The economic turmoil witnessed over the past few weeks is a reminder that fundamentals play an important role in determining price trends in our various trading markets. A debt crisis is a basic fundamental, and due to the interdependence of our global markets, it can send shockwaves felt around the globe. Currencies weaken and strengthen. Commodity and futures markets react since the price for farming exports will be impacted down the road come harvest time. Balances between exports and imports become disrupted. Inventories may have to be revalued. Management teams must suddenly review their near term plans and adjust where necessary.
The European debt crisis and the uncertainty surrounding the Euro and its future were quick to cause the expected flight of capital to safe havens. In this case the U.S. Dollar and the Japanese Yen were the primary beneficiaries in the forex market. The flight into precious metals, Gold and Silver, was more pronounced. Traders, that had graduated from forex demo accounts and had dabbled in the “carry trade” business, raced to their respective trade desks to unwind unprofitable positions.
A “carry trade” is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a higher yielding security, a bond or stock, in a different currency. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used. If the destination currency weakens, then the trader is exposed to a loss unless he has hedged his bets.
Many hedge funds and traders have used the Dollar and Yen as the “base” currency and invested where rates were higher, typically in Australia and New Zealand this time around. The Australian economy has been one of the strongest of the G20 countries.
The unwinding of carry trade volume could signal a further downturn in the Aussie Dollar. If it breaks through 0.85, then deeper cuts can be expected.
The Australian economy has outperformed many around the globe. GDP was up 2.7% in 2009, unemployment is half of what other countries are experiencing, machinery and equipment spending is also up, and China’s demand for resource exports remains unabated. The Central Bank has raised interest rates, and it appears that Australia may have skirted the global recession that has gripped Europe and America.
If the Australian economy is performing at near trend, then what are businessmen to make of all of this global turmoil? Fear and uncertainty, not market fundamentals, drove the Aussie Dollar to an eight-month low of 0.8517 on Wednesday. The consumer sentiment index showed a seven per cent slide for May, its biggest percentage drop since the height of the credit crunch in October 2008. Global turmoil and uncertainty suggest caution as the best strategy, or as the old adage goes, when in doubt, hold onto your position.