Deflation is a significant concern for day traders in the foreign exchange (FX) market. This economic phenomenon is characterized by a sustained decrease in the general price level of goods and services, which can have a profound impact on the returns of FX positions in the deflating currency. In general, deflation is a negative for FX rates, though it can increase the value of a currency domestically. Deflation leads to lower currency values as investors seek to move their money out of the affected economy in search of better returns elsewhere, creating a deflationary spiral, as the reduced currency values make exports more expensive and imports cheaper, leading to lower domestic demand and furthering economic contraction.
But while deflation is generally considered negative, it can also create opportunities for skilled forex traders. In this article, we’ll explore the impact of deflation on FX returns, and how day traders can capitalize on this economic phenomenon.
What is deflation?
Deflation is the opposite of inflation, and is characterized by a sustained decrease in the general price level of goods and services. Deflation can be caused by a variety of factors, including a decrease in aggregate demand, an increase in the supply of goods and services, or a combination of the two. As deflation continues, households limit or delay capital expenditure in the expectation they will able to make the same purchase for less if they wait, and this depression of economic activity is responsible for further deflation.
Deflation is typically measured by the consumer price index (CPI), which tracks the average price of a basket of goods and services consumed by households. When the CPI decreases over time, it indicates that deflation is occurring. Deflation is a serious policy challenge for central banks, since the usual tools at their disposal (rate changes and quantitative easing) are far more effective, and can go far further for dealing with inflation than deflation.
How does deflation harm FX returns?
Deflation is generally considered bad for the FX market because although the value of the currency expressed in terms of a basket of goods increases, the economic competitiveness of the whole economy suffers. This is because investors are less likely to invest in a country experiencing deflation, as the reduced price levels make it less attractive for businesses to operate there, and prolonged deflation suppresses all economic activity, resulting in stagnation or even depression.
This can create a downward spiral, as the increased currency value makes exports more expensive and imports cheaper. This then leads to lower domestic demand, uncompetitive industry with resulting unemployment, and further economic contraction, which in turn can drive down currency values.
These risks in both directions are a big problem for retail traders, as both long and short positions may suffer. For example, if a day trader buys a currency with the expectation that it will appreciate in value, but deflation causes the currency to depreciate instead as traders express negative views on the overall economy, the trader will lose money on their investment. However, deflation can also create opportunities for day traders – perhaps the market will overreact to news of deflation, or perhaps a trader can identify early an economy likely to enter or re-enter deflation. These situations create openings that can be traded by skilled, disciplined investors.
Profiting from deflation
While deflation is generally considered bad for the FX market, it can also create opportunities for skilled traders. This is because deflation can lead to lower interest rates, which tend to depress the forex market, creating an opening for short trades. If a country experiencing deflation lowers its interest rates, it will make its currency less attractive to investors seeking returns on their investments. Of course, if the rates cut is successful in stimulating economic growth, this will lead to an appreciation in the value of the currency, which then creates another opportunity for day traders. This assumes of course that the monetary policy of the market in question is successful, which is often not the case, and in any situation will require excellent market timing.
In addition, deflation can also create opportunities for forex traders who use hedging strategies. For example, a day trader who is concerned about the potential impact of deflation on the value of a currency can use hedging strategies to protect their investments. Traders sometimes use a currency pair hedging strategy, where they buy a currency that is expected to appreciate in value, and sell a currency that is expected to depreciate in value. This can help to reduce the impact of deflation on the trader’s investments, and potentially even generate profits.
Historical example: 1990s Japan
One historical example of deflation impacting exchange rates is the Japanese economic downturn in the 1990s. Known as the ‘Lost Decade’, Japan experienced a sustained period of deflation and economic stagnation. This led to a sharp depreciation in the value of the Japanese yen, as investors sought to move their money out of the country in search of better returns elsewhere. Deflation began in the latter half of the 1990s, and whereas the USD/JPY saw exceptional strength from 1990 – 1995, with JPY appreciating from nearly 160 yen to the dollar in 1990 to just 83 in April 1995, these gains were swiftly lost as traders rotated out of JPY, the rate weakening to over 140 by 1998.
This depreciation in the value of the yen had a significant impact on the FX market, with long JPY traders suffering badly in the 3 year USD rally. For day traders, it created opportunities to profit from the falling value of the yen, but economically JPY weakness compounded their general woes, as the falling value of the yen made foreign goods more expensive, leading to lower domestic demand and further economic contraction.
In the end, the Japanese economic downturn serves as a cautionary tale for day traders in the FX market. It highlights the potential impact of deflation on exchange rates, and the need for day traders to be aware of this economic phenomenon and its potential effects on their investments, especially when considering that the Japanese monetary authorities spent much of the period slashing interest rates to zero and injecting liquidity into financial markets.
Causes of deflation
Deflation appears when individuals expect the value of their money to increase with time, as when costs decrease, effective salaries increase. This creates an incentive to save money and to delay purchases. In a country experiencing 10% annual deflation, the cost of a car will decrease by 10% each year, making it logical for households to delay buying one. A problem arises when all across the country people delay financial decisions and wait longer to buy, since this depresses overall economic activity and can, in extreme cases, lead to recession.
As with all fundamental analysis, the exact impact on currency rates can be difficult to predict. Since inflation erodes FX performance, the markets might take a mild view on moderate deflation, but pronounced or prolonged deflation will result in a loss of confidence in the market, and declining FX strength. A confounding factor is the economic stimulus measures used to combat deflation can be violently negative for FX rates – quantitative easing and rate cuts tending to weaken a currency. This creates two contradictory impulses that make deflation tough to trade.
Deflation and technical analysis
For technical traders, inflation or deflation, like other fundamental factors, form the backdrop against which trends are identified and traded. In theory, a chartist can simply observe the trends caused by deflation and trade them normally using the same inputs and levels. In practice, it pays to be aware of what deflation can do to markets and consider carefully your trade rationale against the deflationary backdrop.
Combining technical and fundamental analysis in this way is a challenging and sophisticated strategy, but one that is critical to the profitability of most manual traders. For automated or high-frequency strategies, fundamentals may sometimes be safely ignored, but this is not recommended for traders using traditional manual trading.
How Rakuten can help
Deflation has complicated effects on currency markets, ones that traders require skill and intelligence to navigate. To practice your skills, why not open a free demo account? sign up today and start trading without risking any of your capital.