Shelter From The Storm
Hello from London! It's been a wild week in the Forex market to say the least – the strong have become weak, and the weak have become strong. Let's go right to the charts to check out the action. Look at the pullback on the weekly chart of the Euro – Japanese Yen (EUR/JPY) currency pair. We might find some support here, as we have tested the lows from early March (see figure 1).
Figure 1: EUR/JPY pulls back to the March lows. Source: Saxo Bank
The weekly chart of another carry trade pair, Great Britain Pound – Japanese Yen (GBP/JPY), has a similar look to it after testing the March lows (see figure 2).
Figure 2: GBP/JPY tests the March lows. Source: Saxo Bank
The Australian Dollar, another big winner this year, has fallen on hard times recently, as evidenced by the monthly chart. Note how the pair is finding support at a former resistance level that held all through 2004 and 2005 (see figure 3).
Figure 3: AUD/USD plunges to an old resistance (now support) level. Source: Saxo Bank
As we can see, the disruption in the credit markets is intertwined with the gyrations of the stock market and the Forex market. Rarely are all the markets this strongly correlated; this tells us that fear is rampant in every asset class right now.
Fed Funds Rate Vs. Discount Rate
I made my first appearance on CNBC Europe early on Friday morning, on Squawk Box. There I was, telling the world for all to hear that the Fed shouldn't cut interest rates from 5.25% until the next FOMC meeting. I shouted from the mountaintops that a Fed rate cut would signal a panic, that it would confirm that the subprime contagion and resultant credit crunch were even worse than previously believed. I cast my lot with the 'tough love' crowd, saying that it would be wrong for the Fed to bail out the companies that caused this mess, and that certain companies should be "taken to the woodshed"
Just a few hours later, someone approached me and said, "Hey, didn't I see you on CNBC this morning? You said the Fed wouldn't cut rates. Well, they just did! They just cut by 50 basis points!" I checked U.S. stock futures, and they were rocking. How embarrassing! How could I have been so wrong, so quickly? Not to mention, so publicly!
However, this was not the case. It turned out that the central bank had not cut the Fed funds rate at all; instead, they cut the discount rate. What is the difference between the fed funds rate and the discount rate? The fed funds rate determines the rates that banks charge each other, while the discount rate only covers loans that the Fed makes to banks. The U.S. central bank, which had resisted lowering rates despite weeks of market volatility and chose to add nearly $120 billion in liquidity into the banking system instead, cut its discount rate to 5.75 percent from 6.25 percent. The Fed made no mention of lowering its target for the federal funds rate, which has stood at 5.25 percent for over a year.
Whew! I hadn't been spectacularly wrong on international TV in front of countless viewers after all. Friday's move seems to be a precursor to a lower Fed funds rate; it's just a question of when the rate cuts will come. According to the Fed funds futures, which trade on the Chicago Board of Trade (CBOT), the Fed funds rate should reach 4.75 percent in October or November, instead of early next year as most analysts believed previously. We might even see 4.75 percent in September, if the Fed decides to provide a "double shot" of relief at the next Fed meeting, which is scheduled for September 18. You can bet that date has been circled on more than a few calendars! The FOMC's statement that it "is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets" signals that a cut before the September 18 meeting is not completely out of the question.
What Does It Mean?
The Federal Reserve Board said it was acting to "promote the restoration of orderly conditions in financial markets." Previous injections of liquidity from the central bank were not enough to prevent seizures in the credit markets. Rumors abound that a major fund or bank could be in big trouble, and may be on the verge of insolvency. When the Fed lowers the discount rate, they are offering shelter from the fiscal storm to institutions that may not be able to borrow the funds they need from other institutions. This is why the U.S. central bank is sometimes called the 'lender of last resort'.
The lowering of the discount rate could mean that the rumors are true, and a major player may be in big trouble. Banks rarely borrow from the discount window because there is a stigma attached to using it. No bank wants to acknowledge that it's not solvent enough or credit-worthy enough to obtain the funds it needs on the open market.
Volatility Gone Wild
When a hurricane approaches the Florida coastline, many people get into their cars and drive inland. But a smaller contingent grabs their surfboards and head straight for the beach. Be careful out there – this trading environment is extremely fast and dangerous. Some traders thrive in a high-volatility environment, while others can't stand it. If you're not sure where you fit in, remember – normal market volatility will return eventually, so if you prefer not to trade live, you can always observe market moves on a simulator and protect your account. In a market like this, the exchange rate can move so fiercely that some traders freeze up like a deer in headlights. How to deal with the current market environment? Protect your account with stop orders if you are not doing so already, and take smaller than normal sized positions.
Question of the Week
Q) Ed, haven't we been hearing about this subprime mortgage problem and related issues for some time now? So why then is the market reacting so violently to something that was already known? Shouldn't this already be priced in to the market?
Ed Ponsi) Thank you for your question. You're correct, and if it seems that we've been discussing this for months, we have. Even though it was clear that there was a problem some time ago, the extent was unknown – and it still is unknown. Think about it this way – suppose the weather report calls for rain tomorrow, and instead we are hit by a monsoon. On the one hand, you could say it was expected to rain, so what we got was what we expected. On the other, we didn't expect a flood. Remember, Fed Chairman Ben Bernanke claimed repeatedly - and testified before Congress on March 28 - that this problem was contained and would not spread to the broader market. U.S. Treasury Secretary Henry Paulson and other top officials voiced similar comments. Those words ring pretty hollow now.
Thank You London! On To Toronto!
I'd like to offer my sincere thanks to the London branch of Online Trading Academy. Georgie Cox and company made my first book signing into a major event, and it was a roaring success. I autographed dozens of copies of my new book, "Forex Patterns and Probabilities" (which you can also purchase through Amazon.com or Trader's Library) and we all had an enjoyable afternoon. The next book signing will occur at the Toronto branch of Online Trading Academy on Friday, September 7, so I hope to see you there!
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. He is a regular contributor to TradingMarkets.com, SFO Magazine and FX Street, and has recently finished his new book "Forex Patterns and Probabilities" (which you can purchase through 