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The ‘dash for trash’ is on, as the near-record low yields available on safe assets has prompted investment professionals to move further out the risk spectrum in a desperate bid to earn nominal returns that satisfy client needs.  Cautious optimism persists among buy-side commentators, but actions speak louder than words, and market movements suggests investors are behaving quite differently than their rhetoric, as robust demand continues to outstrip supply and push the yields on lesser-quality bonds ever lower.  The resulting valuations confirm that a substantial part of the market for fixed income securities has entered the speculative phase of the credit market cycle.

It was all so different not so long ago, as the bullish complacency apparent at the height of the credit bubble, turned to all-embracing fear following the collapse of Lehman Bros.  The first tremors of what would soon become the worst financial crisis in seventy years erased the irrational exuberance evident in the prices of risky debt, but the failure of a major investment house proved lethal; the credit markets ceased to function, as forced selling – and the resulting illiquidity – pushed yields to unfathomable levels.

Extreme risk aversion prompted investors to flee the market for corporate credit en masse, which saw investment-grade bonds suffer double-digit losses in a matter of weeks.  The carnage in high-risk segments was far more punishing, as the spike in the yields of junk bonds to more than twenty per cent resulted in losses of some 45 per cent for their unfortunate holders.

All told, the default rates implied by the yields available on even the highest-quality credits moved to levels that were without modern precedent, and savvy investors could bank on equity-like returns with bond-like risk.  Of course, outsized rewards could be expected if, and only if, the Bernanke-led Fed’s unconventional monetary policies could unfreeze the markets, and return risk appetite to more normal levels.

Near-zero interest rates, in tandem with credit-easing policies proved successful, and the spread on lesser-quality credits versus default-free Treasuries dropped from a peak of more than six per cent at the end of 2008 to below three per cent just eight months later, as investors priced out an economic and financial apocalypse.  Fed policy ensured a quick return to ‘business-as-usual’ on Wall Street.

Corporate bond pricing may not seem excessive to many on first glance.  After all, the credit spreads on lesser-quality corporate bonds have made little progress in the past three years, hovering around three per cent for most of that time, while current spreads are more than one percentage point above the lows registered at the height of the credit bubble.  This observation has seen many buy-side commentators argue that the bull market has further to run.

However, vigorous demand for safe assets, in concert with aggressive central bank purchases, has pushed the yield on ten-year Treasury debt deep into negative territory, when adjusted for long-term inflation expectations implied by the yields available on Treasury inflation-protected securities (TIPS).  As a result, current spreads for lesser-quality corporate credit imply a real yield of just two per cent – a level of return that rewards investors for delaying consumption, but provides little to no compensation for default risk.

It is quite clear that risky corporate debt is dangerously overpriced, but identifying a trigger that changes the status quo is always difficult.  Nevertheless, the trigger could well be a peak in corporate profitability, which may not prove sufficient to derail the equity market, so long as aggregate earnings do not come in too far below expectations, but a wide dispersion of profit outcomes across the individual constituents that comprise stock market indices, could punish corporate bond investors.

To appreciate why, it is important to grasp the financial theory that explains the pricing of corporate credit.  The Nobel laureate, Robert Merton, increased our understanding of corporate debt pricing, when he applied contingent-claims analysis way back in 1974.  He argued that owning a corporate debt claim is analogous to owing a risk-free debt claim of the same maturity, and issuing an option to default to the company’s shareholders – an option to put the firm at the value of the risk-free claim.

The value of the put option is determined by total firm volatility – both firm-specific and market-related – unlike equity prices, which only incorporate the latter.  Thus, if firm-specific or idiosyncratic risk increases on the back of a wide dispersion of earnings outcomes among equity index constituents, the value of the put option will increase and benefit shareholders at the expense of bondholders.  In other words, if stock market volatility and firm value remain unchanged, wealth will simply be transferred from the holders of debt claims to the company’s shareholders.

The theory helps explain why the market for corporate debt typically leads the equity market at important turning points.  Indeed, credit spreads bottomed in the spring of 2007, or more than half a year before aggregate stock prices reached their apex.  A similar dynamic could well be in the offing today.

The Federal Reserve’s unconventional monetary policies may well underpin the excesses apparent in the pricing of lesser-quality corporate credit for now, but liquidity is a dubious concept at best, and can disappear in a heartbeat.  Stormy weather may not be far away.



Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Japanese asset prices have jumped onto investors’ radar screens of late; the return of the Liberal Democratic Party (LDP) to power late last year has sparked hopes that the new leadership might match their pre-election rhetoric with actions that help to bring years of economic stagnation to an end.

The Diet was dissolved last November, and the LDP, under Shinzo Abe, secured a landslide election victory four weeks later, as voters expressed their disillusionment with the Democratic Party of Japan and backed the LDP’s promises to wage a determined battle against deflation through aggressive monetary easing, alongside flexible fiscal management.

Mr Abe harangued the Bank of Japan (BOJ) during the election campaign, arguing that the monetary authority has been far too timid in its efforts to combat long-term deflation.  Further, he threatened to amend the 1998 Bank of Japan Act if the central bank does not soon accede to a two per cent inflation target, and after he assumed the post of Prime Minister, he taunted the monetary policymaker with the words, “There is no future for a country that abandons hope for growth.”

The need for bold action on both fiscal and monetary fronts is not difficult to understand in the context of an economy that has been in relative decline for more than two decades, and recently slipped into its fourth recession since 2000.  Real GDP growth averaged more than four per cent a year from 1974 to 1990, but has averaged barely half a per cent a year ever since, as the economy continues to languish in the aftermath of the bursting of a joint asset and credit bubble more than twenty years ago.

The damage inflicted upon private-sector balance sheets by the implosion of the bubble led to a pronounced and protracted deleveraging that saw private-sector savings surge relative to investment.  The resulting deflationary impulse has seen the GDP deflator drop almost 18 per cent from its 1994 peak, while nominal GDP is almost ten per cent below the peak registered during the fourth quarter of 1997.

The BOJ cut policy rates to near-zero by 1995, and shifted to a zero-interest-rate-policy (ZIRP) in the spring of 1999, which was followed by the adoption of a quantitative easing policy that persisted from 2001 to 2006.  However, the unconventional policy failed to prevent deflation from taking hold and the resulting strong demand for precautionary money balances ensured that the private-sector’s financial surplus persisted at high levels.

High private-sector savings relative to investment contributed to large fiscal deficits that have seen the public-sector debt ratio jump to close to 240 per cent of GDP, a level that is in a class of its own – even compared to the euro-zone’s troubled periphery.  Fortunately, the preference for low-risk assets in a deflationary environment ensured that the growing government debt could be financed by private-sector savings at a low interest cost.

Looking forward however, projections of future fiscal deficits and household savings rates as the population ages, suggests that it is only a matter of time before the Japanese is forced to tap foreign capital markets, which are far less likely to provide funding at today’s historically low rates.

An upturn in borrowing costs would have a large adverse impact on the financial sector’s health.  Indeed, the central bank estimates that a one percentage point increase in yields would wipe out roughly two years of banking sector profits.  Thus, the need to revitalise the Japanese economy is a matter of some urgency.

There is no doubt that the world’s third-largest economy is beset by many structural issues that need to be addressed if nominal economic growth is to be lifted to a level that will put the fiscal position on a more sustainable path.  Constructive government policies are required to raise real growth, but ending deflation is the purview of the central bank, and the time for credible action is now.

Sceptics will argue that increasing the inflation target to two per cent will have little durable impact, since the BOJ has already failed to meet its current target of one per cent.  However, the central bank has all too often been the architect of its own failings, and has snatched defeat from the jaws of victory on more than one occasion.

Indeed, Ben Bernanke, then a professor at Princeton, remarked as far back as 1999 that “Japanese monetary policy seems paralysed, with a paralysis that is largely self-induced.”  He noted “the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work.”

Little has changed in the intervening years, as the BOJ consistently argues that deflation is not the result of timid monetary policy, but stems from structural issues that have lowered the economy’s potential growth rate.  The central bank’s rhetoric has signalled to economic agents that it cannot defeat deflation alone, which has almost certainly reduced the potency of its unconventional policies.

Central bank credibility may well be restored under a change of leadership orchestrated by Mr Abe, but deflationary expectations are deeply engrained and the battle will not be easily won.  Nevertheless, monetary developments in Japan merit close attention in 2013.



Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Since the Currensee marketing department is approximately 75% Crazy Cat Lady, you know we were excited by the Guardian headline, “Ginger moggy beats the professionals and a team of students in the Observer's share portfolio challenge” (Note to confused Americans: moggy means cat in British)

Here’s what happened: two investment professionals took on a roomful of schoolkids and an orange cat in a stock-picking contest set up by the Observer.  Each team invested 5,000 (fake) GBP for a year, and was allowed to reallocate quarterly.  The final ROI : Cat, 10.8%; professionals, 3.5%, and students, -3.2%.

Aha, you cry! It’s the triumph of the Random Walk!  After all, what’s more random than the behavior of a cat? Economist Burton Malkiel's book A Random Walk Down Wall Street is a popular one, and it pretty much says that share price moves, if not actually random, are sufficiently complex as to be practically random.

Hold on, put down the catnip, even if the market behaves randomly, does that mean that random picking is the best market strategy?

If you had bought and held the entire FTSE all-shares index (the universe from which the teams picked their stocks) for 2012, you’d have earned 8.2%.  That reduces the cat’s edge to just 2.6%, still nothing to sneeze at, and makes the professionals and kids look pretty bad.  Maybe “buy the market” is the way to go.

Let’s look at the rules of the Observer’s game.  Players were restricted to stocks in one index – not ideal diversification - and could buy or sell just once per quarter. It doesn’t say for sure, but I don’t think they could do any short selling or avail themselves of future or options on the stock in that one index.  Would you pay a money manager to apply those rules to your hard-earned nest egg?

Clearly the game has been simplified for the school children and perhaps the cat, too.  It’s a fun illustration of randomness, but it was like a poker tournament stopped after the first four cards were dealt.  Trading and money management are long-term full-time jobs, and real professionals need access to all the tools and markets they can get to create diversified portfolios for their clients.

Or, you could always just throw your favorite toy mouse at a grid of numbers and hope for the best.






Retail spot forex trading is financially zero sum for the market as a whole. That means any profits made by one individual must come at the expense of someone else (or multiple someones). Actually, when you factor in the costs of bid-ask spreads, commissions where charged, and the bid-ask spread in carry interest rates (yes, they have a bid-ask spread there too!) for positions held overnight, retail forex trading is actually negative sum for the market as a whole. This is something to keep in mind as you think about your participation in it. (Feel free to use the comment section below to voice your arguments against the above statements. I will happily refute them. J )

Why should you care?

Because it means retail forex is a game driven by skill. While just about anyone can make money in the stock market by holding a mutual fund or index ETF in a bull market (or even in an overall flat market when factoring in dividends), nothing can be further from the truth in forex. It’s a lot like poker where in the long-run the money will tend flow from the weak players to the strong ones. As a result, you want to be among the strong players to have any reasonable expectation of long-term success in the market.

Of course one of the things many folks have relied upon to keep the trading profits flowing is the constant influx of new traders into retail forex trading. They are weak players for the most part, and their losses feed the stronger ones. Of late, however, the growth in forex trading (retail and overall) has stalled out. We’ve even started to see contraction in places. That means those weak newbies aren’t flowing into the market the way they were, and they may even be leaving on net. That will tend to make the market more competitive if it continues, requiring a higher level of skill.

On top of that, social trading has gained a lot of traction recently. That effectively increases the portion of the market controlled by the better skilled traders as more accounts mirror their trades (assuming, of course, those traders being mirrored are in fact skilled).

Combine a market where the weak players may be leaving on net with an increasing proportion of the market under control of skilled players and you have the makings of rising competition among traders. This is something would could actually create a feedback loop whereby traders who don’t feel they can compete personally will allocate funds to programs like Trade Leaders. Furthermore, it will make increasingly clear those who really are highly skilled and those who are only pretenders.

Something to think about as you ponder you own involvement in the markets.

Hedging risk is an integral factor in any intelligent investment strategy. Since no one knows for sure exactly where the markets will move, who’s to say components of your equity portfolio won’t crash and burn when faced with market volatility?

In the game of beating the stock market, many will play and very few will win.

Speculating on potential gains you could achieve on certain investments really isn’t practical. What is practical, though, is assuming an opposite position in single stock futures against your current cash market security position to hedge risk you might encounter. This can be achieved in various ways, one of which is the writing or purchasing of options on single stock futures contracts.

If you’re bullish about single stocks, consider using a synthetic long call strategy. Here, the investor simultaneously assumes a long position and put option on a single stock futures position. Together, the two create a something comparable to a long call. The very attractive benefit of this move being that your maximum loss is limited to just commission plus the premium paid on the option, while your maximum gain is virtually unlimited.

Say you are very confident that the share prices of company X will rise. Instead of buying stock outright at $49 per share, which runs you the risk of loss should the market move against you, you purchase one single stock futures contract on company X. you then take it one step further by buying put options on your futures position. For the premium paid, a long put gives you the right to sell the underlying instrument (future) at the puts strike price, should you choose to exercise it.

Three months later, you learn that you were correct; company X’s share prices have gone up and are now trading at $54 per share. You can now sell your single stock futures contract, which has increased in value along with the underlying security, for a profit. The put you purchased will simply expire unexercised at no harm to your position.

But what if you were wrong? What if the whoopie pies that company X produces have recently been discovered contaminated by salmonella and the result of the news on stock prices is devastating? Well, here is where the put would come into play.

Since the value of the futures contract is correlated with the underlying security, it has also plummeted in price and is now virtually worthless. However, by exercising your put option, you may sell your worthless futures contract at the strike price previously establish when the stock was trading healthfully. Even though company X’s stock price crashed and burned, taking your single stock futures position with it, you can sell it for a loss of only the premium you paid for it along with commissions.

Below is a chart showing a protective long put for visualization of potential outcomes. The red line is the put, and the blue is the spot market, but we will assume it’s the futures position for purposes of the example described above (since spot and futures move together). As you can see, should the stock position continue on an upward trend, you will profit with your long futures position. However, should it take a bearish turn and drop past your purchased put strike price (red) you will have the right to exercise and sell your futures at the strike, which will be more than it is worth.

So why don’t more people establish synthetic long call positions? Is it too much effort? Or do they just not know they exist?

One possibility could tepid congestion. Suppose the cash market stock drops a just few points; enough to sink below your futures purchase price, but not to the point of permeating your puts strike. Then, should congestion ensue until both derivatives reach expiration, you’re stuck with a loss. Granted it would still be limited to 1) the scope of the futures minus the strike of the put and 2) the put premium plus commission, but still, a loss nonetheless.

If you’re bullish, a synthetic long call could possibly serve as a well-protected strategy. Rather than buying the stock outright and risking a hefty loss should the market move against you, for the price of a few fees, you could purchase a put, combine it with a long futures, and limit your losses. Knowledge is power – a well-educated investor has a far better chance of success than an overzealous better.




Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The dawn of a new millennium marked the end of the secular bull market in stocks that began almost two decades earlier in the autumn of 1982.  The magnitude of the subsequent decline in equity prices forced investors – albeit reluctantly – to accept that returns had been more than excessive during the heady days of the dot.com boom.

The verdict that stemmed from investors’ soul-searching soon became clear – the high valuations afforded to stocks meant that they could no longer be depended upon to deliver stellar returns year after year, while the notable increase in correlations among existing classes of risk assets amid the turbulence, confirmed that the diversification benefits of traditional asset allocation models had been eroded.  Not surprisingly, the hunt for non-traditional assets began in earnest.

The search for alternatives coincided with an end to the two-decade long downturn in commodity indices, as supply/demand dynamics converged to push prices higher.  Years of under-investment in the infrastructure of several raw materials combined with the emergence of China as a major source of demand, which led many savvy analysts to conclude that commodities had entered the expansionary phase of a super cycle that could be expected to last for several years, and perhaps, even decades.

The super cycle hypothesis took some time to capture investors’ attention, as two decades of ‘false dawns’ saw investable cash deployed elsewhere, but the game changed following a number of high-profile reports from respected analysts in 2005, including Alan Heap at Citi, not to mention the best-selling book, “Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market,” which was penned by Jim Rogers, co-founder of the Quantum Fund with George Soros in the early-1970s.

Academic papers soon followed, and demonstrated that changes in commodity prices and stock market fluctuations demonstrated a strong negative correlation through time.  Inviting returns alongside the potential for significant diversification benefits proved hard to resist, and the sheer size of the funds that poured into the non-traditional asset class helped underpin the most pervasive commodities boom in modern history.  Indeed, the cyclical upturns of the early-1950s and early-1970s fall well short of the most recent boom in both magnitude and duration.

The global financial crisis and the steep economic downturn that followed brought an end to the seemingly irrepressible rise in commodities, with indices of metal and mineral prices declining by more than thirty per cent from the peak in 2008 to the trough in 2009.  However, the setback proved to be temporary, as the world’s emerging economies soon returned to a high-growth trajectory, and the resource-intensive nature of their growth brought the expansionary phase of the commodity super cycle back to life.

The revived bull market has sputtered of late, and investors are questioning whether the commodities space is still an attractive home for investment funds.  To provide a satisfactory answer to this query, investors need to know whether super cycles actually exist, and, if so, can the supply/demand dynamics be depended upon to justify investment.

More than three decades ago, Walt Whitman Rostow identified a commodity super cycle that is roughly fifty years in length, with expansionary phases extending from 1790 to 1815, 1848 to 1873, and 1896 to 1920.  More recently, John T. Cuddington and Daniel Jerrett employed more sophisticated econometric techniques in two separate papers, and provided evidence that supports the existence of super cycles for both crude oil and metals.

It is clear that commodity super cycles – spanning anywhere from twenty years in length to seventy years – do exist, but that alone, is not sufficient to support the case for investment in basic materials.  Do supply/demand conditions point to a continuation of the expansionary phase, or is it running out of steam?

The demand-side enthusiasts cite the rapid industrialisation and urbanisation of China as reason to remain bullish.  The Middle Kingdom’s economy has doubled in size in just seven years, and the resource-intensive nature of its growth means that it has accounted for more than eighty per cent of the increase in global demand for nearly all energy and metals products over the same period.

However, per capita consumption of energy and most metals is already well above the figures apparent in economies with comparable levels of GDP per capita, while the high investment share of GDP – at more than forty per cent for a decade – calls for a rebalancing of the economy.  Consensus estimates look for economic growth of seven to eight per cent a year in the decade ahead, but simple arithmetic suggests that a successful rebalancing of the economy towards consumption would lead to a growth figure closer to five per cent.

The demand-side case is weakening, but the bulls believe that supply-side constraints will continue to support prices.  It is important to note that two decades of declining prices meant that producers did not commit to new investment projects until they could be sure that the price increases were permanent and not just one more false dawn.  Obviously, after ten years of rising prices, such caution is no longer evident.

The expansionary phase of the commodity super cycle is running out of steam, while investment flows have eroded the diversification benefits.  The motivation for commodity investment is questionable.



Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

It’s that time of year again.

No, I’m not talking about time to get your holiday shopping done (though that’s likely to apply to most readers). Rather, I’m talking about the time of year when the strongest seasonal patterns tend to take place in the markets. They are driven by a combination of things like year-end tax-related portfolio adjustments (think tax-loss selling in the stock market ) and accounting year-end corporate cash movements (think repatriation of foreign profits), among other things.

The result of all this is patterns like the so-called Santa Clause rally which can take place in the stock market, and the January effect in previously beaten down stocks (ones which were subject to tax-loss selling in December, though this effect has waned a bit). We also see some very interesting patterns in foreign exchange rates in December and January. These are well documented in the report Opportunities in Forex Calendar Trading Patterns, but the one which is likely to get the most attention among traders and market observers is the tendency for the euro to be strong and the dollar weak in December, but then to reverse course come the new year.

That begs the question, though, whether it makes sense to trade the markets during the holiday period. This question comes up so often that it was featured as one of those common inquiries answered in Trading FAQs by the experienced traders and market pros who contributed to that book. If you are involved in social trading you will no doubt notice that some traders are active during the holidays and some just decide to pack it in and wait until the markets are back to full participation in January.

Volumes definitely drop off in December as the month progresses. There’s no doubt about that. This is particularly so in years when there’s been a lot of action and significant developments heading up to that period – think elections, major fiscal or monetary policy decisions, etc. That tends to lead mentally exhausted market players to just want a break when they can get it, often resulting in very dull days.

That said, the light volumes can also produce very sharp market moves. If something does happen, because there are so few traders looking to play against a rally or sell-off, the market can go a long way before finally running out of steam. This creates a kind of barbell type distribution to market volatility where you tend to have a lot of very narrow days with a few high movement ones mixed in.

It must be noted that some traders and trading systems can deal with this well. Some can’t. Whether you trade for yourself or through an auto-trading or trade matching system like Trade Leaders, it is worth understanding how your account performs in different types of market conditions. Knowing what the year-end and year-beginning markets are like, you can then make adjustments to either reduce your risk of loss or take better advantage of the opportunities presented.

In academic terms, the Disposition Effect is a psychological bias in traders and investors to take profits quickly and let losses run. This is something which has been talked about in the markets for many years. It comes from a combination of risk aversion effects and a bias toward certainty over uncertainty. In other words, we humans generally prefer a sure gain, even when there is the prospect for a bigger one, while at the same time we prefer having the prospect for a smaller (or no) loss, rather than a sure one.

It’s pretty easy to see how these biases can turn into being quick to book a gain, but giving the market a chance to turn around rather than taking a sure loss.

It is to avoid the potential negative outcomes from this bias – not making as much as we should on winning trades, and taking losses which are much bigger than they should be on the bad trades – that we introduce systems and processes in our trading. For some it goes as far as strictly mechanical trading. For others it includes rules about where to place stops and how to move them up with the market. They attempt to enforce a discipline on us to avoid allowing psychological biases like the Disposition Effect to negatively impact our performance.

Keep in mind, however, that this needs to apply to social trading as well.

In most cases, when using an auto-trading or mirror trading system like Trade Leaders you have the ability to make changes to trades that are done in your account. As a result, there may be the temptation to close out or cut-back a winning trade before it is done by the trader you are following. This is not something that is good idea.

Consider the math of trading performance. Expected returns follow this formula:

R = (win% x avg. winner) – (loss% x avg. loser)

If you close out winning trades early you are impacting the size of the avg. winner. That lowers R - the expected return. This could go so far as to produce a negative expectancy in the most sensitive systems.

In other words, as a social investor you need to ensure you abide by very similar discipline as you would if you are trading in your own right. Don’t let the Disposition Effect drag down your performance.


Stock prices moved sharply higher during the summer months, as investors speculated that further central bank action might just return the economies of the industrialised world to a more familiar growth-setting in the not too distant future.  The world’s leading monetary policymakers from the Bank of England, the Bank of Japan, the European Central Bank, and the US Federal Reserve, duly delivered on cue, but the notion that the latest round of unconventional measures will do anything more than maintain economic growth not too far below trend, is misguided and virtually certain to disappoint.

Investors continue to cling to their misguided beliefs, even though almost four years of ultra-accommodative monetary policies have already failed to deliver anything like a typical economic recovery in the developed world, and the lacklustre activity in the US has prompted the Federal Reserve to commit to a near-zero interest rate policy through mid-2015 – nearly a full seven years after the global financial crisis reached its climax during the latter months of 2008.

Real economic activity remains below its pre-recession peak throughout most of the developed world despite the extraordinary monetary stimulus provided in recent years, and the reason is clear.  Monetary policy loses its potency in the face of a deep and protracted deleveraging; it can do little but soften the blow, and buy time until balance sheets have been repaired, such that credit expansion can proceed anew.

Milton Friedman, the Nobel Prize-winning monetary economist, warned the American Economic Association, in his 1968 Presidential address, not to expect too much of monetary policy.  Investors need to wake-up and appreciate that the late-economist’s words of caution are particularly true of the developed world today, where most economies are caught in a liquidity trap.

A liquidity trap occurs when the implosion of a joint asset and credit bubble severely harms private sector balance sheets, and leads to a pronounced and prolonged deleveraging that renders conventional monetary policy ineffective.  To quote the late American President, Dwight D. Eisenhower, “Pull the string and it will follow you everywhere. Push it, and it will go nowhere at all.”

Central banks may reduce policy rates to zero, attempt to engineer higher inflation expectations that lead to negative real rates, and manipulate asset prices through quantitative easing measures, but the impact on growth will remain muted, so long as the private sector’s borrowing capacity remains impaired.

The inability to stimulate domestic demand may prompt the monetary authority to resort to the last policy tool – the exchange rate – and attempt to engineer a currency depreciation that prompts a sufficient increase in exports vis-à-vis imports that offsets the weakness in domestic demand arising from the desired increase in private-sector savings relative to investment.  However, a competitive devaluation’s ability to replace demand lost to deleveraging depends not only upon the size of an economy’s exports and imports relative to GDP, but also upon the strength of import demand among its trading partners.

The economic reality suggests that the export sector is not sufficiently large across the majority of industrialised countries to make a meaningful difference, while the dependence of many economies upon the consumer means that higher import costs could depress domestic demand even further.  More importantly, most of the developed world is caught in a liquidity trap, which means that ‘beggar-thy-neighbour’ policies are simply not an option.

With no more tools in the central banker’s toolbox, governments have little option but to run large fiscal deficits and fill the demand gap – even though public-sector debt ratios have already climbed to levels that have been shown empirically to retard growth.  In this regard, central banks need to compromise their hard-won independence by allowing monetary policy to become subservient to fiscal policy in an effort to get the industrialised world growing again.

Financial markets have become used to the tactics employed by the most credible central banks in their efforts to dictate fiscal policy and defeat the inflation demon through the 1980s and 1990s.  Indeed, former Fed Chairman, Paul Volcker, forced President Ronald Reagan’s hand by setting real interest rates above the economy’s real growth rate, which put the fiscal position on an unsustainable path.  The battle was won by the central banker, which underlined the Federal Reserve’s independence as we know it today.

Investors need to appreciate however, that changed circumstances call for different rules.  In the presence of a liquidity trap and the resulting deflation risk, central banks need to set interest rates well below the economy’s growth rate in order to keep public-sector debt ratios in check, while governments exploit the favourable borrowing costs and engage in well-planned fiscal stimulus.

Investors continue to look to central banks for solutions to the developed world’s economic travails, but most of the developed world is caught in a liquidity trap, which has rendered monetary policy ineffective.  Premature fiscal austerity will only prolong the economic misery.



Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.