The Daily Edge

Special Report: The USD Analog In Times Of A Liquidity Crunch


If as a trader you are still baffled by the speed at which Forex market dynamics have morphed from bottom-rock depression by any historic volatility standards to the insane wild swings witnessed, this article will be a breeze of fresh air to help you navigate the new paradigm shifts taking place in the currency market.

By the end of it, you will have a better understanding of the total massacre by EUR shorts as carry trade unwound, but most importantly, why by drawing parallels with the last liquidity event from back in 2008 (Global Financial Crisis), going forward, we should be expecting the US Dollar to keep appreciating.

This is a story on how the market went from long carry trade exposure, to a repatriation of capital, only to end up in a USD liquidity crunch.

Where do we come from?

Not long ago, on Jan 17th of this year to be precise, which was 5 days before the coronavirus saga made it into mainstream media, Forex traders had witnessed record lows in FX volatility. This that I show you here is an article by Bloomberg that reflects that suppression in vols.

As a byproduct of this low-vol environment, it became popular by foreign exchange (FX) speculators to borrow a currency which has a low-interest rate to use it as a funding currency. These traders would hope to profit from the spread or carry trade between the low-interest fiat and a higher-yielding currency purchased with the funding strategy.

Now, while any world currency can become a funding currency. In recent times, the euro (EUR), Japanese yen (JPY), and the Swiss Franc (CHF) were all been the preferred funding currencies due to the aggressive monetary stimulus which resulted in low-interest rates.

The whole point of the carry trade is that funding currencies fund the currency carry trade for two main objectives. The first is obviously to make money on the interest rate differential. The second objective is to gain a profit from the capital appreciation.

However, there are inherited risks. Why? The possibility to capitalize on these yield advantages is attractive conditional to the market maintaining low volatility dynamics.

What happens when volatility starts picking up?

If volatility kicks in, as seen due to the ‘COVID-19’ Black Swan Event, it implies more nervous markets and that has detrimental effects on currency pairs that are considered to be “carry pairs,” and without proper risk management, traders can be drained by a surprising and brutal tu due to the culprits explained below.

Hedging: High-interest-rate currencies are negatively related to explosions in global foreign-exchange volatility and thus deliver low retus as in those times low interest rate currencies provide a hedge by yielding positive retus.

Leverage: An important risk factor for retail forex traders to consider with the carry trade is that if substantial leverage is used to implement it, then sharp unfavorable market movements could result in losses that may prompt margin calls or the position being automatically stopped out by your forex broker.

Exchange rate differentials: Apart from the risk of a drastic decline in the price of the funded asset, the speculation trade also carries the risk of a steep appreciation in the funding currency if it is not the speculator’s home currency.

The blow up of to the carry trade as vol exploded?

We’ve had primarily two currencies that due to the higher interest rates set by the Central Banks had concentrated the most carry trade interest. These were the USD and CAD. However, as vol as expressed by measures such as the VIX (fear index) spiked, with swings the likes we haven’t seen since the GFC, there was a sudden shock.

As part of the reshuffle of portfolio to adjust to the new reality, the funding currency short positions were unwound, which led to the strong appreciation of the EUR, CHF, JPY.

The risks underscored above all eventuated at once, with forced-selling of funding currencies due to hedging, margin calls due to over leverage, to name the main reasons. This event is what we would call a repatriation of capital back to funding currencies as the carry trade long trade imploded.

The era of USD liquidity crisis – The USD analog

With most of the repatriation of capital back into funding currencies having run its course amid the decimation of the carry trade, the market has now transitioned very rapidly into balancing out positions to long USD. With that in mind, next I will draw some parallels with the previous GFC crisis on how things may play out from here.

Therefore, in the USD front, I believe we’ve transitioned from a repatriation of capital, which initially led to USD weakness as the unwinding of carry trade structures took place to a new scenario dominated by the shortage of USDs. That’s why I believe that in this new chapter, the USD is now poised to appreciate to the tune of 20{c55dae091e2f4b96c42546a5edb68ce9f701c78980adb8fd55b74e573b5f59f6} and for that, I will draw parallels with the last liquidity event seen by volatility standards, which as we all know, dates back to 2008.

I’d call this section the USD long analog. As human, we have certain cognitive biases that when combined with repetitive market dynamics under the right context, makes trading in a particular direction are higher than 50{c55dae091e2f4b96c42546a5edb68ce9f701c78980adb8fd55b74e573b5f59f6} probability, especially when taking a higher time scale approach as I’d be making the case from a weekly timeframe.

The new context being traded

We have a significant worldwide liquidity event across all asset classes. I would personally put this financial event in the top 3 most disastrous and nerve-wrecking of all times. Think about it, we’ve never been so interconnected and integrated in a globalized world, yet we are forced as a human race with an economy machinery to go on full ‘sudden stop mode’, leading to both a supply and demand shock. This is unprecedented.

Because of it, we are at what I believe to be the onset of a global dash for cash as forced selling and massive liquidation kicks in. Central Banks have been trying to act but their actions have fallen into deaf ears. The Fed has been notoriously stepping in making available via funding channels more than $1 trillion, but the uptake has been poultry.

The total loss of confidence as expressed by the turmoil in equities, the dislocation of capital amid sky-high volatility (VIX closed at all time highs) and the crumbling of credit/funding channels (3m FRA-OIS spread), continues to fuel massive demand for the USD as it communicates shortage of dollars.

Fed measures are not enough as they are willing to lend but banks don’t want to hold a bag of risky bets by lending it to businesses at risk of going under. Essentially making those with access to Fed’s funding not interested and those interested without legal access (I am talking about Oil, aviation, cruise line companies).

The more credit/funding deterioration, which leads us to the distresses of a market unable to operate, from a framework or structural perspective, properly. This has also been observed via the FRA/OIS spread, which is a way of measuring the shortage of US dollars in the system.

The reasoning behind the USD strength to come

For those interested in watching a video presentation of the USD long analog, here it is:

First, we need to think about the qualifiers that would cause a run to the USD in mass for an extended period of time. For that, in this chart of the USD index below, which aggregates in equally-distributed terms the flows in or out of the USD against G8 FX, there are a number of factors to consider.

*If you’d like to access the G8 FX Indices I use, feel free to access the following public document  or alteatively, you can access the indices charts via Mataf.

First, is the USD starting to outperform safe haven assets? Yes it is. The chart below shows the strength of the currency vs funding currencies and safe-haven assets.

The tipping point to understand when the USD shortage is a real conce is the liquidation in gold positions despite the insane risk aversion. This also happened during the GFC, which is a point I prove in the chart above in the 4th panel in blue line, which features gold priced in USD.

Next, are we seeing a structural breakout in volatility standards, with a lag of 1-week (5-period). If so, that is a red flag that the fear is kicking in. In the chart below, once can clearly seen in the second panel that vol breakout via the white line at a time when the VIX has gone absolutely ballistic. Last time this happened was in the GFC.

Third, has the USD index broken its price structure as well? As in the case of 2008, when the USD liquidity crunch led to the breach of a descending trendline, this time, the demand flows into the USD have caused a resolution above the upper end of a multi-year range.

So, now that we have evidence of all these 3 elements converging at the same time, the last liquidity event from the past where a scramble for USD liquidity also manifested, suggests a run of about 20{c55dae091e2f4b96c42546a5edb68ce9f701c78980adb8fd55b74e573b5f59f6} in the USD is in store. The upside seen so far is a poultry 2{c55dae091e2f4b96c42546a5edb68ce9f701c78980adb8fd55b74e573b5f59f6} as of March 18th.

How long would it take for this run into the USD until the move completes? By duplicating the same candle pattes that we saw back in 2008, we are looking at approximately 3 months (15 candles in the weekly). You can find the reasoning in the chart below.

“History never repeats itself but it rhymes,” said Mark Twain. We are at the very onset of this USD bull run which provides huge opportunities for those nimble enough to spot the opportunities. The parameters I need to see to qualify this type of movement have also now been met as the USD index and vol broke structures.

Brace yourself because if the speed at which things have moved may have baffled you, history tells us, based on the last GFC, that the vol in the USD is just getting started.


About the author

Ivan Delgado

Ivan Delgado is a decade-long Forex Trader. Feel free to follow Ivan on Youtube. Join thousands of traders who follow Ivan's insights to increase their profitability rate by learning the ins and outs of how to read and trade financial markets. Ivan has you covered with in-depth technical market analysis to help you turn the corner.