The Euro is Dead, Long Live the Euro

The Euro is Dead, Long Live the Euro

A day will come when all nations on our continent will form a European brotherhood. A day will come when we shall see the United States of America and the United States of Europe, face to face, reaching out for each other across the seas. – Victor Hugo 1848.

In December 1996, the designs for the euro banknotes were chosen after a contest. The Council of the European Monetary Institute (EMI) chose the winner, the Austrian artist Robert Kalina, “Ages and Styles of Europe” was the theme. The symbolism was; windows, gateways, and bridges. Luc Luycx, a Belgian artist, won the European wide competition organised to design the euro coins. He designed the European common side. The national side is different in each of the twelve countries. The euro initially became the common currency of Europe for twelve countries in the European Union. This was quite simply the biggest changing of money the modern world had ever witnessed when the currency ‘went live’ in 2002.
The European Union (EU) is as wealthy as the United States. The EU is the world’s biggest trading area. The euro is the second largest reserve currency and the second most traded currency in the world after the United States dollar. As of July 2011, with nearly €890 billion in circulation, the euro had the highest combined value of banknotes and coins in circulation in the world, having surpassed the U.S. dollar. Based on International Monetary Fund estimates of 2008 GDP and purchasing power parity among the various currencies, the eurozone is the second largest economy in the world.
George Soros, whose $10 billion bet in 1992 preceded the Bank of England’s devaluation of the pound and John Taylor at FX Concepts, who runs the world’s biggest currency hedge fund, have predicted the euro’s breakup, or forecast it will slump to parity with the dollar. However, their prediction could easily be translated as a bet, they obviously have reasons why they want a collapse and those reasons are not altruistic, it’s basic greed. Those fully committed to the shrill of wailing opposition versus the currency might have backed the wrong team. Be under no illusion that despite being on it’s own knees whilst naval gazing, the threats to the USA’s reserve currency status have always caused a stir in the USA administration since European economic unification. Particularly when that threat to the dollar’s reserve status extends to oil being priced in euros.
Against the dollar, the euro has ranged from 82.3 cents in October 2000 to $1.6038 in July 2008. General consensus seems to that the euro will hold above $1.30 this year as Central Banks (can you say Swiss National Bank) and sovereign-wealth funds seek alternatives to the dollar.
Despite all the turmoil the euro actually strengthened by 1.42 percent last week against a basket of nine developed-nation peers, the most since gaining 1.55 percent in the period ended June 3, according to Bloomberg Correlation-Weighted Currency Indexes. It has risen 2.5 percent from this month’s low on Sept. 12, the indexes show. At last week’s close of $1.35, the currency is 12 percent stronger than its average of $1.2024 since January 1999. While strategists have cut their forecasts for appreciation, they still see it rising to $1.43 by the end of 2012, based on the median of 35 estimates in a Bloomberg survey. A circa 40% fall, in order to reach parity with the USA dollar, is surely off the radar?
Schneider Foreign Exchange, the most-accurate currency forecaster during the six quarters through June 30, according to data compiled by Bloomberg, predicts the euro will trade at $1.56 next year. They also go far further by suggesting that a default by Greece would prove to be incredibly “cathartic” for the region, shifting attention straight back to the U.S.’s $1 trillion budget deficit and rising debt, according to Stephen Gallo, the firm’s head of market analysis. That focus could also return to the UK as its deficit and debt management which only by the grace of ‘clever’ public relations and deflection has remained unquestioned. Whilst the UK’s credit card bill (deficit) appears under control the mortgage (overall debt) is still massive.
“I don’t think the euro is going to break up, it’s facing lots of challenges but it’s not going to fall apart,” Audrey Childe-Freeman, global head of currency strategy in London at the private-banking unit of JPMorgan. “Economically, no member country would gain from a breakup of the euro-zone and that’s why politically, it’s unlikely to happen.”
“Too much political and ideological capital has been invested into making the euro project work and bringing the continent of Europe closer together since the end of World War II to allow it to unravel now,” – Thanos Papasavvas, head of currency management in London at Investec Asset Management Ltd., which invests about $95 billion, said in a Sept. 20 interview with Bloomberg.
Whilst all the mainstream media focus has been on the potential collapse of the Euro, particularly by right-wing politicians who are prematurely dancing on it’s grave, should they begin to finally accept that such a huge project cannot and will not be allowed to fail? When considering recent history it’s worth recalling how strong countries such as Argentina emerged from their secular monetary crisis, the worry manifesting throughout the Euro’s enemies could be that the Euro region may emerge stronger and more united once this crisis is finished. A concept that the USA administration could find unpalatable if ultimately affecting the reserve status of their currency.

Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/the-euro-is-dead-long-live-the-euro/

Daily Market Roundup by FXCC - September 26 am

So a nuclear physicist, a lawyer and a history student walk into a meeting..if you were expecting a joke, or an ending with a punchline, then I’m sorry to disappoint. The nuclear physicist is Ms. Merkel, the lawyer is Ms. Lagarde and the history student is one George Osborne and this trinity of (supposed) brilliant minds have very different ideas and agendas as to how to heal both Europe’s and the global financial community’s debt crises. Everything is changing. People are taking their comedians seriously and the politicians as a joke, but the ultimate cost of the final European ‘stability fund’, at circa €3 trillion, is no joke.

If you had to objectively pin your hopes on one of their diverse rescue theories you may choose the non politician’s, however, you’d quickly recall the Ms Lagarde was a politician until two months back and still is. All politicians should have 3 hats – one to throw into the ring, one to talk through, and one to pull rabbits out of if elected and Ms Lagarde’s appointment, as the ‘elected’ head of the IMF, was undoubtedly a political appointment and she’s desperately searching for that one single rabbit to pull out the hat.

One improvement and development of the multitude of G20, IMF, ECB, FED meetings that have taken place on both sides of the Atlantic during the past two weeks, is that finally a unified policy appears to be taking place. An injection of funds into a number of continental banks is the cornerstone of the new and revised three-pronged plan being discussed to ‘save’ the single currency. Finally we get to learn the size of the potential cheque that’ll be stiffed onto the unsuspecting citizens of the seventeen members of the Eurozone, and a few others who’ll have to contribute in order to keep the shrapnel and collateral damage to a minimum. The combined cost could be a truly jaw dropping €3 trillion and it involves giving additional firepower for the European Financial Stability Facility (EFSF).

The shoring up of banks under a recapitalisation scheme would finally and mercifully allow Greece to default on its debt, something all leaders have been nervous of because of the potential damage to Europe’s banks. The plans, under discussion by G20 finance ministers and the IMF in Washington, may finally be unveiled this week. It comes amid warnings that the FTSE 100 Index could fall as low as 4000 without rapid intervention.

The plans would lead to an orderly default by Greece and allow the country to remain within the eurozone, private sector creditors would bear a loss as high as 50%. Once Greece is ‘stabilised’ focus then turns inevitably to Spain and Italy. It’s believed that the EFSF needs €2 trillion euros to meet the financing needs of these two countries singularly if they are shut out of the markets.

In Japanese the haiku is composed of 17 sound units divided into three parts – one with 5 units, one with 7 units and another with 5 units. Since sound units are much shorter than English syllables, it has been found that following the Japanese example results in a much longer poem often filled up to make the count with unnecessary words. It’s not a Haiku yet the current situation was summed up perfectly by Japanese Finance Minister Jun Azumi; “the Lehman crisis was about rescuing a company. Now it involves a country’s sovereign debt so in a sense, the situation is more severe.”

The markets’ response to the latest pronouncements from global finance leaders is muted, so far the SPX daily index future is currently up 0.91%, the FTSE future up 1.1% the euro is currently up versus the dollar and yen. Sterling has recovered versus CHF, USD and YEN from it’s new lows of mid last week.

The data releases today that could affect sentiment include;

US – New Home Sales Aug
UK – Nationwide House Prices Sept.

Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/september-26-am/

Making Sure You Muse on Forex News

Making Sure You Muse on Forex News

How economic literate are you? Some twenty years back as a bit of pre work ‘fun’, I set a small team of salesmen I was managing a pre work test. As with all our Wednesday sessions there was a prize at stake which always ensured a competitive edge to the quiz. The test had ten questions on the key economic issues of the day. One question that sticks in my mind was “what is the current interest rate?” At the time the rate was an eye watering 13-14% and despite most of us having mortgages only one or two of the eight knew the Bank of England’s base rate. It got worse, the result was that the ‘winner’ took the prize with four correct answers and the questions were not too taxing. Now what surprised me at the time was that both myself and my colleagues were selling multi unit office equipment deals, often with a large ‘ticket’ value, into the City of London. I’d expected (incorrectly) that all of us would be what I’d term “commercially aware”.

As a student of economics I’ve never lost my hunger for financial news, but I didn’t set the test at a high level, it was very basic. When walking into some of the major global financial institutions I believed that you had to have a brief understating of how they ‘worked’ even if only to strike up casual conversation away from the deal you’re there to (hopefully) take care of. For example, if selling equipment into a major bank today you should be able to comfortably hold your own in a discussion on where you believe the economy is headed.

As a consequence of my profession I have to be commercially aware, not just as a specialist forex trader, but also to offer FXCC a range of blog posts, articles and thoughts that will prove to be wide ranging, enjoyable and of worth to our clients. There’s little point in us regurgitating the same news published elsewhere, therefore we attempt to provide something slightly edgier and thought provoking, whilst still ensuring our customers eye is kept on the ball in relation to the key events and issues of the day.

Unlike my former work colleagues I’d expect forex traders to be commercially aware, perhaps if self employed traders they’ve spun out of a work environment that ensured their interest in economic matters has continued. But if you’re not as commercially aware as you could or should be how do you gather more knowledge and ultimately will it make any difference to your bottom line? You could argue that unless you have a dedicated squawk and or a Bloomberg terminal then most news arrives too late to be relevant. However, we’re suggesting a more holistic intellectual curiosity approach to the fundamental reasons why markets move and not being a dedicated ‘news’ trader.

We’ll provide of list of useful commercial news centric websites to visit as a start, some such as zerohedge.com and market ticker.org are slightly iconoclastic, but you’d never rely on a single news source, for example the government owned machine that is the BBC, to impartially deliver your news and influence your views would you? It really is up to individual traders to dyor (do your own research). Why not bookmark a few and create a folder, perhaps sign up for the newsletters and alerts on each? And whilst on the subject of newsletters or alerts sign up for them, all of them. You should have a specific email address, your “trading” e-mail where all trading related news goes.

I often chuckle when I read complaints on forums from posters with regards to receiving “spam” off forex brokers or spread betting firms. Firstly they’re not spam, fx firms send out bulletins and offers or updates, not spam. Secondly, the time taken to click open and view an email takes seconds, there may be one nugget of information contained therein that can prove invaluable. Traders will often spend hours perusing forums when their time could be spent reading world class content, free of charge, from some of the finest economic minds available. So here’s a brief list, we’ve left out a few of the obvious destinations such as the FT given the subscription price is exorbitant and their news is covered elsewhere. There’s also a ‘Google trick’ enabling you to see the FT news you want free of charge. Simply visit Google/finance and look for FT articles, you can then access the specific article free of charge.

Here’s a starting list, enjoy the read.

bloomberg.com
reuters.com
marketwatch.com
sharecast.com
zerohedge.com
google.com/finance
fxstreet.com
forexfactory.com
forexpros.com
economist.com
market-ticker.org




Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/making-sure-you-muse-on-forex-news/

Market Commentary - Fracking Shale Gas, Fracking Economy

The slump in share values and the volatility of the forex markets hasn’t reduced me to swearing, I moved on a few years back from swearing at the monitor and “the markets” when my trades went bad. Oh ok, I admit it, I still do it now and again, but hey, you have to have a competitive streak in this business right? The fracking in question refers to the process of shale exploration for gas in the UK, it’s known as fracking.

There are times when the energy crunch we’re facing hits you, not just at the pump (when you realise that petrol has increased by circa 30% during the past four years), or when you contemplate that, despite the economic gloom, Brent crude is still over $100 a barrel and we are literary scraping the oil and gas barrels. The relatively new phenomena of extracting oil from tar sands, or drilling for natural shale gas, is deeply worrying. Shale gas is extracted by drilling down into the ground and then hydraulically fracturing the shale using high pressure liquid to release the gas. The process has proved controversial in the US because the drilling process involves chemicals, including carcinogenic compounds, which can pollute water supplies.

Billions has already been invested by companies seeking to explore shale gas extraction in Pennsylvania and only now has a Pennsylvania appeals court ruling raised questions as to who can legitimately claim ownership of the natural gas embedded in the Marcellus shale formation, potentially putting in doubt the legitimacy of thousands of drilling leases. Ownership of the oil and gas rights isn’t clear. For more than a century, Pennsylvania has required landowners to consider oil and gas rights separate from more general “mineral rights” when transferring ownership of resources beneath the surface of their property. The defendants in the title dispute argue that shale gas is different and should be considered part of the mineral rights because it is contained inside rock.

The environmental issues versus shale gas are well recorded, the most prominent of which is the contamination of the water supply to residents within the vicinity. A recent study of the effects of shale-gas extraction on drinking water published in the Proceedings of the National Academy of Sciences tested 60 drinking water wells in Pennsylvania. All of the water wells, with concentrations above 28 milligrams of methane per litre of water, were within one kilometre of active drilling. A dissolved methane concentration greater than 28 mg/L indicates that potentially explosive or flammable quantities of the gas are being liberated in the well and may be liberated in confined areas of the home. In ten instances the water wells have recorded readings of over 30 and approaching 70.

In the UK the process of shale exploration is known as fracking, energy firm Cuadrilla Resources has recently announced plans to sink up to 800 wells in the Lancashire area of the UK but campaigners have called for a ban on shale gas exploration amid environmental and safety concerns. The problems have prompted campaigners to call for a Britain-wide ban on shale gas extraction. Calls for a moratorium on fracking were ruled out earlier this year by a committee of MPs who said they’d found no evidence it poses a risk to water supplies from underground aquifers. The company’s exploration efforts near Blackpool were stopped earlier in the year due to fears they were causing tremors, they estimate there is 200 trillion cubic feet of underground gas in the area. They plan to sink as many as 400 wells over the next nine years and up to 800 over 16 years if gas extraction is successful.

We have a relatively new fuel extraction method, that can and does pollute the water supply, can cause localised earth tremors, is incredibly front end investment intensive, is in economic terms a very poor return on investment and given the huge front end cost the ultimate consumer price will be very high, but our insatiable appetite and desperation for fuel causes our elected officials to wave away concerns over the long term benefits in return for the short term gains for the few.

As the great and the good of the world’s financial elite have gathered and continue to gather in various meetings in Washington they’re also reduced to fracking for ideas to tap the evaporating shallow pools of liquidity in order to satisfy the one dimensional growth model they stubbornly adhere to. They know they only have one answer, one fracking trick left, an absolute mega bi-lateral QE to end all QEs, but they can’t bring themselves to do it knowing that the inflation caused would (in real and inflation adjusted terms) wreck the investment positions of many of the assembled good and great..the turkeys just can’t bring themselves to vote for Christmas.

After the tumult of yesterday Asian markets fell in overnight and early morning trade, but not by as much as feared given the fireworks on Wall Street yesterday, the CSI closed down 0.6% and the Hang Seng closed down 1.36%. The ASX closed down 1.56%, commodities falling hits the Australian index particularly hard. The SPX equity index future is currently in positive territory circa 0.7%. The ftse is currently up marginally by 22 points. Brent crude is up $99 a barrel and gold is off $4 an ounce. Sterling has recovered some of it’s position versus the majors, up approx. 1% versus the dollar, 0.5% up versus yen and flat versus the Swissy. The Euro has made small gains versus the dollar,0.5% which has fallen versus the Franc. The Swissy is fairly flat versus most of the majors but has drifted slightly versus the Euro.

There are no major data releases this afternoon prior to or at the NY opening.


Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/fracking-shale-gas-fracking-economy/

Daily Market Roundup by FXCC - September 22 pm

The World is on the Eve of the Next Financial Crisis

U.S. stocks have slumped dramatically, the Dow Jones Industrial Average has suffered its biggest two day decline since November 2008 to finish the trading day 3.51% down. The investors’ concerns, that policy makers are running out of tools to avoid another global economic recession, will not disappear.

All ten industries represented in the Standard & Poor’s 500 Index retreated at least 2.2 percent. The S&P 500 closed down 3.19% dropping circa 7.5 percent in four days. The MSCI All-Country World Index slid 4.9%, extending a drop from its May 2nd high in excess of twenty percent. The S&P 500 has fallen 18 percent from the three-year high reached on April 29.

The world is on the eve of the next financial crisis, with sovereign debt its epicentre according to Mohamed El-Erian, the chief executive officer of Pacific Investment Management Co., which runs the globe’s biggest bond fund. The European Central Bank failed to put in place a “circuit breaker” in order to contain the region’s debt crisis, El-Erian said at an event in Washington today.

At the same event world leaders and major finance chiefs demanded that Europe acts decisively to arrest its debt crisis, whilst emerging economies said they’d consider providing more backing to help prevent the chaos from spreading. As finance ministers and central bankers gathered for talks in Washington (against the backdrop of plunging stock markets) the leaders of; Australia, Canada, Indonesia, Britain, Mexico, South Africa and South Korea stressed the risk of the Eurozone debt crisis becoming contagious. Officials from the BRICS countries, including China, Brazil and India announced they’d consider giving more funds to the International Monetary Fund in order to boost global stability and liquidity.

The leaders wrote an open letter to France who are currently chair of the Group of 20 leading economies;

Euro zone governments and institutions must act swiftly to resolve the euro crisis and all European economies must confront the debt overhang to prevent contagion to the wider global economy.

Emerging-market stocks also tumbled, sending the benchmark index to the biggest drop in three years. Commodity producers led the retreat. The MSCI Emerging Markets Index fell up to 6.2 percent at one point in the session to 881.52 at 11:52 a.m. in New York, the steepest decline since November 2008. Indonesia’s Jakarta Composite Index slumped 8.9 percent, the most among world bourses and its largest slide since October 2008. Russia’s Micex index sank 7.8 percent, benchmark indexes fell more than 4 percent in India, Hungary and Poland. The Shanghai Composite Index and Brazil’s Bovespa lost more than 2.7 percent.

Americans filed fewer new claims for jobless benefits last week, however, the decline was too small to dispel the macro worries that the economy is dangerously close to falling into a new recession. Applications for unemployment benefits dropped 9,000 to 423,000 in the week ended September17, the Labor Department said on Thursday. This was roughly in line with the expectations gathered by Bloomberg.

Moody’s Investors Service lowered debt ratings for Bank of America Corp, Citigroup Inc and Wells Fargo & Co on Wednesday, saying the U.S. government is getting less comfortable with bailing out large troubled lenders. The government is “more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled,” said the rating agency, a unit of Moody’s Corp.

Moody’s decision hit Bank of America’s value hard, it downgraded both the long and short-term debt of the holding company and long-term deposits at its main banking unit. The ratings agency downgraded short-term debt at Citigroup and limited the Wells’ cut to its senior debt and to deposits at its lead bank. Bank of America is still struggling with billions of dollars of mortgage losses, litigation and stresses from the need to raise capital to meet new regulatory obligations. Bank of America Corp. is among a group of lenders that could face a wave of fresh lawsuits claiming the system they’ve used for more than a decade to register mortgages cheated cash-strapped counties out of millions of dollars. After Moody’s downgrade, the cost to insure $10 million of Bank of America’s debt for 5 years in the credit default swap market rose 48 basis points to $378,000 per year.

The Euro has lost ground versus the dollar and yen, but gained versus sterling. Sterling has continued it’s recent mini collapse versus the dollar, the Swissy and yen. The Aussie dollar has fallen versus the USA dollar, the dollar has faded versus yen and remained quite flat versus the Swissy. The equity index futures for the ftse and the USA are marginally positive.

Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/september-22-pm/

The Recent History of Epic Bank Failure has been Forgotten

During the 2008-2009 banking crisis the FDIC website experienced a surge in traffic. Plenty of observers have kept a ‘weather eye’ on the site since. It listed and continues to list failed banks and financial institutions in the USA whose depositors and investors required assistance from the Federal Deposit Insurance Corporation.

The late 2000s financial crisis led to the failure of a number of banks in the United States. Twenty-five banks failed and were taken over by the Federal Deposit Insurance Corporation (FDIC) in 2008, while 140 failed in 2009. In contrast, in the five years prior to 2008, only 11 banks had failed.

The receivership of Washington Mutual Bank by federal regulators on September 26, 2008, was the largest bank failure in U.S. history. Regulators simultaneously brokered the sale of most of WaMu’s assets to JPMorgan Chase, which planned to write down the value of Washington Mutual’s loans at least $31 billion.

2011 has seen a slight resurgence of failures when the authorities had hoped that the banking system had been, to all intents, cleansed. To date in 2011 71 USA banks have failed, whilst none have failed at the level of WaMu the fact remains that the systemic failure of the USA banking system is still apparent. Despite the bailouts, both secretive and publicised, and the regular programmes of quantitative easing and asset purchase, the symptoms are constantly treated but the disease appears to be incurable, at least by using the methods which to date have failed. In 2010 157 banks failed and there were some considerable failures that, had they failed in for example a smaller European country such as the United Kingdom, would have caused quite a stir;

Horizon Bank 1,300
Charter Bank 1,200
Columbia 1,100
Community Bank and Trust 1,210
First Regional Bank Los Angeles California 2,180
La Jolla Bank 3,600
Advent Bank Corp 1,600
Appalachian Community Bank 1,010
Riverside National Bank of Florida 3,420
Amcore Bank 3,400
Broadway Bank 1,200
Bancorp 1750
Eurobank 2,560
Frontier Bank 3,500
R-G Premier Bank of Puerto Rico 5,920
Western bank Puerto Rico 11,940
Midwest Bank and Trust Company 3,170
Tier one bank 2,800
Crescent Bank and Trust Co 1,000
ShoreBank 2,160
Premier Bank 1,200
Hillcrest Bank 1,600

Out of the 157 failed banks in 2010 twenty two banks went under citing liability figures of over $1 billion. The total asset failure from bank failures in 2010 was $95,975 billion.

2011 has seen less than half the failures of 2010..so far. However, not only do we still have four months left in year the worrying fact is that failure is still deeply embedded in the banking system. It would appear that no amount of assistance can permanently fix the issue. There are several niche sites that list potential USA bank failures, alarmingly some are unerringly accurate.

The bank blog has a top forty watch list, out of the forty it had on respirator, nineteen have subsequently failed. Fortunately the biggest banks are not on the watch list..for now. Prior to the Fed’s two day meeting the belief was still prevalent that a too big to fail attitude remained within the USA authorities.

Given Ben Bernanke’s abject refusal to announce a new round of QE that view may have to be amended. An epic failure, similar to that witnessed in 2008 to Lehman cannot be ruled out. If we experience such a collapse then we’ll know we’re well and truly back in 2008 territory, what solution, temporary or otherwise, can be created is a mystery..

Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/the-recent-history-of-epic-bank-failure-has-been-forgotten/

Contagion – Don’t Talk to Anyone, Don’t Touch Anything

Contagion – Don’t Talk to Anyone, Don’t Touch Anything

The 2011 film Contagion has been a relative hit with USA movie-goers. On the independent film peer review site rottentomatoes.com it’s rated highly. There was a French film in 2009 also called contagion and the suspicion is that in the very best ‘Hollywood tradition’ the film industrial complex of America has taken a great foreign language film and given it their sizzle by altering the storyline (ever so slightly) and packing the film with ‘A’ list stars. Ironically or coincidentally the word “contagion”, which was last over used in 2009, is once again being spoken with increased volume and regularity.

Contagion follows the rapid progress of a lethal airborne virus that kills within days. As the fast-moving epidemic grows, the worldwide medical community races to find a cure and control the panic that spreads faster than the virus itself. At the same time, ordinary people struggle to survive in a society coming apart…

It wouldn’t take too much skill to change this movie description to fit the current global financial malaise, we’d simply exchange the words “medical community” with “financial community” and the fit would be complete. As to whether Ben Bernanke would get a leading role ahead of Jude Law, or Christine Lagarde ahead of Marrion Cottilard is doubtful, what is probably certain is that the film has a hopeful ending, a scenario that can’t be guaranteed in the reality that Bernanke and Lagarde are currently starring in.

Wikipedia has an entry for financial contagion that explains the phenomena within a couple of paragraphs;
Financial contagion refers to a scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy, in a manner similar to the transmission of a medical disease. Financial contagion happens at both the international level and the domestic level. At the domestic level, usually the failure of a domestic bank or financial intermediary triggers transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby undermining confidence in similar banks.

An example of this phenomenon is the failure of Lehman Brothers and the subsequent turmoil in the United States financial markets. International financial contagion, which happens in both advanced economies and developing economies, is the transmission of financial crisis across financial markets for direct or indirect economies. However, under today’s financial system, with large volume of cash flow, such as hedge fund and cross-regional operation of large banks, financial contagion usually happens simultaneously both among domestic institutions and across countries. The cause of financial contagion usually is beyond the explanation of real economy, such as the bilateral trade volume.

There are other descriptions of contagion which have pre-dated that of a financial ‘virus’. They include: a disease that is or may be transmitted by direct or indirect contact; a contagious disease. The direct cause, such as a bacterium or virus, of a communicable disease. Psychology; spread of a behaviour pattern, attitude, or emotion from person to person or group to group through suggestion, propaganda, rumour, or imitation. A harmful, corrupting influence; fears that violence on television was a contagion affecting young viewers. The tendency to spread, as of a doctrine, influence, or emotional state.

The psychology of contagion is fascinating and far more relevant than the disease descriptions were the current malaise is concerned. There is undoubtedly an opportunistic political movement in play, emanating from the USA and the UK, its purpose is to point blame in the direction of Europe and specifically Greece for the current crises and predicament. As contagion theory once again sweeps through the eurozone, where Greece’s debt crisis is apparently infecting neighbouring countries and threatening to make its way across the Atlantic to U.S. shores, perhaps it’s time to unravel the theory and put some perspective on the origins.

We’re reminded on a daily basis of the contagion danger, but as most medical students would testify virulent diseases tend to ‘take out’ the weak, or those already plagued first. Healthy economies aren’t susceptible to Greece’s ‘disease’, the sick ones, already plagued with high debt levels and bloated state budgets, don’t need a carrier to become infected, they’re already incubating the disease. Capital flight from these countries is not evidence of contagion, capital isn’t fleeing sovereign debt markets in, for example, Spain, France, Portugal, Ireland and Italy because Greece can’t pay its bills. Bond yields are rising because of an increased risk those countries may find themselves in the same boat as Greece: unable to meet their onerous debt obligations. In short they’ve caused their own problems.

The complexities of the interconnected financial world was best illustrated by the subprime mortgage defaults which infected banks in Europe and Asia, thanks to the miracle invention of securitization no banks were safe. European banks that hold Greek debt are vulnerable to losses and they’re vulnerable to all the PIIGS debts and France’s debts too. The French banks are incredibly exposed to a combined contagion even if contained to certain European countries. Contained to Europe alone the default of: Greece, Italy, Portugal, Spain, Ireland and indeed France would be eye watering, a minimum cost of circa €2 trillion has been ‘kite flown’ as a measure of the black hole which may need to be filled and there’s the real fear, not Greece’s debts singularly, but the domino viral affect. Greece, as a proportion of that void, would be less than 10%.

The U.S. is already infected with the debt virus. It’s still in its incubation period, it helped create the disease in a financial lab during the last decade. Similar to the film this 2011 real life version of the 2008-2009 original drama may be more dramatic and the hope for humanity may echo the optimism the film ends with. However, there are many amongst us that will still retain the opinion that had the problem been handled correctly in 2009 we wouldn’t need to be subjected to this latest block-buster dramatic Hollywood re-make.

Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/contagion-dont-talk-to-anyone-dont-touch-anything/

Searching for +1, Perfect Correlation in Forex Trading

Searching for +1, Perfect Correlation in Forex Trading

“Wow, has anyone else noticed that when the EUR/USD goes up the USD/CHF goes down?” is a ‘Eureka’ announcement often made by new traders when they first stumble upon basic correlation. In some respects it’s a good sign, it displays awareness.

However, as many forex traders will testify if it’s that easy we’d simply wait for one currency to spike and immediately take that perfect -1 negative correlation trade. It’d work for a while, then some funky algorithm at Blackrock would no doubt ‘front run’ the play taking out all our fun whilst hoovering up all the pips.

Surprisingly correlation is one of the least discussed topics on forums dedicated to forex trading and yet a thorough understanding of its mechanics and relevance should form part of any forex traders toolbox.

Correlation is a measure of the relation between two or more variables. The measurement scales used should be at least interval scales, but other correlation coefficients are available to handle other types of data. Correlation coefficients can range from -1.00 to +1.00. The value of -1.00 represents a perfect negative correlation while a value of +1.00 represents a perfect positive correlation. A value of 0.00 represents a lack of correlation.

Because currencies are priced in pairs, no single pair trades completely independent of the others. Once you are aware of these correlations and how they change, you can use them control your trading portfolio’s exposure.

The interdependence of currency pairs is straightforward to understand, here’s an example; if you trade Sterling versus yen (GBP/JPY) you are actually trading a derivative of the GBP/USD and USD/JPY pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of these other currency pairs. The interdependence of currencies stems from more than the fact they are traded in pairs. Some currency pairs move in tandem, other currency pairs move in opposite directions, which is often the result of more complex forces.

Correlations change, which makes shadowing the changes in correlations important. Sentiment and global economic factors are increasingly dynamic and often change on a daily basis. Strong correlations today might not be in line with the longer-term correlation between two currency pairs. It’s therefore essential to consider the six-month trailing correlation. This provides a more focused perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate. Correlations change for a variety of reasons; diverging monetary policies, a currency pair’s sensitivity to commodity prices, unique economic and political factors. Viewing correlation tables from minutes to weeks is also advisable for a comprehensive viewpoint and understanding.

How can we use correlations to manage our trading exposure, how can we use them to our advantage?

The most obvious answer is correlations can help us to avoid entering two positions that in effect cancel each other out. Knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time (the -1 correlation) having trading positions of long EUR/USD and long USD/CHF is in some respects the same as having no position. A correlation table will illustrate that when the EUR/USD rallies, the USD/CHF will experience a sell-off.

Conversely, being long EUR/USD and long AUD/USD or NZD/USD is similar to doubling up on the same position given that the correlations are so strong. However, there may be valid reasons to hold trades of similarly correlated pairs, diversification being one.

The EUR/USD and AUD/USD correlation is not 100% positive, therefore traders can use these two pairs to diversify their risk while still maintaining a directional view. Here’s a simple example to follow; if bearish on the USD, instead of buying two lots of the EUR/USD, the trader could buy one lot of the EUR/USD and one lot of the AUD/USD. This ‘imperfect’ correlation relationship between the two different currency pairs allows for more diversification and a marginally lower risk. It must also be noted that the central banks of Australia (RBA) and Europe (ECB) have very different monetary policies, therefore in the event of a dollar rally, the Australian dollar may be more or less affected than the Euro, or vice versa.

Let’s take our correlation discussion a bit deeper by using hedging.

A trader could use different pip values to their advantage. For this example we’ll once again use the EUR/USD and USD/CHF. Our correlation tables suggest that they have a near perfect negative correlation, but the value of a pip move in the EUR/USD is $10 for a lot of 100,000 units while the value of a pip move in USD/CHF is $11.02 for the same number of units. Therefore, in theory, traders could use USD/CHF in order to hedge any EUR/USD exposure.

If our trader had one short EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units when the EUR/USD increases by ten pips the trader would be down $100 on the position. But since the USD/CHF moves diametrically opposite to the EUR/USD, the short USD/CHF position should be profitable, in all likelihood moving close to ten pips higher, up $110.2. This could in turn adjust a net profit of the positions into $10.2 instead of -$100. This ‘hedge’ also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst case scenario, losses become much lower.

Source: FX Central Clearing Ltd. (FXCC BLOG)
http://blog.fxcc.com/searching-for-1-perfect-correlation-in-forex-trading/