sexinsexo-happy everyday: 2008/10/19

How Will A Rate Cut And Recession Affect The Dollar’s Reserve Status?

Risk aversion has dominated all markets; and the demand for liquidity and security has sent panicked investors to the US dollar. However, with the world's largest economy wading slowly into a recession and interest rate speculation pointing towards the lowest returns from US assets in history, how long can the greenback's rally last? There are two major considerations for how far the dollar's rally may go: the general level of risk sentiment and the health of the health of the US economy. Before market participants ever concern themselves with returns and the level of interest rates, fear must be stemmed. Panic has overwhelmed the market such that liquidity and safety of funds are the only concerns for capital allocation. This sense of preservation has evolved with time, starting with bank defaults, going on to a credit crunch and then to massive capital losses through the ensuing market crashes.

However, through this process, the true driver behind the declines eventually came to light: leverage. Investors, banks, lenders and even consumers around the world had steadily leveraged themselves on credit since the markets recovered from the bursting of the Dot Com bubble. In the bull market, banks created derivative products to make returns of 30-plus percent, lenders relaxed their conditions and ran down reserves, and consumers drove up their credit bills to record levels to purchase goods. Now, the house of cards has come crashing down; and everyone is demanding their money back. The problem is that the losses that are being incurred have been multiplied by the leverage and is subsequently overwhelming the initial capital that originally supported the deals and investment. Now with margin calls, defaults and illiquid markets, a long line is forming to unwind positions; and the market must deleverage or face catastrophic defaults. This means that all the world's governments can do is ease the pain – and not stem the tide. Boosting confidence in counterparties, guaranteeing lending and steadying the natural drop in asset values is all the that officials can do.

And, while the market will not likely see the end of its deleveraging next week, we can still see the dollar reverse should confidence in its safe haven status be shaken. There are two major events scheduled for the week that may sour the greenback's rally. The first release is the Federal Reserve's rate decision on October 29th. Economists expect a 25bp cut to 1.25 percent; but the market has already priced in a 100 percent probability of a 50bp cut and even a 25 percent chance that the policy board will take the benchmark rate all the way down to 0.75 percent. The central bankers will need to consider whether such a move would even help (as previous easing hasn't yielded the intended effects with banks not passing on the savings) and if it will instead just invite more problems when the global economy actually recovers. The other prominent event is the follow day's advanced reading of 3Q GDP. There is little doubt that the US is already one foot into a recession (we need two quarters of contractions for a technical recession), but the long-term strength of the dollar going forward will depend on how shallow the nation's recession is and how quickly it recovers relative to its global counterparts.

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Forex Trading BID/ASK Sizes Affected by Lack of Liquidity

Finance ministers and central banks worldwide have been taking a number of actions to increase liquidity and stabilize financial markets. However, despite the recent drop in interbank lending rates which led to a marginal improvement in investor's appetite for risk, forex trading conditions remain relatively difficult.

For instance, liquidity in the currency market has been so thin that relatively small orders can potentially move exchange rates up or down by one or two pips. Moreover, the recent spike in exchange rate volatility has made banks reluctant to take the other side of many trades.

Lack of Liquidity Has Been Affecting the CLS, a Global Settlement System for Foreign Exchange Trades

In 2002, the world's largest banks created a global settlement system for managing settlement risk on foreign exchange trades. Continuous Linked Settlement, also known as CLS, was set up to mitigate the risk of default in interbank FX settlement and radically changed the way FX deals were settled. For instance, CLS allows financials institutions to settle payment instructions related to foreign exchange deals almost in real time, eliminating the time zone differences that can cause payment delays and give rise to settlement risk. As of September 2008, CLS was settling more than 1.5 million trading instructions a day in 17 currencies, which represent nearly 95% of global foreign exchange trading. Despite the benefits, the CLS also has some disadvantages and the system is very dependent on the credit worthiness of its members. For instance, to settle a trade through the CLS system, a bank delivers the currency it owes to the CLS Bank but that payment is not released unless the counterparty deposits the offsetting payment for the transaction. However, given more pressing needs elsewhere in their businesses, many banks have pulled the plug on their forex dealing exposure which means more illiquid markets and less competition in setting bid and ask rates.

Forex Trading Conditions Have Been More Difficult but the Currency Market is Still the Most Liquid

Even though, making forex trades has been more difficult over the last few days, the currency market is still the most liquid financial market in the world with an average daily volume of US$ 4 trillion, according by the Bank for International Settlement. This is more than three times the total amount of the stocks and futures markets combined. Moreover, there are several mechanisms you can use to mitigate the lack of liquidity which stems from the crisis in the global financial system. For instance, with a no-dealing-desk forex broker, every trade is executed with one the world's premier banks which compete to provide you with the best bid and ask prices. This competition between banks reduces the potential for market manipulation by price providers and the best spreads are streamed to you with a small markup.

Central Banks Have Been Injecting Liquidity into the Banking System. But Will They Succeed?

To some extent, there is a growing concern among international investors that the recent efforts to bail out banks around the world will fail to restore investor's confidence and avoid a global recession. In fact, judging by the recent price action, many investors have been reluctant to take leveraged positions on foreign currencies and liquidity in the forex market has been drying up due to a strong demand for U.S. dollars from financial institutions seeking a safe-haven currency. In addition, some companies have been keeping their money in house to meet their operational needs and there is even some speculation that foreign banks increased their demand for dollars to settle some credit derivatives contracts tied to the bankruptcy of Lehman Brothers. However, central banks have been pumping unprecedented amounts of cash into financial institutions, and the introduction by governments worldwide of several stimulus plans could lead to a substantial improvement in investor's confidence in the global financial system. Other reason to be optimistic is the recent sell off in commodities which should alleviate some pressure from the world economy. In fact, recent data on consumer prices points towards lower inflation going forward and lower interest rates could be the last defense of the world economy against a global recession. This week, the rate that banks use to charge each other for overnight loans in dollars fell to the lowest level in four years, and many investors are confident that lower borrowing rates in the interbank market could lead to a world wide recovery in the appetite for risky assets like higher yielding currencies.

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