Forex Market Deconstruction

Now that the trading week is over I thought I'd write about a few things that came to mind over the last couple of days.

Current Situation
Everyone is expecting the Fed to come along and put a multi-hundred billion dollar package together with the help of congress. Obviously, this is relieving a lot of the unprecedented pressure on both stocks and various Forex markets. The only fly in the ointment I'd keep an eye on is whether or not things get delayed for any period of time.

The recent explosion in carry trade prices and equity prices is completely dependent on the confidence that has been brought about by a pending solution. Any risk that the solution won't arrive when promised or that it will take longer than promised could lead to some degree of reversal.

The Mighty VIX
Have you heard various pundits talking about the VIX? Basically, it's a measure of volatility. When prices are jumping around quickly the value of the VIX will be quite high. Anyway, people have been referring to a VIX above 30 indicating some type of volatility threshold that might imply we've bottomed. These high volatility periods represent some level of market emotion, such as panic, after which everyone that wanted to sell has sold.

However, we've hit VIX values that should have represented a reversal multiple times. Is the mighty VIX broken? Why did the bounces at those prices represent false rallies?

The answer is simple really. The VIX levels that traditionally have represented a bottom, or an emotional capitulation in the markets, were previous determined during lesser financial stresses. So, various market players assumed the VIX value meant there was a bottom, but they were working on the assumption that bottoms were decided by a static value.

The VIX value needed to call a bottom is variable. It's relative! The size and scope of the problem combined with the sensitivity (or expecations) of those watching the VIX have to be measured together. The expectation of a simple reversal due to a high VIX thwarted it.

So, in the future, when everyone is looking for a 40 or 50 in the VIX, remember that a lesser disaster may be predicted by a lower VIX value. If you sit around waiting for a super high VIX value you might just be left with a pocket full of cash while the market makes it's big reversal.

Did The Carry Trades Bottom?
It would be very easy to sit back, type out y-e-s, and be done with it. Unfortunately, things are much more complex than that. We're certainly going to have some massive relief and subsequent acceptance of risk. However, a bottom will be determined by whether or not other flare ups start to occur. Are any other countries going to end up searching for that last seat when the music stops?

I hope we saw a bottom. I'm playing it like it's a bottom. I'm convinced it will be a local bottom as long as the Fed's plan is adopted.

Other issues are out there though. Will this represent a turning point for the strength of the US dollar? Will it represent a decline in the Japanese Yen? If so, then what might happen to the NZDUSD or GBPUSD? I don't know how the US economy will react, whether or not they'll print money, or whether or not they'll soon start to increase interest rates. However, I do expect the Yen to decline. It's been driven up a lot, and quickly, by people trying to preserve capital. It will go back down when those people start to worry about missing out on an ability to earn.

Expect a bounce downward. Expect it to happen when you think all is well. Expect it to go far enough to shake your resolve. If you do get dumped, expect it to change direction shortly after... ;)