Published: April 19th, 2020
‘Fear is the mind killer,’ say the characters in sci-fi epic Dune. It’s also a key driver in forex and equities markets. With every new announcement about states of emergency, lockdowns, and dire economic data, fear is changing trading strategies and stoking up the ‘risk-on’ vs ‘safe haven’ asset debate.
Of course, the fear factor has always influenced market price action – fear of losses, but also fear of missing out on a rising trend or opportunity.
But these are unprecedented times, and fear is making its presence felt in ways that some novice traders may not have experienced in the past. It's worth taking a step back from the daily ups and downs of the past few weeks and try to gain a big-picture perspective on what's been happening.
When fear grips markets, it often drives a mass response where a majority of traders take the same action in their trading strategies. In forex under the corona crisis, fear has shown a clear pattern.
Investors are generally risk-averse in the sense that they want the value of their holdings to remain more or less stable when markets are in a state of volatility, and avoid a bumpy ride.
In times of danger that often translates into favouring less risky assets. We have already seen short-term gilts in the UK move into negative yields, which often happens when investors shift from riskier assets such as stocks into low-risk government bonds.
What we’ve seen so far in both forex and equities is a generalised fear response, where traders believe recession – and potentially even a market crash – could be just around the corner. So as traders ‘get emotional’ and large numbers of investors look for the exit door, some markets are being walloped.
But others may suffer less, or even offer potential opportunity.
The key, as ever, is to undertake daily research, look for trend indicators, react to news where appropriate but try an avoid being caught up in the daily news agenda.
Trading strategies are beginning to align in response to the crisis as consensus grows about where the perceived danger is, and where the perceived safety is.
Analysts and traders seem to have concluded that the US – the biggest economy in the world – is, or soon will be, in recession. If that's the case, the Eurozone may follow.
On those expectations, traders have begun looking for a convergence of interest rates at the zero bound. Quantitative easing has already started and will undoubtedly continue so long as central banks have to pick up the tab for massive fiscal stimulus packages needed to get economies through the current lockdowns and their expected aftermath.
That has forex traders scrambling to clarify what will differentiate one market from another, and cause one currency to rise while another falls.
One emerging view is to treat currency markets on a ‘first in, first out’ basis, where traders favour the currencies of countries that were ahead of the curve in terms of concrete steps to deal with the crisis. The expectation is that they will be the first to emerge from any downturn, and their currencies will be the first to rebound.
Australia and New Zealand were quick to implement safety measures, while China appears to be emerging from the wreckage. For some traders that points to an earlier rebound for all three currencies.
While the Eurozone is still looking for a unified response to the crisis, as the second epicentre of the outbreak (after China) it's been dealing with outbreak longer and implemented emergency measures sooner than the US.
Longer-term the EUR could gain. Yen has also shown gains on “risk-off” sentiment, though the government’s recent state of emergency declaration could change the picture.
Some traders though believe that, even if recession does take hold, borrower demand for the greenback will eventually drive the dollar back up.
Companies are drawing down their credit lines and taking money out of the banking system. At the same time, many oil-producing countries have reacted to oil’s price crash by tapping into their dollar reserves to fund day-to-day government operations.
Those trends have dove-tailed to keep US treasury yields buoyant, despite the collapse of equities markets.
Traders who’ve pegged their strategies on a return of dollar dominance have seen evidence that their confidence will be rewarded. Recent Fed actions demonstrate that the US is much more willing to inject liquidity into markets than the Eurozone and ECB, confirming the greenback's traditional place as “currency of last resort.”
Over the past year, equity traders have regularly bought into price dips caused by negative news. In an intensely negative situation like the COVID-19 pandemic, however, that strategy is harder to execute profitably.
The news agenda means otherwise bullish traders are feeling trapped by some of their bets and looking for the right points to exit. Six months ago any notable spike might have been interpreted as an opportunity to lighten up. In markets roiled daily by coronavirus panic, it’s unlikely that there is going to be a V-shaped bounce back anytime soon.
While many traders have understandably expressed despair at the torrent of news around crashing indices and ‘market meltdowns’, others with a longer-term view see current trends as overdue corrective action.
When corrective action does happen in equity markets, analysts are quick to remind us that stocks tend to sell off en-masse. Within that mass action, it has to be remembered that some stocks will retain or regain their value, while others may emerge from the carnage as winners if post-pandemic market conditions favour their products or business models.
Broad selling eventually distorts pricing in individual stocks – and that will create opportunity.
It's an excellent example of why fear really can be a mind killer in financial markets. Sometimes you have to resist the temptation to rush into a trend. Otherwise, it will be a profit killer too.