2010: The Year of Volatility

Evaldo Albuquerque (December 30, 2009)

(*And the Year of Profits for Those in the Know*)

Looking back, we can now say 2008 was the year of the financial meltdown, and 2009 was the year of stimulus packages and bailouts.

But how about next year?

In my mind, I see 2010 being the year of volatility. In other words, we will see lots of market surprises that will shock the markets and catch investors unaware.

Now that may sound a bit scary, but it’s actually great news for us short-term traders. Successful traders have long used volatility to capture substantial profits in all financial markets, including Forex.

Today, I want to walk you through some of the most important developments taking place next year – including several risk events that will offer some great trading opportunities. As traders, we should all keep an eye on how these things will play out.

Giving Economic Stimulus Was Easy…Taking It Back is the Tricky Part

Stock markets around the globe have posted incredible gains since reaching their bottom in March. And many investors already have a “business as usual” mindset. But the global economy will face some serious headwinds next year.

In fact, even bigger problems still lay ahead of us as countries emerge from the global recession.

In 2009, we saw central bankers around the globe injecting massive amounts of liquidity into their economies to avoid a global depression. Now they have to start draining it. Therein lies the problem.

It Was Easy Giving Stimulus…

As the effect of that fiscal stimulus peaks, the future path of growth will become more volatile and uncertain. This will shake investors’ confidence in global recovery.

It’s very clear that government programs are acting as a life support that’s keeping economies alive. But not everyone realizes it yet.

Also, government funding cannot remain the primary source of growth for much longer. The cost of bailouts, stimulus and other economic support packages has stretched finances to unsustainable levels in many countries.

Nations like Japan, U.K., U.S., and many countries in the Eurozone will have to start unwinding that stimulus. Otherwise they will risk passing a point of no return for their individual fiscal health.

We all know that a strong private sector is the only thing that can drive a sustainable economic recovery. But consumers may not be ready to take center stage yet.

Despite a recent decline in unemployment rates in the U.S., most comprehensive measurement of unemployment shows a much worse rate of 17%. Because unemployment will remain high for quite some time, the threat of a double dip recession in the U.S. won’t go away anytime soon.

Why U.S. Real Estate Problems Are Far from Over

The latest data on house prices have been encouraging, leading many people to conclude that prices have stabilized. But I see more trouble ahead.

Why? Because 1 out of every 12 home loans is still either delinquent or in the process of foreclosure. And there’s a new wave of mortgage resets next year.

Why do you think Treasury Secretary Geithner has just extended the deadline for the Troubled Asset Relief Program, the “TARP” program that funds bailouts? Why has the Federal Deposit Insurance Corp. (FDIC), which oversees the dissolution of failed banks, just increased its 2010 budget by 56%? And why are banks so reluctant to make new loans?

The answer to all these three different questions is the same: There are more loan defaults and bank failures coming!

To make matters worse, Obama’s housing tax credit is set to expire in April. The Fed also announced a couple of weeks ago that it will conclude other programs that have been supporting the housing sector by the first quarter of next year.

So let me see if I get this straight. The Fed will end these programs in the midst of a new wave of foreclosures and rising defaults, especially in commercial real estate!? That sounds dangerous to me.

China Must Walk a Fine Line to Avoid Another Crisis

Few people realize the effect that Chinese policies have around the globe. The truth is that Chinese decisions will shape up much of the global scenario in the years to come.

Next year the risk of inflation and asset bubbles will intensify in China. And since the Chinese are in the driving seat of the global economic recovery, any slippage will be felt across the globe.

The whole world is betting that Chinese growth will save the globe. China is under pressure to live up to that reputation. So it’s very possible the Chinese government will not take the necessary steps to control capital misallocation.

The country’s unprecedented liquidity and credit expansion already points to inflation, asset bubbles and banking sector risk in the near future. So they will have to find the perfect balance between avoiding a major domestic crisis and keeping the economic recovery alive.

A lot of the money the Chinese government injected into the economy found a place in non-productive assets, such as real estate. The average price of houses in China today is NINE times the average household income.

In the rest of the world, a multiple of four times would be enough to raise red flags. Although is too early to confirm a bubble is indeed in place, there’s more than enough evidence to worry.

In a perfect world China would let its currency appreciate, and speed up the rebalance of the global economy. They would no longer need to buy as many Treasuries to prevent their currency from appreciating.

By doing so, they would single-handedly reduce the demand for dollars and hence global liquidity. They would also decrease the risk of excessive speculation into unproductive assets.

But if they do that, who will finance American debt?

Without China’s demand for our debt, there’s a chance that investors could sell-off their Treasuries. That would drive yields up high enough to kill the fledgling recovery in the U.S.

But wait, it gets more complicated.

Most economists believe the yuan peg to the dollar is a beggar-thy-neighbor policy that inspires protectionism. Next year I expect to see more pressure on the Chinese to let the currency appreciate.

But with shaky global demand, the Chinese may have good reason not to let the yuan appreciate. After all, a more expensive yuan means that China’s exports would be less of a bargain. That means they lose their competitive edge in the global market.

Tensions around global trades have already intensified in past months, especially between China and United States. If the Chinese keeps avoiding a more flexible currency, we may see an escalation of protectionism measures that may lead to trade wars. And the great depression showed us that the combination of recession and protectionism can lead to disaster.

Why Volatility = Profits for You

Up to this point, you may be wondering why all this volatility is actually a good thing.

After all, I’m talking about another downturn in U.S. real estate, central bankers pulling economy-saving stimulus out of their respective countries, China avoiding bubbles, and massive storm clouds circling the E.U.

It all sounds pretty grim doesn’t it?

Well it can be, if you’re an average Mom and Pop investor who doesn’t see the signs coming. As my colleague, Sean explained yesterday, we could see a major stock market crash this year because of all this volatility. (By the way, he also gave some helpful tips for how to protect yourself from the crash, which you can read here.)

But as a trader, I hear “volatility” and I start grinning. That’s because I know volatile, violent shocks in the markets have created some of the biggest, and fastest FX profits in the past decade.

In late 2008, as the financial markets crashed, you could literally short any exotic currency against the dollar and make a bundle.

And next year, as all these events swarm together, we’re going to see some amazing opportunities to short key European exotic currencies (who will follow the euro lower), and even play a few Asian exotic currencies if China manages to botch up this recovery.

Also, keep in mind that I’m only talking about a small handful of events that will lead to higher volatility next year.

There may be a lot more dirt under the carpet. Dubai’s debt problems should definitely serve as a wake up call. Next year we can easily uncover other unintended consequences of the reckless credit growth that we’ve seen in past years. Not to mention there are major debt problems swirling around the E.U.

Keep an out for events that can shock the markets in 2010.

Remember any major game-changing event is an opportunity to profit on both the long and the short side. In fact, volatility can be the best thing to happen to your portfolio in 2010, if you’re positioned correctly.

Best Regards, Evaldo Albuquerque, Editor Exotic FX Alert

EDITOR’S NOTE: A recent MBA, Evaldo Albuquerque specializes in predicting these volatile, market-changing events that can move the Forex market. Next year, he will be guiding his Exotic FX Alert subscribers through the worst of these events with quick Forex moves on both the long and short side. To get the inside track on all his best Forex trades (and every trade our currency editors publish), click here.

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