Europe may be in calmer waters after the currency bloc’s leaders hashed out a EUR 1 trillion plan to save the currency bloc and pull Greece out of the way of default, but the last few weeks have taught us valuable lessons that we would be wise not to forget. Trading is always risky and there are always events that can happen that you can never plan for.
Trading currencies is even riskier. Since a currency ‘s value depends on a huge multitude of factors including politics, economics and even social issues, you can prepare as best you can, but the chances are at one time or another you will get caught out.
For example, a developed western nation had not defaulted for nearly 70 years, yet here we are talking about how close Greece was to going bankrupt, defaulting on its debts and dragging the entire Eurozone down with it. If you told this story to an alien with no knowledge of Europe or the debt crisis then they would probably be flabbergasted that the 32nd largest economy in the world threatened to bring down the second biggest currency.
Usually if there is a geopolitical event or social issues – like the recent riots in London or a bomb– then investors know how to react. At the mere site of smoke billowing from a building or people fighting with police the immediate instinct is to preserve your capital and pile into the most liquid assets available. Safe havens tend to soar – for example gold, the dollar, the yen and the Swiss franc – while riskier assets that rely on growth and stable conditions to flourish like stocks and some currencies including the Aussie and the Canadian dollar tend to come under pressure.
However, political risk is a different kettle of fish, especially when confronted with something that has never been dealt with before like Europe’s sovereign debt crisis. This requires patience, discipline and most importantly attention to detail. Below are a few lessons that we should all heed from the Eurozone crisis. The latest deal is definitely a step in the right direction for the currency bloc but it might not be the end of the saga as problems remain unresolved. So these lessons may need to be put into practice sooner than you think.
Lesson 1: Don’t trust a safe haven
The last few months have taught us one thing: there is no such thing as a safe haven. The traditional safe havens like the Swiss franc, the yen and gold have either under-performed and failed to hold their value during the peak of this crisis (like gold) or have been impacted by central bank intervention (the Swissie and the yen).
The Swiss National Bank (SNB) intervened back in August when the euro/ Swiss franc cross got dangerously close to parity. Firstly it lowered interest rates to below zero, it engaged in swissie swaps and eventually it imposed a floor at 1.20. For those who thought the SNB wasn’t serious, it was a tough period. The lesson there was not to fight the SNB because when it wants to weaken its currency it does so aggressively.
The Japanese authorities have made similar noises, however, so far they have avoided following the SNB and the yen has strengthened to record highs versus the US dollar below 76.00. But, at these extended levels investors need to be careful. In the past the Bank of Japan has surprised the market by intervening when you least expect it, so just because it hasn’t acted now doesn’t mean it won’t going forward.
Gold’s position as a safe haven has come under scrutiny during the Eurozone crisis. It was the world’s traditional store of value and when a major currency looks like it is on the brink of collapse one would expect gold to appreciate. However, that was not the case. After appreciating nearly 30 per cent over the preceding 12 months, gold became a victim of its own success in September as investors chose to book profits where they could. Investors ditched gold in favour of the dollar and US Treasuries. Who would have thought US debt would be in such demand after the US had its own default crisis in July and then lost its triple A credit rating days later? The lesson to remember here is that markets work in mysterious ways.
Lesson 2: Attention to detail
This is perhaps the most important lesson of all. Most people only had a brief understanding of how the Eurozone works but it was vital to fill in those knowledge gaps. The Eurozone is a currency union only and each country has its own sovereignty, so even though Germany and co. had the money to sort out Greece it kept stalling, which eventually caused the crisis to spiral out of control. The original EU Treaty was specific that one nation would not pay for another, so hence the reluctance to throw money at the problem and sort it out. Only when the costs of not doing so started to soar did Europe’s high command step up to the plate.
In the interim period risk would rally and then sell off as round after round of discussions led to disappointment. Even in the build up to October’s uber-summit investors were not clear whether Europe would deliver, and financial markets were reacting to every breath that came out of policy makers’ mouths to see if Europe would ditch their own rule book and save Greece to save the Eurozone.
Lesson 3: Range trading
Amidst all of the uncertainty of recent months most of the major stock markets and currency crosses have been stuck in a range. EURUSD for example dipped all the way to 1.31 when markets sold off sharply in early October. However, short euro positions were extremely stretched leading to a short-covering rally that petered out around 1.3900. For the weeks leading up to the summit the most traded currency pair in the world was stuck in a frustrating range between 1.3800 and 1.3950/60. It was only once the EU authorities announced their plan that markets rallied strongly and punched above the crucial 1.4100 area opening the way to 1.4500.
Those were volatile times as markets went up and down 150 pips or more based on headlines. Trying to navigate through the multiple and often contradictory comments from Europe’s leaders was not for the faint hearted and required some skill to come through unscathed. Booking profits and trailing your stop/losses on winning positions were the orders of the day.
In the aftermath of the deal we need to wait and see if the positive tone to risk is nothing more than a prolonged relief rally. Either the markets will be satisfied that the EU high command has the problem in hand, or the missing pieces of the plan will eventually cause investors to lose faith and ditch risky assets. One thing is for sure, politics is likely to influence the markets for some time yet.
Kathleen Brooks can be contacted at Forex.com