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There haven’t been many bright spots in financial markets during the last twelve months. But despite the doom and gloom, one market has boomed – the foreign exchange market.

Why?  The reason is simple.  It is arguably the only market where investors don’t have a bias towards either being long or short in a trade.  That’s because whenever you trade foreign exchange you are always long one currency and short another.

It’s the same whether you’re trading the Aussie dollar against the US dollar, or the US dollar against the Euro.  The foreign exchange trader is simply taking the view that one currency will be stronger compared against another.

To get more insight into recent stgelopments in the FX market and what traders should look out for through 2009 and into 2010, I spoke with respected currency trader Boris Schlossberg at GFT Forex in New York.

Schlossberg says GFT Forex has seen an explosion in demand for FX trading during the past year.

But whether they are experienced or novice FX traders, they’ve all had to change the way they trade. Strategies that worked two years ago aren’t necessarily working today.

According to Schlossberg, the main reason traders changed their approach is the decline of the carry trade.  That’s where investors borrow funds in a currency with low interest rates and invest those funds in a currency with a higher interest rate.  Schlossberg says “The carry trade is long since dead.”

Between 2004 and 2007 the carry trade was massive as big differences built up between interest rates in various countries.  It worked like this:

Borrow 1,000,000 Japanese Yen at an interest rate of 0.25%.

Sell Japanese Yen in the foreign exchange market at a rate of 100 Yen to USD$1.

With your USD$10,000 you buy US government treasury bonds yielding 3%.

You make the difference as a profit, roughly 2.75% on your money.

To close out the trade you sell the treasury bonds, convert the proceeds back to Yen and pay back the loan.

And if you’ve played it right and the exchange rate is now 110 Yen to USD$1.  So you only need to convert USD$9,090 back into Yen as the exchange rate has moved in your favour.

However, once the carry trade started to unwind it had the opposite effect on the currency.  The Japanese Yen started to gain in value so investors had to use more US dollars, not less in order to pay back the Yen loan.

The credit freeze is partly to blame.  Investor appetite for the carry trade slumped as interest rates were slashed.  Suddenly investors were scrambling to repay Yen denominated loans which caused the Yen to further increase in value as everyone was buying Yen.  The carry trade quickly started to work against investors and it started to unwind.

Now that interest rates are so low in the main currencies of the US dollar, Euro, Pound Sterling and Yen, the carry trade is almost redundant.  According to Schlossberg the vast majority of FX trades are now based purely on what he calls news flow.

That is, trading based on the dozens of economic statistics that are released on a daily basis.  These events will always have an impact on the value of a currency.  Examples include interest rate decisions, GDP data and employment numbers.

And traders are flocking to currencies where the news flow is most available.  That’s why 95% of FX trades involve the major currencies of US dollar, Euro, Pound Sterling and the Japanese Yen.

Looking ahead to the next twelve months Schlossberg believes this trend will continue.  He says there are two key events to look out for.  The first is how bad the financial situation in the United States will get.  The longer problems continue the more investors are going to look for an alternative to the US dollar as a save-haven currency.

And that has a direct impact on the second event.  Any strength in the US dollar, he says, is dependent on foreign investors being able to absorb US debt – much like they did with the carry trade.

The important difference is that between 2004 and 2007 US interest rates on bonds were at a level investors were prepared to accept.  Now, the same bonds are barely above zero for a one-year bond, and only around 3.5% for a 30-year bond.

That’s why the focus for foreign exchange traders has moved to trading based on news flow.  The likely impact on foreign exchange markets is continued volatility as traders look to anticipate news events and trade accordingly.

For FX traders this presents a great opportunity for traders to make big gains quickly but you also need to watch that big losses don’t pile up equally quickly.

 

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