencies of today there is one key difference, and it is this. Today’s situation is far more dangerous for one simple reason - the US trade and budget deficits.

The FED’s decision to use QE to prevent financial Armageddon has created many unforeseen and unwanted consequences. One is the creation of an artificial imbalance in the economic world, to which there is no easy answer, and until this imbalance is resolved then currency markets are likely to remain volatile and in a state of flux for years to come.

So, what has been the reaction to this problem by Russia and China, both of whom are heavily US dollar dependent with China in particular holding more reserves in dollars than Japan? The reactions have been very different. Russia started to shift away from the dollar in 2009 reducing its reserves by increasing their Euro holding from 20% to almost 40% over a 12 month period, whilst still retaining their longer term US bonds.

China, on the other hand, appears to have been given a lifeline by the US FED via their QE programme which has allowed the Chinese to replace their long term bonds with short term holdings. This can only suggest one thing. That China is preparing, with help from the FED, to float the Chinese yuan and eventually move away from the corrosive effect of the dollar peg in favour of currency diversification.

However, at the same time neither China’s currency, nor indeed any other currency, has the required liquidity to replace the US dollar as the currency of first reserve.

China’s distaste for the dollar is supported by other members of BRICS, and China often uses other BRIC members as allies in its own game plan. For example, instead of buying directly from trade partners, China has set up swap agreements as a means of avoiding the US dollar completely.

So far it has set up currency swaps with Argentina, South Korea, Hong Kong, Indonesia, Malaysia and Belarus. But, more alarmingly both China and Russia have agreed to expand the use of their own currencies in bilateral trade agreements.

To add further to this cosy relationship, China is now in close talks with Brazil and, as a result, these countries can now use the Chinese yuan to buy goods and services in China, along with its close neighbours who depend on China’s trade network. Think of this as a shopping club where certificates are exchanged for goods and services, a club where these certificates or coupons have replaced money. Brazil can now use its yuan to buy goods and services from, say Indonesia or Malaysia without the need to settle in dollars.

The ultimate for China would be if they could extend these swap agreements to a partner in Europe. The game for China, and it is a game, is to remove the US dollar from its position as a currency of first reserve, and to have it replaced with one which includes the yuan as part of a balanced basket of currencies.

Naturally, this would reduce the dominance of the dollar as a result and increase that of the yuan, whilst simultaneously strengthening China’s trading position and providing a more controlled economic environment for growth.

Amongst all this there is a healthy dose of political rhetoric between the US and China, and whilst superficially there is a gloss of entente cordiale, beneath the surface lurks the old animosities of a communist state and the ultimate symbol of capitalism. Further reinforced with the current trade wars which have taken centre stage.

In part this can be traced back to the US policy of QE and the FED’s desperate attempt to avoid a financial collapse and provide the framework for a revival of the US economy.

In addition, competitive devaluation or “the race to the bottom” by central banks desperate to protect export markets has now created a dangerous imbalance in the forex market. This market has changed beyond all recognition in the last few years as old antagonisms are resurrected and protectionist policies implemented. In simple terms we are now seeing the major economic groups fight for supremacy and their battle ground is the forex market. These economic groups fall into three broad categories.

The first group is that led by China and the BRICS, who are busy creating their own trading circle using currency swaps as a direct attack on the US dollar to weaken its position, as it continues to slide under the weight of the Federal Reserve’s monetary policy.

The second group is Europe and the Euro with its political leaders desperate to salvage the euro project as they create ever larger bail out funds to avoid the embarrassment of default by an EU state. And if you are wondering if the Euro project sounds remarkably similar to a peg – you would be correct, because it is.

In forty years, no peg to any currency has ever lasted more than a few years, as it is impossible for any country to maintain its monetary policy to retain the peg. Many have tried and all have failed.

Classic failures have included Argentina and Mexico in recent years, with the former finally defaulting and creating the biggest default in history of $95 billion. This record still stands unless Greece is allowed to default.

In reality Europe and the euro project is no more than a peg between 17 countries, most of whom are now struggling to survive, with Spain, Italy Portugal and Greece teetering on the edge.

All of these countries are in effect part of what amounts to a hard currency block centred on Germany. Just as with Argentina pretending the peso was a US dollar, the fiction in Europe is Greece and Germany can operate within a common currency. Simply having a common currency does not make it a reality. It can only be so if Greece were to adopt the monetary policies of the ECB (European Central Bank) which is a proxy for the hard currency Bundesbank – something which clearly can never happen. To use a very simple analogy. This is akin to asking a spender and a saver to live in harmony together. The relationship will never survive, and this is what makes the Euro project even more risible.

To expect Greece with all its cultural and economic differences to adopt the same monetary policy as Germany, is unrealistic in the extreme. The same applies to Spain, Italy and Portugal, and it is simply a question of time before the project collapses. The project will only collapse when Germany finally throws in the towel, and with the ECB now standing as the lender of last resort, this could be some time coming.

The last rites for the Euro have been read many times, and the shorts have been squeezed, time and time again as the Euro continues to survive. Every move lower is greeted by the Euro bears as the demise of the single currency, which then promptly reverses to recover its bullish momentum.

The Euro will survive, for the time being, but like all the other 'pegs' it will ultimately collapse. It cannot survive in its present structure. One only has to look at history, and it's not a question of if, but when. Germany will return to the Deutschmark, Spain to the Peso, Italy to the Lira and Greece to the Drachma. The waters will calm and another peg failure will be added to the long and growing list.

The third group can loosely be categorised as the emerging markets of Latin America and Asia. Many of the countries within this group are major exporters within the top 20 global economies and growing fast. And their long term survival depends on having competitive export markets, but so far they have not banded together in any formal way to tackle this problem.

One reason for this is that thus far their focus has been regional rather than global. However, with many of these countries inextricably linked to the dollar through strong commodity exports, this may change in the future.

Finally, of course, we have major economies such as Japan, Canada, Australia and the UK, supportive of their own currencies, but watching Europe and the BRICS block leviathans execute their strategies to weaken the dollar and ultimately see it replaced.

For Europe this is a politically motivated strategy, whilst for China it is fuelled by trade concerns underpinned by politics. Many countries around the world see the FED policy of weakening the US dollar as simply one of self interest, and akin to a protectionist or interventionist policy commonly employed by countries such as Japan. But all these attempts to manipulate the currency markets always have two things in common.

First they always fail, and second they always cost the central bank concerned a vast amount of money in the process which is subsequently viewed as wasted. No central bank however large has the ability to reverse a currency trend no matter how much money they inject into the system. A good example is the SNB - Swiss National Bank which has spent untold millions trying to weaken the Swiss Franc and has, in effect, simply given up.

So this is the world of the forex markets which on the surface appears to be simple and straightforward. But beneath this apparent simplicity lies a complex web of politically motivated strategies coupled with long and deep seated animosities, all of which are played out in a simple exchange rate. And this is one of the many reasons trading in currencies is so difficult.

It is the market where international politics is played out on a grand scale each and every day, as these global economic powerhouses jostle for position.

Unfortunately for the US dollar, the FED is playing a very dangerous game, and it could ultimately rue the day that quantitative easing ever began should the dollar eventually be toppled from its unique position as the currency of first reserve.

Is this likely to happen? Anything is possible and if it ever did, it is debatable whether this would create a more stable environment for economic growth primarily because, as I said earlier, few currencies have the necessary liquidity to replace it.

In the meantime the IMF has also weighed in with its own proposals based on a mechanism referred to as an SDR, which stands for Special Drawing Rights. In simple terms, this would be a synthetic currency made up from a basket of currencies, primarily the US dollar, the euro, the yen and the British pound. Of course this simplistic approach has since been countered by Asian countries who want the yuan included as well as currencies from Latin America.

The IMF’s view is this would create a more stable environment for world trade to thrive and negate much of the impact of the current “race to the bottom”.

However, until then the US dollar will remain the lynch pin of the currency markets, and love it or loathe it, it is here to stay for the time being.

As forex traders we have to understand the underlying politics of the other major groups in the markets and my objective in this chapter has been to provide you with a deeper view of the currency markets and the powerful forces which drive it.

In the next chapter I want to explore the relationship between commodities and bonds, and the cross market relationship between these two capital markets.