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Forex Contagion and the Lessons of Feb. 27
March 8, 2007

Abe Cofnas has spent over a decade as an equity broker, futures trader, and technical analysis instructor. Abe was one of the first professional trainers in the world to provide web-based interactive training exclusively on Forex trading. Since 2001, Abe's Forex Trader column in Futures Magazine has been a mainstay of the publication, providing innovative observations and educational tips on Forex trading to a world readership of over 65,000 traders.  You'll enjoy learning Forex from this master!

The market moves of Feb 27th, when the Dow suffered its worst day in 4 years, was a classic case demonstrating the reality of inter-market phenomena and the illusion of a disconnect between fundamentals and technicals in market moves. Those who claim that fundamentals don' t count need to reassess their claims. No one really knows what sets off a sell-off (until after it is over), and we can't predict the next one with certainty. But during the sell off of Feb 27th we saw some of the inner realities of market structures reveal themselves in a triangulation of factors.

First, the significance of the Forex market as a force in world capital flows and market moves became apparent when the Dollar Yen pattern started sliding. Its vibrations caused a remarkable synchronicity, as if both markets were dancing to the same beat. The Yen, in effect became the leading indicator for the equity markets.

February 27th also reminded equity investors that markets are not linear and they can suddenly enter into chaotic patterns. Forex traders, particularly carry traders, had a rude awakening. Carry traders have had profitable conditions for over 3 years by betting on selling yen and buying currencies with higher interest rates such as (NZD, and GBP). Having committed to a winning strategy it is hard to separate oneself from it, even in the face of evidence. But on Feb 27th many were reminded that there is no free lunch. Many of those who held carry trade portfolios (GBPJPY, NZDJPY) saw more than 20% draw downs in 1 day. Importantly, there were reports that the Yen strengthening caused the need for equity investors to liquidate positions to meet margin calls on carry trades that were suffering large drawdowns as the Yen surged. The carry trade involves global assets of over $100 billion and a lot of this money is borrowed. The sell off was a threat to liquidity. That is also why Gold did not go up, but sold off as well. Just the opposite of conventional wisdom, where Gold is hyped as a refuge in crises. A third factor that was precipitous was that Chinese equity markets sold off 9% partly in reaction to concerns over a US slowdown. This generated follow-on concerns of a Chinese slowdown. China will have great difficulties sustaining the GDP growth levels of recent years. The Chinese GDP is now being projected to be at 8.0% for 2007. Rather than fearing a Chinese slowdown, it would be better to look at its impacts. Traders should start seeing the Aussie become weaker as global demand slows for commodities. The catalyst triggering a convergence of these factors may have been the remarks of Alan Greenspan about the potential of a US recession. On March 5th yet another Yen surge triggered another example of emotional contagion as equity markets in Asia and Europe sold off and in the US equity markets triggered more weakness.

What we have in these events is a glimpse into the future of global markets and some important lessons. Global markets are interconnected more than ever and they are therefore subject to waves of emotional contagion. A statement by a foreign minister or central banker can create the equivalent of a chemical reaction-diffusion in the market. Events in one market will cascade into other markets as liquidity in a global phenomenon are not isolated. All markets become threatened. Traders in the equity markets focusing only on intraday charts are like swimmers at the beach ignoring the large waves that are forming because they are not seeing them. A lesson for equity traders is to that we have truly become a 24/7 trading world. Forex markets act as the jet stream of the world money flow and any shift Impacts all other markets. Equity traders and investors should have forex accounts that could in future equity sell-offs be used to create an effective hedge by trading in their forex account.

A final lesson regarding Feb 27th is that chaos creates opportunity. One didn' t need sophisticated indicators to see the compelling opportunity to sell USDJPY during the afternoon of Feb 27th. The warning signs were there by applying the classical tools of Support/Resistance and trend lines.

Even when the Yen surged, the trend lines came alive acting as invitations to the join the party. No other indicators were necessary for trading in this environment.

No one knows what the next tipping point will be, but we can learn from Feb 27th and its aftermath that understanding Forex is a necessity in our current era of the global capital markets. Yet knowledge has to be actionable. Watching the USDJPY fall, on the sidelines, without the ability to trade it, by not having a Forex account, can be a painful experience.