There were lots of reasons for markets to fall yesterday.
The situation in North and South Korea looks somewhat edgier than it has for many years. Spain’s takeover of a regional bank has highlighted the feeble state of Europe’s banking system.
You could probably come up with plenty of other reasons – I haven’t even mentioned Aussie mining taxes, or BP’s ongoing oil spill woes, or China, or deflation fears yet. But in the end, markets fell for one reason – more sellers than buyers.
The question is, how long will it go on for?
Stock markets could have another 10% or so to fall – for now
Most markets are in official ‘correction’ territory now. In other words, they’ve fallen by at least 10%. How much further could they go for now?
• How high yield stocks can help you through the market panic
• How to avoid stocks that have too much debt
David Rosenberg of Gluskin Sheff – a well-known bear – reckons that the current slide could see the S&P 500 fall a fair bit further from here. “On average, corrections that take place after such a massive move up from a depressed low is 20%.” That could take it down at least as far as 970 from the current level of around 1,070.
The key levels to watch for are 1,065 on the S&P 500 (which is where it fell to during the ‘flash-crash’ earlier this month), and then 1,044, which was the February 5 low, says Rosenberg. And as the US tends to lead global markets, you can assume that whatever happens there would be reflected here.
On a wider basis, “to turn bullish, we would need to see Libor-OIS spreads begin to narrow again, corporate spreads tighten, and stability in the euro.” These measures currently don’t look too healthy. The Libor-OIS spread is the difference between what it costs banks to borrow money over three months, and what it costs them to borrow money overnight. The wider the gap, the more concerned markets are about bank solvency. This morning, the spread hit its widest level since last July.
Meanwhile, corporate spreads – which measure how much more expensive it is for companies to borrow compared to ‘safer’ credit risks – are also widening.
The euro is becoming the new carry-trade currency
And as far as the euro goes, the chances of seeing stability there seem low right now. There are the concerns over the banking system of course, and the general fear over the break up of the euro. But on top of that, there’s another reason to expect the euro to keep falling in the longer run. That’s because it’s looking more and more attractive to use as a ‘carry trade’ currency. The carry trade is where investors borrow cheaply in one currency, then use the money to invest in a higher-yielding asset elsewhere.
The classic pre-credit crisis carry trade was to borrow in Japanese yen, then stick the money in US Treasuries for example. You profit because your borrowing costs are lower than the yield you get from the investment. And on top of that, you get the benefit from the yen falling against the dollar.
However, the yen doesn’t really fit the bill any more as a decent carry trade currency. Why not? Well, a carry trade currency needs to have two qualities. For one, it needs to be cheap. So interest rates have to be low.
Special FREE report from MoneyWeek magazine: When will house prices bottom out – and how will you know?
- Why UK property prices are going to fall 50%
- When it will be time to get back in and buy up half price property
But perhaps more importantly, you need it to remain weak, or at least stable. The trouble with carry trades is that any profits can get wiped out rapidly if the currency you’re borrowing in rises against the one you’ve invested in. And carry trades can reverse very rapidly – at turning points, other carry traders rush to close their positions before they get wiped out, forcing the carry currency to spike higher as demand surges.
At the moment, the yen is seen as something of a safe haven currency. So when turmoil erupts, investors run to it. That means it’s not ideal for carry trading. The euro on the other hand, now looks like a prime option.
The euro is still well above its lifetime average value
Interest rates are low. And with inflation weak and economic growth under serious threat, the chances of the European Central Bank raising rates in the foreseeable future seem as close to non-existent as you can get. Meanwhile, the euro’s weakness seems assured. Saying things like that is tempting fate. But it’s worth remembering that despite all its woes, the euro is still trading above its lifetime average against the dollar, of around $1.18.
As Jonathan Clark of FX Concepts put it last week: “Until the problems in the eurozone are solved, the euro and other low interest rate European currencies like the Czech koruna are perfect funding currencies for purchases of high interest rate currencies, as well as a variety of other risky assets.”
That means we’ll continue to see selling pressure pushing the euro lower. Obviously you can use spread betting to trade the euro / dollar pairing, as we’ve noted on several occasions (you can find a suitable spread betting provider for you at our spread betting comparison table, if you fancy taking a punt).
However, if that’s too risky for you – and believe me, it’s easy to lose money spread betting even when you call the direction of the broader trend correctly – we’ve more on using currency exchange-traded funds to play the foreign exchange market in this week’s issue of MoneyWeek magazine, out on Friday. If you’ve not already subscribed, you can subscribe to MoneyWeek magazine.
Our recommended article for today
Inflation or deflation – which is the biggst threat?
Do we face inflation or deflation, and what can retail investors do either way? MoneyWeek’s panel of experts explain where they stand in the debate, and why.