Currency moves are often determined by the participant’s attitude toward risk. A market participant who is risk averse is unwilling to take any chance and wants the prompt and safe return of 100% of their principle. At the other end of the spectrum is the consummate speculator, always looking for an angle that will increase his return on capital. If he places five bets, all estimated to have a pay back probability of ten to one or better, what difference does it make if one or two bets pay back nothing?
Frequently, market pundits claim that events have altered perception about the risks of positions in different markets. This week, for example, Ben Bernanke, Chairman of the Federal Reserve Bank testified that the rate of economic growth in the United States might be slowing down, caused in part by the sovereign loan difficulties in the Euro zone. With global equities markets in retreat after the Bernanke testimony, responding to these warnings, currency market participants knew the drill. They bought the safe assets, as determined by prevailing market consensus, the USD, and the JPY, and they sold those currencies that are deemed to suffer because of slower economic growth.
During times of severe panic, market participants become hysterical, resulting in unruly market conditions and high volatility. There is always opportunity to make money by keeping your whit’s about you while others are losing theirs. Often scared traders act like a noisy herd of lemmings, anxious to get rid of their positions at any price. Once they have finished getting out, the market usually reverses. God forbid, however, should you buy just in front of another herd of tardy lemmings, slow in getting rid of their positions.
What makes the currency markets so volatile because of changes in the assessment of risk? There are many reasons, of course, but we will offer a few explanations.
Money or a currency is supposed to be a store of value. It is an asset until we can find a better one. Most of us have expended time and energy to accumulate this money, and it is important to us, as owners of this currency that the dollar that we own is not worth .90 cents when we go to exchange the money for something else. If something threatens the value of our money or savings before we can either spend or invest these funds, we become protective, or risk adverse. So your money is very important to you, and if you think some pending economic event is going to depreciate the value of your money, you are going to be quick to move it.
Time is money, an expression we have all heard. Likewise, surplus money invested over a period of time should result in more money. Instant awareness of global markets, thanks to the internet, now affords us with an international buffet of investment opportunities. For example, let us assume that you have a tidy sum of money now, but you need this money in approximately a year, and you wish to earn some interest on these funds. The rate for a one year US T Bill is currently .27%, intentionally kept low as the government tries to stir up a recovery. That is not too attractive. In Japan the rate is even less, only .13% for an entire year, but in Australia you could get 4.48%, and Brazil offers a very attractive 11.92% for one year.
With each alternative one year investment, you also need to make a call on the currency which you will use to purchase your investment. Yes, the return of 11.92% is great, but the Brazilian real can make your ownership of a one year Brazilian note, an adventure. This investment is definitely not for the faint of heart, as the real can fluctuate 20% over the year, and the inflation rate can diminish the value of the real you receive in return.
Let’s say that the Australian Dollar looks like a safe place to park your little nest egg for a year. You can earn some interest and it does not seem like you are assuming a lot of risk. There is the risk, however, that the Aussie dollar will depreciate, but you feel this chance is minimal.
Others share your views of the Australian investment, and many investors, much more aggressive than you get involved in the ‘carry trade.’ The carry traders borrow where the rates are cheap, and lend where they are dear. It is so profitable, on paper at least, they borrow and lend very large sums. Experienced carry traders know something this good will not last forever. As the trade gets loaded with more and more players, it is just a matter of time until the trade gets jumpy, and mere rumors can impart speculative volatility in what had been a quiet trade.
The trade was initiated because it was a safe place to park some money for a risk adverse trader. Too much company in the trade increases the risk. Spook the market with any sort of a story, and someone will break for the exit. If the story gains some traction, the lemmings start to run, and you get a real stampede. Your choice is to join them, even race them to the exit, or to hunker down, knowing that the currency will not go to nothing.
From this example you can see that the leveraged investor is the one at risk, and the quickest to get out of the market. If you are using the 400 to 1 leverage your broker so kindly offers you, it is best to be precise with your entry point if you want to enjoy longevity as a trader. Leverage, in fact, is one of the major reasons that markets are so volatile. It is tantalizing to dream of success employing the maximum margin allowed but the reality of trading with the max margin is fraught with danger. Further, if a whole bunch of traders, with highly leveraged positions, are trading in the same pair as you, it takes very little to get a market to run one way or the other. It is kind of like a cattle stampede. How and why it got started none of the cattle knew, and they certainly did not know where it was going.
Ironic as it may seem, risk adverse traders lose money because they are too cautious, or risk adverse. Frightened money has no business being in the market, and usually ends up being in some one else’s account. Putting money at a place in the market where the best assessment is you are not going to lose, usually means you can not make any money either. And, if you were wrong in the assessment about the safety of that investment, you are going to end up taking less money out of the account when you close it. Usually the deliberate, cautious assumption of risk, where some upside potential exists, is your best bet.
Over a period of time the markets collective assessment of the ideal safe havens will change. At the moment, the USD, US Government Treasuries and the yen are the safe havens of choice. Neither investment pays much interest, but they are both considered safe places to park money. Should conditions change; the money will fly off to other locations perceived to be safer.
Risk aversion traders, another name for those people who are deadly afraid of losing money, are usually so cautious they are their own worst enemy. Often they are gullible, responding to rumors that can move markets, and quick to run when confronted with real or imaginary adversity. When a market is loaded with risk adverse traders, it is so very important to forecast how they will respond to altered conditions. To survive profitably in this situation, it is like being a judge in a beauty contest. As a judge it is your job not to pick who your choice is as the most beautiful participant, but rather, who the crowd is going to crown.
Markets, in some ways, are like beauty contests. If you can successfully anticipate how the crowd is going to vote this can be very profitable. The concentrated money flow into a market, on either the long or the short side is going to move the price. Correctly anticipate what the mob is going to do, and they will generously place money in your account. How long will they leave it there, how long do you ride the wave? The answer to that question requires skill, experience and some luck. You never really know until the move is over.
Successful risk aversion means that traders can correctly identify the location of a safe haven. While the mattress and the vault night be logical storage areas for your wealth, what happens if the currency you place in these safe havens depreciates in vault? This happens if inflation erodes the value of your currency or it can result from your currency loosing in relation to other currencies.
A safe haven can change over time as the economic health of a country or a region changes. Wealth can be dissipated by foolish political decisions. Placing more power and money in the hands of the central government will usually result in the loss of liberty and economic stagnation.
Currently the Japanese yen is very popular as a safe haven where wealth can be stored during troubled times. Japan, however, has some looming problems that may alter the perceived safe haven status. The Japanese Government is currently spending about twice as much as they are collecting in tax revenue. To accomplish this feat, they have to borrow massive amounts of money to stay afloat. It is estimated that the national debt per capita exceeds $80,000. The aging population, during their working years was thrifty, and saved trillions of dollars. Much of their saving was loaned to the Japanese government to finance the Japanese debt.
For years, interest rates in Japan have been very low. Currently ten year notes yield only 1.15% per annum. If these rates, for what ever reason, rise dramatically, the Japanese government would be confronted with serious financial problems. With total Japanese sovereign debt twice the size of the GNP, this has the potential of causing major problem. When that happens, you do not want to have your safe haven money or investments in yen denominated accounts. The world is always changing and the investor must be cognizant of the changes and alter investments accordingly.