daily forecasts

Currency Trading Conditions Are Likely to Improve

Thursday, 18 September 2008 12:52:12 GMT  |  DailyFX Team

The currency market has recently been struck with adverse Bid/Ask spreads and unfavorable interest rate rolls stemming from evolution of a global financial crisis. Indeed, the lack of liquidity in today’s very volatile market place has made it difficult to assume leveraged positions. More succinctly for FX traders, the drop in market liquidity has led to the recent spike in overnight borrowing rates. In turn, this has led to tight or even negative interest rate rolls for many pairs at the interbank level. In reality, rollover in the Forex Market reflects more than just the benchmark interest rate differential between two currencies; and the true spread between accessible borrowing and lending rates helps us to understand why one trader could have to pay rolls even if he holds a long position in the highest yielding currency. Looking ahead, financial markets are likely to remain under a considerable stress; but the recent injections of liquidity by the world’s preeminent central banks and efforts to improve policy should help to alleviate some pressure in the financial system over time.

Money market difficulties are quite visible in overnight borrowing and lending rates, as dealers make it prohibitively expensive to hold positions that they view risky to their own operations. In fact, US Dollar Overnight London Interbank Bid Rates, or the rates at which banks are willing to bid for overnight borrowing from other banks, skyrocketed over 400 basis points in the span of a single day. Such a dramatic move underlines banks’ unwillingness to lend to each other and the true scarcity of such funds.

US Dollar Overnight London Interbank Bid Rate (Libid)

What Does it Mean for Forex Traders?

Traders will see the effects of sky-high London Interbank Bid rates on interest rates charged and collected on leveraged forex positions. If major bank are unwilling to lend to each other, they will make it prohibitively expensive for forex traders to borrow US dollars or any other currency—sending funding costs through the roof. At the same time, those same financial entities will pay relatively little on margined currency positions in which the trader is due to receive interest payments, and the end result is that margined forex traders may be forced to pay interest on either side of the market in even the most high-yielding forex pairs.

Interbank market illiquidity likewise translates into higher transaction costs for the forex trader, as banks’ unwillingness to take on risk means that they are likewise unwilling to act as counterparties to forex traders. Given more pressing needs elsewhere in their businesses, many financial institutions have pulled the plug on their forex dealing desks, and the result is less competition in setting bid and ask rates in even the most historically liquid forex pairs. Illiquidity only exacerbates market volatility, as less liquid markets are more prone to sharp price fluctuations. Indeed, our DailyFX 1-week volatility index remains at its worst since the Asian Financial Crisis and the failure of Long Term Capital Management.

When Will Forex Trading Market Conditions Improve?

Conditions in forex trading markets may continue to worsen if we do not see marked improvement in global liquidity; the main risk to the forex trader is that banks remain unwilling to provide funds in interbank forex dealing and credit markets. One key risk barometer is the difference between money market rates and the equivalent risk-free US Government bond. Yesterday we wrote that thespread between 3-Month Treasury Bill rates and money market yields was at its worst since the stock market crash of 1987, but that same spread has now worsened to its worst in at least 24 years. Indeed, the 3-month US T-Bill now yields an almost-unbelievable 0.07 percent—its lowest in at least 50 years.

Until financial markets improve and investors feel confident in the stability of major financial market institutions, we will likely see US Government bond yields continue to drop; faced with few alternatives, traders will park their money in riskless assets. As forex traders, we will subsequently watch spreads between US Treasuries and their equivalent interbank money market rates to gauge the level of confidence in financial markets. Unless we see marked improvement through the near term, we believe that forex traders should be careful not to take undue risks in current market conditions.

Written by David Rodríguez, Quantitative Analyst for DailyFX.com

To contact the author of this report, e-mail drodriguez@dailyfx.com

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