“When people believe that the market is overpriced and buy anyway, that’s almost THE definition of a bubble.” Robert Shiller, Yale University
“A financial bubble is characterized by trading in an asset at a price that strongly exceeds the asset’s intrinsic value.” Wikipedia
Will The FX Market Be Next?
Recently, financial markets have not been for the faint hearted. Bubble after financial bubble has burst or is deflating. When this happens, the question is always, “Will every market turn out to be a bubble?”
The simple answer is no. The FX market is not in a bubble. In fact, as per the second definition above, currencies should technically never be in a bubble, since they have no intrinsic value (no projected future cash flows).
Currency positions can get rather crowded though. FX traders are currently quite long on the euro and the UK pound, more so than at any time over the last several years, which may provide headwinds for further short-term gains in those currencies. But even the large size of those long positions, relative to the massive overall size of the FX market, should prevent the formation of any type of bubble that in time may burst. My take: I am also bullish those two currencies, but over the long-term, not necessarily over the short-term.
Bubbles Bursting and Deflating
Let’s look at the bubbles that have burst or are deflating:
- BITCOIN and other CRYPTOCURRENCIES. Bitcoin and other cryptocurrencies plunged $100 billion in a single day (February 2nd). Bitcoin sustained a peak to trough decline of 70%, falling from its December high of $19,511 to $5,922 early last week.
- US TREASURIES. On January 19th, the yield on the 10-year jumped over 2.63% (a critical technical level). It’s now 2.92%, a whisker away from 3 percent, the level that traders around the world will be eyeing closely. Why? The US 10-Year Treasury yield is the benchmark of all benchmarks, used by investors all over the world in measuring performance, so a break above 3% could be a cascading event in overseas markets.
- SHORT VOLATILITY IN EQUITIES. When the stock market sustained its biggest plunge in over six years, those who bought disaster protection in the VIX (the CBOE Volatility Index) had a huge payday. One Denver hedge fund pocketed $17.5 million on a $200k wager. Alternatively, being positioned short the VIX was catastrophic — the Short VIX ETF dropped in value by 90% in two days.
- S&P 500. On January 29th the S&P peaked at 2,878. Six days later it fell to 2,531, then popped up to 2,726 the next day, before falling again to 2,531 two days later. That kind of volatility makes long-term investors finally take notice.
- REAL ESTATE. Global real estate funds on average gained 13% last year. Since peaking on January 26th, they have dropped by 9%.
One Bubble Still Poised To Burst
- CREDIT. As a group, Global High Yield (aka Junk) bonds have outperformed all asset classes over the last year, aside from Developed Market Equities and Emerging Market Equities. Spreads between high-yield and investment grade bonds are at ALL-TIME lows. We’re watching.
The FX Advantage
So, while we listen to the POP! and SQUEEK! of bubbles bursting and deflating, we should feel confident that the FX markets won’t be one of them. My take: stay the course.
The Fine Print
This article is intended for US audiences only.
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