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.