The global economy was impacted by the 2007-2009 credit crunch, which began in July 2007 in the United States as a result of a lack of confidence in mortgage securities and eventually expanded to Europe and the Far East. In purchasing power parity terms, the world economy was expected to increase by only 0.5 percent in 2009, the worst pace since World War II. Many financial institutions, manufacturing enterprises, particularly automobile firms, and commercial organizations have collapsed as a result of the liquidity crisis in developed nations. The liquidity issue is having an impact on forex trades.
What is a credit crunch?
The credit crunch is defined as a sudden scarcity of funds for lending, resulting in a reduction in the number of loans available.
A credit crisis can happen for several reasons:
- Interest rates are rising unexpectedly.
- The government has direct authority over money.
- A lack of liquidity in the capital markets.
Credit crunch risk and how it affects your forex trades
Low interest rates
After a credit crunch, many banks lower the interest rates in order to boost the economy. For example, the Bank of England cut the interest rates from 5.5% in 2007 to 2% in December 2008. They dropped the rate even further in 2009, to 0.5%, which remained the basic rate for over ten years.
For day traders in the forex market, interest rates are critical because the greater the rate of return, the more interest is accrued on the currency invested and the bigger the profit. The risk with this, of course, is currency fluctuation, which can quickly wipe out any interest-bearing gains. After an announcement by the bank that they will lower the interest rates, many forex pairs affected by the announcement will have a bearish run.
Housing starts decline
During the financial crisis in 2007, the housing sector was one of the hardest hits. One of the most severe global repercussions of the credit crunch was an almost 20% reduction in property in the United States. The strength of a country’s economy is reflected in its housing market data. As a result, it has a significant impact on the currency value of the country from whence the data originates.
When the housing market begins to deteriorate, a central bank will strive to boost liquidity in the market to stimulate growth. An interest rate cut would discourage investors, resulting in a drop in the value of the respective country’s currency.
Low rate of employment
When the unemployment rate rises, especially if it does so abruptly, it has a negative impact on the currency pair, causing it to turn bearish. A recent example occurred at the end of 2017 when UK unemployment increased by ten basis points to 4.4 percent, causing the GBPEUR to fall to 1.3944.
Bad debt by major banks
The enormous magnitude of bad debt held by lenders made this credit crisis stand out from those of prior years. Although banks had securitized their debt by selling it to other institutions, no one knew who owed what to whom. The issue with securitization is that banks sell the same debt too frequently. This resulted in a situation in which the value of the finance was replicated by numerous banks.
Banks froze all loan availability due to the unpredictability of the scenario. They attempted to cling on to any residual reserves in order to improve the appearance of their balance sheets. This can affect forex trading, especially if it’s the big banks. Without enough money running because of freezing, the economy will go down. As a result, the currency in the country will fall.
Low gross domestic product (GDP) readings
During the credit crunch in 2008, there was a worldwide recession in the industrialization and emerging economies. According to Oxford Economics (2009a), global GDP fell by about 1.5 percent (and more than 2% in constant US dollars), with the G7 GDP falling by nearly 4% and emerging market GDP expanding at only 0.7 percent, pulled down by the main economies’ weakness.
Traders are more likely to observe a sell-off of that particular domestic currency in relation to other currencies if the GDP number is lower than predicted. In the case of the United States, lower GDP rates indicate an economic downturn, reducing the likelihood of an increase in interest rates in the United States, lowering the attractiveness or overall worth of the USD and USD-based assets. The more GDP data falls short of expectations, the more the currency falls.
The collapse of financial institutions
Following the credit crunch in 2007, plenty of financial institutions, automotive, insurance, and hospitality businesses failed or were severely harmed. Financial institutions such as Lehman Brothers and Washington Mutual went insolvent in the United States and Europe. The US government was also required to invest $20 billion and support $306 billion of Citigroup loans and securities.
Market liquidity has been diminished, volatility has increased, and a greater emphasis on counterparty risk has been placed on foreign currency markets. This affects forex pairs, thus affecting the forex market negatively.
The credit crunch is described as a sudden shortage of capital for lending that reduces the number of loans available. The credit crunch was experienced mostly in 2007-2008. It had a radical impact on forex trading, increasing volatility across the board. Major effects include low interest rates, low rate of employment, low gross domestic product (GDP) figures, the decline of housing starts, and bad debt by major banks.