Currency Traders: The Fed Has No Clothes! Part 5

(Or, in other words: What’s Going To Happen With the US Dollar?)

Let me explain the state of the currency markets in the 1980’s: More than ninety-five percent of all cash currency transactions were made through banks. Brokerage firms did not offer cash FX prices, companies had to deal through banks and cash brokers only dealt with banks and a select few Investment Firms. The banks controlled the flow of all the cash currency transactions and other than outright position limits and cash FX trading was basically unregulated in the bank arena.

Today, only roughly fifty-five percent of the transactions in the cash FX market go through banks. The rest go through exchanges, FCMs that make markets in cash currencies to retail and institutional customers and through the electronic brokerage service, a brokerage clearinghouse that allows very large net-worth individuals, corporations, banks and investment firms to deal direct. These days, General Motors can sell dollars directly to a large private speculator through EBS. The days when the handful of large banks in the world controlled the cash FX markets and could really influence flows are gone. Banks no longer have the risk tolerance to carry the huge speculative positions we routinely carried in the 1980’s—they have credit risk and mortgage portfolio problems to worry about. Risk has shifted largely to the speculating crowd and the central banks don’t have control of that crowd. For better or worse, control of the cash FX market has shifted from the few to the masses and that has greatly diminished whatever power the central banks had, IF they ever had the power over the cash FX markets traders attribute to them in ‘the good old days’ of cash FX.

The dollar is currently in a very strong down trend. Until that long-term trend changes, the central banks know that buying US dollars against the major currencies is throwing money away. They do not have the reserves or the sheer power to turn these long-term trends in the cash FX market. And in the case of the United States, the Federal Reserve has so many other urgent matters it needs to address, the dollar’s level is not even on the list of policy items worth pondering.

Currency traders shouldn’t spend any time or emotion worrying about whether the central banks are going to stop the dollar’s slide. The truth is quite simple: when the flow of capital out of the United States ends, the slide of the dollar will stop. It’s well known amongst the larger market participants that the countries that had traditionally held the majority of their reserves in US dollars have been diversifying their reserves out of US dollars and into other currencies. China and Japan have sold a huge amount of US Treasury Instruments and then sold the US dollars they received from these sales—many insiders estimate that China now holds less than 1/3 the US assets it held three or four years ago.

With the emergence of several new large economies [Europe, China and India] that are beginning to rival the US in buying power, investors around the world realize that ‘flight to quality’ may not necessarily mean a move into US denominated assets. As little as six months ago, when I mentioned it might soon take three US dollars to buy one euro, people generally felt I was overreacting to a short-term down trend in the dollar. But these days, it’s become clear that the United States is not in the driver’s seat when it comes to determining the level of the dollar, the level of their own interest rates and the capital flows in and out of their own country. The markets will take the currencies where they take them and the central banks, like all other traders, can go with the flow or stand aside—anything else will result in losing positions that eventually will be liquidated.

I wish you all good trading!

By Timothy Morge

Currency Traders: The Fed Has No Clothes! Part 4

(Or, in other words: What’s Going To Happen With the US Dollar?)

For the next three years, the central banks intervened aggressively in the currency markets, and they made it a habit to try to get the most ‘bang for their buck’ by confirming their intervention and usually leaking their intent to intervene before the markets even opened to a select few traders. And so it seemed to many traders that the central banks ‘called the shots’ and had complete control over this market. And when traders today talk about those three years and talk about the Fed and the other major central banks in general, they seem to feel they are fairly invincible when they want to take action. But nothing could be further from the truth.

Like all things in life, if you use a trick too often for too long a period of time, people get used to it and it begins to lose its effectiveness. The dollar had fallen so far, traders that tried to sell as soon as they heard the central banks were intervening usually found themselves short US dollars at poor levels, because they had jumped in and sold the break out to new lows. After several years of seeing the same announcements and watching the central banks pummel the markets, traders simply got smart: when the central banks intervened, they simply stepped out of the way.

Once the general market stopped jumping on the bandwagon when the central banks announced they were intervening, the traders the central bankers were using also quit initiating their own new short positions—instead, when the phone rang and they got the order to sell dollars, they’d simply execute the order and then go back to what they were doing. This indifference to the central bank sell orders quickly highlighted the truth: without a trend, the central banks were just market participants. The size of the cash FX market is so large, no one player or even five or six players—even five or six or seven central banks—can turn a major trend around in the cash FX market. The trends in the cash FX markets come from huge capital flows and only long-term changes in the policies that cause these flows eventually stop and turn the trend.

When traders these days think about that three year period, they believe the Fed and the other central banks changed the trend in the dollar and sent it reeling lower; time gave the central banks ‘super hero powers’ they never had in real life. The dollar had been falling for more than six months and had declined more than twenty-five percent from its highs before the central banks even started to plot the Plaza Accord in 1985.

When they finally acted, they jumped on a fast moving train: The dollar was already in a very strong down trend and they simply advertised their blessing of the existing trend. Here’s a chart that shows where the US dollar peaked and just how far it had fallen before they began to blatantly sell dollars:



More in part 5…

By Timothy Morge