International Credit Crunch Brings Risk Aversion to Forex Market

A worldwide credit crunch and economic problems (mainly in the United States) have torched the equities markets for the past two weeks. There are fears that the subprime mortgage crisis and the housing problems will escape their respective sectors and infect the market as a whole. The losses are magnified by the uncertainty of many traders, exemplified by the VIX volatility index surging past previous levels. As is usually the case in a situation like this, risk aversion is controlling the market. With regard to foreign exchange trading, two phenomena emerge: a flight to safety for capital and a carry trade unwind. As Boris Schlossberg of DailyFX.com notes, the only winners in this scenario are the US dollar and the Japanese yen.
Flight to safety in the forex markets is beneficial to the US dollar, at least temporarily. This is because investors pare back from riskier investments and park their capital in dollars for the time being. The result is a peculiar situation where the crumbling of US markets is actually a boon for the US dollar. But traders should realize the dollar strength will not last. As for the US stock market, there is a sense that the credit crisis is reaching other areas; there are reports in Bloomberg that situation with subprime mortgages are hurting the earnings of companies across the spectrum.
And the economic reports have been mixed. The regional manufacturing surveys (Philly Fed and Chicago PMI) have disappointed, confounding observers who thought the weak dollar would allow exports to support the manufacturing sector. But unemployment is in line to grow by 100K for the NFP report later this week. How traders react to that data will determine the long-term direction of both the US economy and the US dollar, but on a short-term basis, the dollar looks good.
Growing risk aversion also creates problems for carry trade longs. Yen bulls have killed the fx market for the last two weeks. There has been a 1000 pip decline in GBPJPY (from its record high), and the yen has also gained 700 points against the three commodity currencies. In fact, the yen improved against all 16 most highly traded currencies last night. Carry trade lovers cannot start crying over their losses yet, however; Kathy Lien of FXCM claims there is still plenty of room for the yen to appreciate. Fear is the dominant factor ruling the currency market right now, signaling a strong near-term weakness in the Australian dollar and the New Zealand dollar, two currencies that have gone up significantly on the back of the yen-based carry trade. I am not one who believes that the credit crunch puts us in line for a global slowdown (and the great thing about trading currency is that it doesn’t matter—there is the same opportunity for profit in a bear market as there is in a bull market). But I think traders should be wary of high risk investments and focus instead on more stable currencies and economies.