Currency Devaluations – A Forex Trader’s Guide
In the past few years we have seen many currency devaluations, for example Thai government devaluing their currency, and fall of Philippine Peso. We will consider a few key pointers concerning the business of currency devaluations and how to play them.
Devaluations are perfectly obvious with the benefit of hindsight. Experience is, therefore, really the best way to gain an understanding of the dynamics of the process. Nevertheless, there are obvious factors to be borne in mind from which – even if you have not previously considered how to trade devaluation situations – one can enquire insight without experience.
- Devaluations tend to creep up on the trader. They begin as a period of expanding volatility and result in a major bubble, which bursts at the inflection point (i.e., the moment of devaluation) and then frequently tends to cause a massive explosion of interest in stocks, bonds and interest rates which diverge from the falling currency.
The media never manages to spot devaluation. They will note that a currency is under strain. They may even suggest that the situation could be untenable in the long term. However, they are much keener to regurgitate the increasingly hysterical ranting of finance ministers, senior government officials and the like, recounting the now heavily discounted twaddle that there is no cause for concern.
Devaluations will often be announced while the market is closed. Italy, for instance, has traditionally tended to devalue over the weekend – which explains why Milanese dealers habitually disliked holding long forex positions in their home currency over such breaks. Even the UK’s last devaluation in 1992 took place in the evening.
Governments by their very nature have a tendency to over-estimate their own power, influence and ability to take on outside forces. Those who are forced to devalue never ever admit that their personal incompetence brought this about. Devaluation plays therefore tend to focus on the most unbalanced of situations. Look for a government is desperate straits to balance their budget. Beware of a currency that looks dangerously overvalued (anecdotal evidence of a visit their as a foreigner will generally suffice in this regard). Furthermore, watch government reserves. If the central bank is sustaining a currency’s level by propping the value up with even small amounts of intervention over a prolonged period of time, then the vultures will be circling to pick over the bones of this particular economy. Having said that, the forward transactions utilized in a great deal of this support often cloud the picture for months, or even years, to come.
When a potential devaluation currency is in play, the watch for the government pulling out all the stops to maintain its value. Instant currency controls are frequently a last resort. Sometimes they are successful – as in 1992 when the Irish Punt successfully beat off the speculators, thanks to the relatively arcane money market processes employed by the authorities. However, in the Thai case, the economy was so evidently in crisis, that the introduction of capital controls had little favorable impact on the currency.
Watch interest rates. The level of sensitivity to these tends to differ from country to country depending upon the structure of a nation’s debts and so forth. The UK, for example, can be extremely interest rate sensitive – not only in terms of industry and business, but also because domestic loans are almost invariably at floating rates and there is a very high level of home ownership (and therefore mortgage borrowing).
When interest rates are soaring, watch the option positions.
By this stage, the battle lines are well and truly drawn. If you want to get into the think of the combat then short the currency in question by whatever means are most economical. Note that the process of buying options at this state is unlikely to be either economical or very profitable – even if you get the direction correct – as the volatility levels will largely discount the likely extent of the devaluation. When assessing your risk/reward, bear in mind that – as a very rough average – devaluations tend to be around 10%.
Governments and central banks in particular like to mislead the markets as their desperation to decrease the pressure on the currency grows. Therefore, again watch the levels of government reserves, but with a degree of skepticism.
Any government borrowing money from another central bank is in big trouble. It may not have to devalue, but it is certainly demonstrating a sign of near terminal weakness – not to mention stupidity. The cost of such loans would be far better spent actually helping taxpayers to great prosperity, rather than imposing a future bill upon them due to the government’s vanity over a particular currency rate.
Finance Ministers under pressure can become quite unhinged. Look for utterly bizarre statements as a sign that they are losing ground.
Look for profit opportunities not merely directly as a result of the devaluation, but also in its aftermath. Watching devaluations is a fascinating experience, as there can often be considerable rewards in doing what in many ways appears utterly ans totally the wrong thing. For example, options volatility tends to go through the roof in bonds and interest rate contracts. Yet despite premium reaching giddy levels, this can often be the best thing to buy.
Post devaluation, volatility tends to remain high amongst all local instruments. There are many opportunities to profit intraday and short-term interest rates in particular are often very fraught, with wide daily ranges providing a broad array of potential profit opportunities.
Finally, if you don’t feel a tiny bit exhausted after a major devaluation, I would wager that you haven’t been trading hard enough!
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