Futures, Sep 2007 by Laidi, Ashraf
For retail traders, forex arbitrage plays are generally limited to trades measured by seconds. However, with careful analysis of the global risk appetite in shifting currency markets, you can uncover longer-term possibilities.
Exploiting arbitrage opportunities in spot forex markets is a rare enterprise available to retail investors. Trading on the prices of multiple market makers and on firms providing “no dealing desks” can help generate upside potential for the active day trader. Paying close attention to the highs and lows of futures and spot forex prices also can help gain a momentary advantage in price direction.
However, here we’re aiming for a longer-term perspective. Using the activity in gold futures, along with close charting of the Japanese yen, equities and volatility measures can help pick clues for what could be the next source of dynamism that dictates forex market activity in G10 currencies.
The year 2007 has witnessed a shift in the underpinnings of the currency markets, transitioning from flows based largely on expectations of Federal Reserve policy, to flows driven by risk appetite. Examples include frequent episodes of carry trades into higher yielding forex, equities and metals and the subsequent partial unwinding of these trades. Capturing the next catalyst to currency market dynamics is neither a science nor an art, but a continuation of the patterns seen in the first half of 2007 and may help prepare for moves the rest of the year.
Before outlining these factors, it is important to shed light on the drivers behind the market developments of late February through early March, which triggered a 5% decline in the yen, a 6% decline in the S&P 500 and a sharp slide in high-yielding currencies in less than two weeks. More significant, gold dropped more than 9% during the same period amid a sharp reduction in risk appetite following a one-day 9% drop in China’s main equity index.
The surprise element of the Asian sell-off prompted an unwinding of risk-based carry trades, whereby investors borrowed low-cost yen and Swiss francs to take part in higher yielding currencies (Aussie, Kiwi, sterling, euro) as well as participate in rallying equities, gold and oil. The Chinese correction and fallout in the U.S. subprime market sent a jolt across these trades, prompting a sharp, yet brief, reduction in risk appetite and an unwinding in those trades.
As for the dollar, the impact was mixed. The unwinding of carry trades saw a rally in the U.S. dollar against the Aussie, kiwi, euro, sterling, Canadian dollar and gold, as traders unwound positions, which drove the preceding dollar sell-off earlier in the year. Once risk trades were re-established, equities surged to new highs and the yen slumped to multiyear and record lows. Complacency returned to the market, along with renewed pressure on the greenback in most of the second quarter and into the third.
YEN-FINANCED EQUITIES
But an additional pattern began to form in July, which was not solely driven by carry trades chasing high yielding plays, but also driven by a broad loss of confidence in the U.S