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The fundamental driver of trading is that one party has goods or services that they wish to sell and that another party wishes to buy. A trade can be made if they are brought together and can agree a price for the transaction. Markets have developed to facilitate this process. This is as true for financial products as it is for any other. The real drivers of the volume of trading in financial instruments are, however, fear and greed. Fear drives individuals, companies and financial institutions to take action to reduce or hedge risk. Greed drives the same parties to look for ways to profit from the trading activity itself.
We will start by looking at how spot markets operate and why hedging needs naturally result in the development of forward or future markets. Our main focus in this series of posts will be on the nature of arbitrage transactions and their importance in influencing financial instrument prices, and how financial institutions seek to profit from trading activities. We will look at the methods used to manage the risks taken in such activities in the future.

What does economic recovery mean and how is it different from mere “stabilization”? It is the equivalent of the patient on the one hand getting back his/her vital signs but still remaining essentially horizontal, and on the other hand wandering around the ward. There is a clear difference! In economic terms, recovery means real economic indicators such as retail sales, industrial output and imports are no longer contracting, but actually rising. In particular, as imports start rising, first on a year-on-year basis due to basing effects and then on a month-on-month basis, this is the first real sign of fundamental recovery. At street level, more practically, the first sign of recovery is people back in the shops and retail prices making a bottom.
During Phases III and IV, prices fall until such time as consumers are tempted back by bargain basement prices. Phase V is when that temptation produces results. The elimination of corporate de-stocking which had hitherto been a drag on growth, coupled with lower interest rates and looser fiscal policy which provide support for weak domestic demand, help boost economic growth. Corporate re-stocking of inventories gives a further lift to that growth take off. In terms of the trade balance, inventory re-stocking accelerates the recovery in imports, in turn accelerating the pullback in monthly recorded trade surpluses. However, by this time, capital flows have begun to offset and then exceed trade flows as investment returns to the region. Rising real economic indicators attract rising capital inflows, helping once again to produce a rally in the local currency. However, unlike in Phase III, this time the rally is fundamentally- based rather than just liquidity-based.

While Phase III remains ongoing, the economic patient is still showing no major sign of recovery. Inflation peaks, which in turn allows domestic interest rates to peak. The trade account swings hugely, in many cases from a deficit to a surplus as import demand collapses. This accelerates the recovery in liquidity, helping to force down interest rates and thus causing the liquidity-based rally which we talked about earlier. Eventually, the trade surplus, low interest rates and basing effects help support the economy. Put bluntly, the economy hits bottom and a period of stabilization ensues.
Readers should note that economic stabilization does not mean the same as recovery, in the same way that hitting the ground after a fall from some height does not entail recovery (indeed, if the height is sufficient there is unlikely to be any recovery!). Both processes usually entail a prolongation of pain, but at least the pain is not getting worse. Thankfully, economies are not as frail as the human body. They can indeed fall from great heights, smack down hard on the concrete with a sickening thud and yet still recover; the timing of that recovery depending crucially on the extent of the fall.
At the microeconomic level, companies are still continuing the process of de-stocking of inventory. Consumers remain very cautious and retail prices continue to decline to levels aimed at causing them to buy. That said, the fall in interest rates eventually provides crucial support for cash-strapped companies and banks. These hastily complete their inventory de-stocking process, switching most of that supply to export markets unaffected by the crisis, and start the process of re-stocking. At the international level, the reality of the economy hitting bottom, as evidenced by declining contractions in economic indicators, leads to the expectation of Phase V, economic recovery. Phase IV is not plain sailing for local currencies however. As domestic economies stabilize, so do imports. Indeed, year-on-year basing effects accelerate that process. Thus, what we usually see in Phase IV is those trade and current account surpluses peaking on a monthly basis. During Phase III and the initial part of Phase IV, trade flows are actually more important than capital flows — as most offshore investors have already left by then, taking their capital with them. Reduced trade surpluses thus have a greater effect on market movements than would otherwise be the case, serving to weaken the local currencies.