Trading Forex During a Recession

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Economic downturns are unavoidable. They will appear when they are ready, not if they are ready. The following question for currency traders is, “Is the forex market recession-proof?” The answer is no, and this necessitates a response from forex traders. Consideration must be given to the type of recession involved, as well as making the best prediction possible about the length and severity of the recession.

If you already have positions in the market, you may want to consider protecting them during a downturn. If you’re new to the market, you’ll need to identify the best forex trading opportunities. These could include buy-and-hold strategies or forex day trading.

Nobody wants a recession to happen, but forex traders who plan for one can turn underlying changes in a country’s economy into trading opportunities. The following breakdown of how to trade forex during a recession discusses how to profit from the turmoil caused by economic slowdowns.

What exactly is a recession?

A recession is defined as a period of reduced economic and industrial activity during which the gross domestic product (GDP) of an economy falls for two consecutive quarters. That GDP figure is based on data from the manufacturing and service sectors of the economy. It is possible that both fall in value, or that one falls so far that it drags the total number down to a negative reading.

Other data points can provide an indication of an economy’s fortunes and add more “color” so that traders can attempt to take profitable positions. Real income, inflation, employment levels, industrial output, and wholesale-retail sales are all secondary figures to keep an eye on. Demand for a country’s currency can be expected to rise as these metrics change.

Historical perspective about recession

In general, the period between 2010 and 2020 was one of long-term economic prosperity. It was distinguished by low interest rates and inflation levels as a result of central banks pumping cheap money into financial markets following the Great Recession, which lasted from December 2007 to June 2009. That was the longest period of contraction since the 1929-38 Great Depression.

The tools used by governments and central banks to manage the economy can appear blunt and slow at times. At the same time, they can overshoot, resulting in an economy emerging from recession and immediately entering a period of excessive growth. This makes predicting the duration and severity of a recession difficult, which leads to increased price volatility due to analysts having widely differing views on possible outcomes.

Forex market during a recession

During a recession, forex markets may not react in the same way as other asset classes. Stock markets, for example, typically fall in value during an economic slowdown, but currencies serve as a lubricant rather than a tangible part of the economic system. One trend that is likely to be observed is that the currencies of stronger economies will gain value relative to those of weaker economies.

Economic fundamentals determine whether one country’s currency is more or less likely to be demanded. Consider the currencies of major exporting countries such as Japan as an example. During a global recession, Japanese automakers and technology firms can expect a drop in demand for their products. Because a large portion of that demand comes from global trading partners, any decrease in demand for Japanese goods will result in fewer Japanese yen being purchased in currency markets.

USDJPY – Daily Price Chart – 2018 – 2022: Source IG

A recession can also be short-lived and localized rather than global. This could be due to a short-term political event, such as the Brexit referendum, the outcome of which surprised the investment community. It caused a short-term drop in confidence and economic output levels, as well as a drop in the value of the pound.

GBPUSD – Weekly Price Chart – 2010 – 2022: Source IG

Recessions are something that forex traders must approach with caution. Preparing for one through fundamental and technical analysis can result in profitable trading of short and long-term currency price movements.

Currencies that perform badly during a recession

During a recession, successful forex trading begins with conducting research and monitoring key data points such as interest rates.

A contracting economy can expect assistance from its central bank and government. Interest rates are one of the most effective and quick-acting policy tools, and most central banks adjust them at regular meetings, which typically occur once a month.

Reduced interest rates can help stimulate an economy by making borrowing more affordable. Consumers and businesses both benefit from increased cash flow, and a virtuous circle of increased spending and production can kick-start the next period of growth.

Because of the lower interest rates, savers’ returns will be reduced. If another economy is not experiencing a recession at the same time, or is outperforming its peer group, interest rates in that country can be expected to remain higher. Selling one currency and buying another allows savers to switch to a currency with higher returns, which affects the prices of both currencies.

Devaluing a currency through interest rate policy can also boost exports in a failing economy. Its products become more affordable on international markets, which represents another way for it to begin to recover. As a result, central banks see interest rate cuts as a two-pronged approach to moving an economy forward.

Currencies that perform well during a recession

During a global recession, the currencies of countries with stronger economies are likely to strengthen. Interest rates are likely to remain higher, as the central bank is concerned about the risk of inflation as well as a possible slowdown in growth.

Currencies, recessions and the fear factor

It is critical to consider both the ‘fear factor’ and economic fundamentals. Demand for the US dollar and Swiss franc is expected to rise during a global recession due to their status as safe-haven assets. This is because if a prolonged recession causes a meltdown of the global financial system and banks face default, you should hold the currency that is least likely to be caught up in a bank run.

A drop in sentiment caused by a recession can also cause large corporations to scale back their expansion plans. If US-based multinational corporations scale back on ambitious overseas projects, currency prices will suffer. As investment in emerging markets declines, so does demand for  the currencies of those countries, as there is no longer a need for the developing country’s currency to be bought.

How to trade forex during a recession

During a recession, forex trading can be as much about how you trade as it is about what you trade. There are numerous forex strategies that can assist you, but we have highlighted some general guidelines to follow in order to maximize returns.

Investment Timelines

A clear strategy is always a good idea, but it becomes especially important when running forex trading strategies during a recession. Because some recessions can last for years, investment timelines must be carefully considered. Day traders, on the other hand, can hope to profit from excessive intraday price movements.

As a result, it is critical to ‘run your winners’ and stay in profitable trades. Not every trade will turn a profit, and successful trading is based on minimizing losses and maximizing returns on profitable trades.

Sell short and buy long

Each forex transaction consists of two components. The procedure entails buying one currency while simultaneously selling another.

By selecting the right currency pair, you can maximize your profits by winning on both legs of the trade. Those who believe the European Central Bank will not raise interest rates in the first half of 2022 can sell short EUR. IG offers EURUSD, EURGBP, EURJPY, EURCHF, and EURCAD, among other EUR-based currency pairs.

EURUSD – Daily Price Chart – 2021 – 2022: Source IG

In terms of practicality, trading EURUSD is the obvious choice because it is the most widely traded currency pair in the world and trading spreads are tight. However, there could be another currency pair that provides better returns.

Notably, the price of EURUSD moved by 5.64% between 1st June and 31st May 2022, while EURCAD moved by 6.60% during the same time period. This is because the Canadian dollar is regarded as a better bet than both the euro and the US dollar.

EURUSD – Daily Price Chart – 2021 – 2022: Source IG

Managing risks

Price volatility is likely to rise during a recession. Investors who are’spooked’ can make erratic decisions, and uncertainty about how effective policy measures will be leads to very different views on where prices should be.

Scaling back on position size and leverage during a recession can thus benefit forex trading. As a result, price swings can be larger in percentage point terms but smaller in cash terms. Smoothing out returns and increasing capacity to hold positions are all part of being a prudent investor and generating consistent long-term returns.

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