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Forex Trading Conditions Improve After Coordinated Effort to Boost Liquidity

Tuesday, 14 October 2008 13:56:51 GMT  |  Antonio Sousa, Chief Strategist and David Rodriguez, Quantitative Analyst

Forex trading conditions, including BID/ASK spreads and overall market volatility, have been improving over the last two days on speculation that actions taken by policy leaders to inject liquidity in the banking system will help to reinstate investor’s confidence in global financial markets.

The key US Dollar overnight London Interbank Offered Rate (LIBOR) has improved substantially through the past two days of trade, as announced government initiatives force significant improvements in interbank lending markets. European bailout plans have gone as far to guarantee interbank loans, and this has singlehandedly increased banks’ willingness to lend to one another. On the other side of the Atlantic, US Treasury, FDIC, and Federal Reserve initiatives have thus far led to a broad improvement in financial market conditions—with commensurate benefits in interbank lending market liquidity.

The past two days of clear improvements in global financial market conditions have likewise led to similar amelioration in forex trading market conditions. A reduction in counterparty risk has made major banks and trading entities more willing to provide liquidity, and we can easily see the effects on Bid/Ask spreads in the highly-liquid Euro/US Dollar currency pair. According to the Bank for International Settlements, daily trading volume in the Euro/US Dollar currency pair grew to an incredible $840 billion dollars in 2007. Such impressive liquidity often means that we will first see improvements in global financial market through the Euro/US dollar, and five-hour trade settlement typically means that counterparty risk is negligible in currency market transactions.

The chart below shows Bid/Ask spreads available in FXCM retail trading accounts from year-to-date. Since FXCM uses prices provided directly by the world’s major institutions’ currency dealing desks, this is an accurate picture of spreads available in interbank markets. FXCM markups are accounted for in the below spreads.

The fact that the average FXCM spread in the EUR/USD has fallen substantially through the past 48 hours of trade signals that forex conditions stand to improve further on recently announced government measures. Such an effect likewise translates into improved risk sentiment through global forex trading, and already we see that the Japanese Yen has fallen substantially against all G10 currencies for the second consecutive day of trading. The table below shows that the previously downtrodden Australian Dollar has rallied an incredible 14 percent against the Yen in a mere two days of forex trade. Whether or not we can see a further improvement in the Australian Dollar and other high-yielders will almost-exclusively depend on whether financial market conditions may continue to improve through the near term.

 

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