These are important concepts to understand to protect your money, so read this post carefully. I'm going to explain the difference between these 2 terms and how you can apply this knowledge in times of uncertainty.

In a bail-out, the government gives banks money to help the banks stay in business. A bail-in is when a bank exchanges customer deposits for bank stock, at the bank's discretion. This exchange is also done to prevent the bank from going out of business. 

How is this all possible? Is it even legal? Keep reading to get all the details.

How Banks Get Into Trouble

Before I get into the difference between bail-outs and bail-ins, it's very important to understand how banks get into trouble in the first place.

Once you understand these reasons, you'll have a better idea of how bail-outs/ins help banks stay in business.

As you probably know, there is such a thing as broker risk. I've been warning people about it for years and it's one of the key risk elements that you need to be aware of as a trader.

You can read more about it in this tutorial on broker risk.

The remedy for broker risk is to leave a good portion of your money in your bank account. That's usually a safe place when times are good.

But if the economy starts to go bad, then you also have to consider that the money in your bank is at risk too.

There are many ways that a bank can get into financial trouble, but here are the 2 most common reasons.

High Loan Defaults

If a lot of bank customers cannot pay back their bank loans, the banks cannot pay back their other obligations.

There are many different scenarios that could cause this. In our current market conditions, unemployment is going to be the biggest problem facing banks.

When people lose their jobs, they can't make their loan payments.

Another issue that can cause defaults is when the banks make loans to people who do not have the ability to repay them. We saw this in the 2008 financial crisis where mortgage brokers were giving out “fog a mirror” loans.

If you could go into the office of a mortgage broker and fog a mirror, you could get a loan.

Loose lending guidelines can lead to many defaults.

A Bank Run

This is the most devastating problem that a bank can face. A bank run is when a majority of customers of a bank all withdraw their money at the same time.

In order to understand why this is such an issue, you first have to understand Fractional Reserve Banking. Here's a good video that explains how it works.

So borrowed money is counted as “reserves” in other people's accounts, to lend even more money.

For example, let's say that Mary borrows $100,000 from a bank to start her business. She doesn't need that money right away, so she puts that money in her bank account.

The bank is allowed to put $10,000 (10%) of that money in reserve, then lends out the other $90,000.

Then the process gets repeated over and over again.

So the bank essentially created $190,000 our of thin air.

It's free money.

That's why banks are so profitable.

What to hear something even scarier? 

As this article is being written, the Federal Reserve Board recently changed its rules and have said that the minimum reserve is now zero.

That means banks don't have to keep any reserve for every loan they make!

So they are free to lend out the full amount of money in your bank account. If anything goes wrong with the loans that were made with your money, it's ALL gone. 

Now that you understand how banks can get into trouble, let's dig into the 2 options that get them out of trouble.

Bail-Outs Explained

A bail-out is straightforward.

A government feels that certain companies (like banks) are essential to the economic health of a country, so they give those companies or organizations a loan to stay in business.

Sometimes the banks have to pay back the loans, sometimes they don't. It just depends on the terms of the loan.

These banks are considered “too big to fail.”

Therefore, the taxpayers end up paying for these failing companies. 

The biggest issue with a government bail-out is that a company has to get approval from the government to get the bailout.

Notable Bail-Outs in History

The most famous bail-out in recent history was the $700+ billion bail out of the financial sector by the US Government. This happened after the 2008 financial crisis that was created by the irresponsible use of Collateralized Debt Obligations (CDOs) and other similar mortgage-backed derivative products.

Other notable bailouts in US history include:

• The Great Depression
• The Savings and Loan Crisis

Banks in Greece were in trouble during the 2008 and had to resort to bail-outs. Greek banks only allowed customers to withdraw €60 per day.

That limit was later increased to €5,000 per day and was only lifted 3 years later.

As you can see, a financial crisis can have a sudden, debilitating and long-lasting effect on people.

There are many other smaller examples throughout history, but those are the recent highlights.

Bail-Ins Explained

Here's where things get a little more complex. 

A bail-in is basically the ability of a bank to use customer funds to keep the bank in business. It's not quite stealing because the bank gives its customers stock in the bank, in exchange for taking the cash.

In other words, a bank can just dip into your account and take funds out, whenever they want.

Would you want stock in a failing bank?

Hell no.

But that's how the banks justify taking your money. 

From the bank's perspective, it's a much better solution because they don't have to beg politicians to get the money they need to stay in business. Politicians can be reluctant to institute bail-outs because that money is coming from taxpayers.

If enough taxpayers get angry that their money is being used to prop up large corporations, that doesn't reflect well on the politicians.

However, if a bank uses a bail-in, they piss off much fewer people and don't have to get approval from a third party.

This is all perfectly legal of course. In the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010.

Here's a great video that explains it all.

What About FDIC Insurance?

But I'm sure that you've seen the “FDIC Insured” sticker that is pasted all over your local bank. It says that deposits are insured to at least $250,000.

That's somewhat reassuring…but there are 2 catches.

1. This assumes that the FDIC has enough money to insure all of the accounts at all of the banks that are in trouble. In the event of a total global financial collapse, that might not be possible. It's like insurance companies that go broke after a major hurricane.
2. If you have more than $250,000, then those additional funds won't be covered.

Yeah, not as great as it initially seems.

Notable Bail-Ins in History

Don't think that this can happen in the real world?

Think again, this isn't just theory.

Cypress was one of the first countries to do a bail-in during the 2008 financial crisis. Customers with over €100,000 were forced to “donate” money to the bank to help keep the banks afloat.

Greek citizens are now suing Cypress for damages that total over €307 million, plus interest.

So What Should You Do Next?

Now that you have this information, here's what you can do next, to protect your money. Remember, knowledge is not enough, you need to take action.

Understand What a Healthy Bank Looks Like

The first thing you should understand is the financial health of the banks that you keep your money at.

• Are they making a lot of bad loans, or are they being conservative and looking out for the best interests of their customers?
• Are the making a lot of bets in the derivatives markets?

If you don't know how to determine the health of a business, then start by doing some research on how to read a balance sheet. You can start with this article. It's not hard to do, once you understand how a balance sheet works.

The hard part can be finding that information. You can see US bank filings here.

There's also the chance that they can be “cooking the books,” or reporting false information. Some large banks don't publish their derivatives trading.

Therefore, after you investigate the balance sheet, you should dig deeper into news stories and figure out ways to uncover assets and liabilities that don't appear on their balance sheet or website.

Understanding the overall health of your banks will go a long way to protecting your cash.

Move Your Money

If your bank isn't in good shape, then move your money to a bank that is more financially stable.

Also consider alternative investments like gold or Bitcoin. To learn how to buy Bitcoin for the first time, read this blog post.

Physical gold is a great way to store your wealth, but also remember that you'll need to pay for things online. That's where Bitcoin comes in handy.

Conclusion

Success in trading is all about risk management.

You not only have to understand the risks on each trade you take, but you also have to understand the risk to the money in your bank account.

Do your homework, get educated, and you won't end up like the 90%+ people out there who aren't paying attention. 

At the end of the day, banks are going to look out for themselves, not you.

So get educated and be ready to do what's in your best interest.

The post What’s the Difference Between a Bail-Out and a Bail-In? appeared first on Trading Heroes.

Some people say that Forex is recession proof and others that say it's not. Let's take a look at this important question and find out which side is right.

Forex trading is recession proof because traders can select from a wide variety of currency pairs and go long or short, with equal ease. Even a global recession affects individual currencies differently, so there will always be an opportunity to make money. A recession also increases volatility in the currency markets, leading to even more trading opportunities. 

Now I'll dig deeper into why Forex is such a good market to trade in a recession, and the definition of a recession.

What is a Recession Proof Market?

A recession proof market is a market that provides equally good trading/investment opportunities, regardless if there is a recession or not.

It's actually easier to define a recession proof market by starting with a market that isn't recession proof.

For example, the real estate market is heavily affected by the overall health of the local economy.

When the economy isn't doing well, then many people are out of work and they don't buy houses. On top of that, real estate investors make the most money when property values go up.

You cannot make money while real estate values are dropping.

Well, technically there are ways to do it, but they are not nearly as easy to implement as buying a cashflow property or buying and holding an appreciating property.

Therefore, real estate has severe restrictions when it comes to making money on a depreciating property.

On the other hand, in a market like Forex, it doesn't matter if there is a recession or not because you always have opportunities to make money.

It's equally easy to go long or short, and there aren't any restrictions when prices go down.

What Happens to Forex in a Recession?

There are many things that can happen to individual currencies during a recession.

That's the beauty of trading Forex.

Even in a global recession, different currencies will be affected to varying degrees, and in different ways.

On top of that, since single currencies are paired in different combinations, you have the opportunity to pick the pair that best matches your trading strategy.

For example, let's take a look at what happened during the 2008 global financial crisis, also called The Great Recession.

The events related to this recession roughly happened between 2007 and 2010, so let's examine this time period. First, here's what the S&P500 looked like on the weekly chart.

The blue vertical lines mark the beginning and end of the period we are examining.

The S&P500 dropped from a high of about 1576 to a low of 666. I'll get into why the US stock market is not recession proof in the next section.

But for now, I'm showing you the chart, just to give you a point of reference.

Now let's take a look at the weekly chart of the Australian Dollar versus the Swiss Franc during this time. These charts are pretty correlated, so if you wanted an easier way to trade the S&P500 short, you could have done it through this currency pair.

But other currency pairs reacted differently during this time period. For example, this is what the USDCAD pair looked like.

It's not exactly an inverse of the chart above, but it's pretty close.

When you compare the volatility of these 2 charts, you see that the AUDCHF was more volatile than the USDCAD from 2007 to 2008. But AUDCHF was less volatile from about 2008 to the end of 2010.

So although the price action was similar, it was not exactly the same.

You could have chosen to trade one or the other, depending on which currency pair was a better fit for your trading strategy and risk tolerance.

The US Stock Market in a Recession

Now let's dig deeper into the difference between Forex and the US stock market in a recession.

Stock trading is different from currency trading.

When you trade stocks, you have to pay close attention to the overall market sentiment and the performance of each sector because they can have a huge impact on the performance of individual stocks.

If the overall market is bearish, then it's generally better to stay in cash or look for shorting opportunities. Since you cannot short all stocks, it can be difficult to find profitable opportunities in a down market.

Therefore, stocks are not recession proof. 

Sure, there might be some stocks that outperform the markets in a recession, but they are few and far between…and always risky to trade.

Shorting the stock market via Exchange Traded Funds (ETF) is possible, but can also have risks, due to management fees.

The Futures Market in a Recession

Another way to trade during a recession is to trade the futures markets.

I consider the futures markets recession proof because it's pretty easy to trade long and short in most markets.

You can also trade a wide variety of products and contracts.

However, the futures markets can have the following drawbacks, when compared to Forex:

• Less liquidity
• Can get locked limit up/down
• Potentially higher commissions per trade
• Higher minimum account balance because of higher margin requirements

So you can certainly trade futures during a recession, but it's not as easy to trade as Forex. 

What is a Recession?

Any discussion on recession proof markets isn't complete without the definition of a recession.

The National Bureau of Economic Research (NBER) determines if we are in a recession or not.

They used to define a recession as a decline in Gross Domestic Product (GDP) for at least 2 consecutive months, but that is no longer the case.

The current definition of a recession can be found in their Recession Dating Procedure here.

It states:

“A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. “

That's not an exact definition, but there are a lot of economic indicators out there to take into account. So only focusing on 1 or 2 metrics does not make sense.

Looking at many different economic inputs gives us a more accurate view of how well the economy is doing as a whole.

What is a Depression?

So what's the difference between a recession and a depression?

Like with a recession, there isn't an exact quantitative definition of a depression. But generally speaking, it's a longer and more severe version of a recession.

Some people used to define a depression as a 10% or greater drop in GDP, but that definition is no longer used.

A Final Word of Warning

Just because a market is recession proof, does not mean that you will always be able to make money in that market. You'll need skill and a proven trading method to consistently make money in Forex.

There is always risk in trading.

But if a market provides good opportunities, regardless of overall economic conditions, it can be a great market to specialize in.

If you don't have a proven trading strategy yet, then don't start trading until you do.

Go to our Strategies page to get some ideas on strategies that might work for you.

We have tested several strategies and show you the results.

Then learn how to backtest that strategy so you know if it works or not.

Backtesting will also give you deep confidence that a strategy will work. When you have confidence in your strategy, you're much more likely to follow it.

Conclusion

Forex is a great market to trade because you can trade very small position sizes, there's a lot of liquidity, and it's equally easy to go long or short.

This makes it one of the most recession proof trading markets available.

Luckily, Forex is also an easy market to backtest. That's the easiest way to understand what happens to individual currency pairs during a recession.

You don't have to test thousands of individual stocks or worry about using different contract months, like in the futures markets.

Get started with our Complete Backtesting Guide here.

The post Is Forex Recession Proof? appeared first on Trading Heroes.

The race to the bottom amongst central banks has not stopped at zero and has extended into negative interest rate policy. Currently, the Bank of Japan and the European Central Bank employ a policy that includes negative interest rates.

Both policies have pushed long term interest rates down sharp enough to generate negative rates as far out as 10-years. This means that is you purchase a Japanese sovereign government bond, with a 10-year tenor, you will lose money at maturity.

So what are negative rates and why would a central bank employ this strategy? First a little about central banks…

The Function of Central Banks

In general, a central bank is a bank of a country or union (such as the European Monetary Union). Institutional commercial banking companies have accounts at the central bank just like you would have an account at your local bank.

These central bank accounts allow it to handle its daily business. By making policy tighter, the central bank restricts the business of a money center bank and when policy is looser, business can flourish.

A Negative Interest Rate Explained

A negative interest rate is similar to a regular interest rate but instead of the borrower paying the lender, the lender pays the borrower.

With a regular rate the central bank would pay a commercial bank interest on its deposits, with a negative rate, the commercial bank has to pay the central bank an interest rate to keep money on deposit at the central bank. Central banks lend and borrow to commercial banks all the time and their overnight rates set a floor and ceiling for borrowing and lending.

So rates in a few developed countries are now negative. In Japan, the deposit rate, which is the lower rate is negative. This means that instead of receiving interest on deposits commercial banks in Japan now have to pay for depositing funds at the Bank of Japan.

Now, just because the deposit rate in Japan is negative does not mean all interest rates in Japan are negative. While nearly all sovereign bonds are in negative territory, such as the Japanese government bond, corporate bonds, municipal bonds, and high yields bonds have positive interest rates.

The interest rate used by the European Central Bank for refinancing is zero. This is the rate paid by banks when they borrow from the ECB for longer than overnight. So why would someone want to pay the government money to hold on to capital for 10-years?

The answer is safety.

Government bonds at G3 countries, such as the United States, Europe and Japan are considered risk free, meaning there is little chance if any that you will lose your money because the sovereign nation defaults. Since there is a lack of options for pension funds that need to hold on to risk free instruments, the 10-year bond is in some cases a necessity.

Is Purchasing a Bond with a Negative Rate Crazy?

In a way, pledging your money to a country where you need to pay them to hold on to your money for 10-years, is crazy, and that is exactly how these central banks want you to feel. They want you to take more risk and place your money in assets that will increase in value, so you will feel wealthier and potential spend some more money.

The central bank removes a portion of a commercial banks capital every day when the interest rate is negative. In theory, a commercial bank would reduce its reserves considerably when there are negative rates in an effort to reduce their costs.

Generally, the central bank only charges on reserve balances over a specific amount. Commercial banks cannot use their excess reserves to lend money to consumer, they only can use this excess capital to lend to other institutions.

The central banks created excess reserve to protect against adverse market scenarios. Prior to the financial crisis in 2008, commercial banks rarely had excess reserve, but in a world were some banks are too big to fail, this process is now deemed necessary.

For times when market volatility is beyond what is considered normal, central banks have created extra reserves for emergency situations. For situations like the European Debt Crisis, banks were afraid to lend to one another the central bank needed the excess reserve to keep commercial banks solvent.

Negative Rates Generate Price Appreciation

Does a negative deposit rate help generate price appreciation? Sure, if a commercial bank is being punished for keeping excess reserve on hand, they are more likely to lend that money to another commercial bank, helping to stimulate growth and inflation.

In essence this pushes the lending rate down. As banks start to attempt to lend their excess reserves to other commercial banks, they run into competition which further reduces the rate.

The decline in the overnight rate drags down other rates making it cheap for consumers to borrow. When consumers borrow at lower rates they tend to invest and spend more money.

Negative interest rate also incentivizes banks and investors to purchase items that are like capital such as short term debt and other safe government instruments. Rates for financing in the capital markets will also decline along with the decline in the deposit rate.

So how does a negative rate effect a currency?

Well, when you purchase a currency pair you receive the interest rate of the currency you are long and pay away the interest rate of the currency you are short. This is referred to as the yield differential.

If you are long a currency that has a negative rate and short a currency that has a positive rate, you will be paying away on both sides of your trade. The negative rate currency becomes unattractive which is also a goal of a central bank.

Negative rates in theory make a currency less attractive and therefore should decline in value. So if you are long the CAD versus the USD you would be paying away to hold that position.

Conclusion

The introduction of negative interest rates is relatively new, and both the ECB and BoJ are not sure how this experiment will play out. Both Japan and the Eurozone are facing low inflation and so far, this technique has not been able to increase inflation to the target range of 2%.

This is a guest post by Irit Rutenberg at FX Empire. All opinions expressed are those of FX Empire and not of Trading Heroes. 

The post What is a Negative Interest Rate? appeared first on Trading Heroes.

Oh snap!

The Fed is dovish.

Wait…what does that mean again? 

Are they raising interest rates or lowering them? Does that mean that the US dollar will go up or down?

Sound familiar?

I used to get confused by the terms hawkish and dovish. Both with the meanings and more importantly, how each monetary policy can affect the value of a country's currency.

But whenever you read something about monetary policy, it's usually in geek-speak and it takes a few minutes to digest the real meaning and real-life application of the terms.

Want some plain English?

In this post, I'll give you the trader's definition of both hawkish and dovish, and show you two easy mnemonics that you can use to remember them in the future. 

Remember that there are a lot of factors in play in a nation's economy.

So while I'm going to make this as easy to understand as possible, the effect of monetary policy on a nation's economy is never black and white.

Introduction to Hawkish and Dovish Monetary Policy

Hawkish and dovish are terms that refer to the general sentiment of the central bank of any country, or anyone talking about a country's monetary policy.

They are not concrete, in the way that the Nonfarm Payrolls (NFP) number was 255,000 this week.

It is simply a way to refer to an overall outlook, and opinions will vary…greatly.

Some people may think that the ECB (European Central Bank) is dovish, while others may think that it is hawkish.

To make things more interesting, the hawkishness or dovishness usually has to be read “between the lines.” A central bank will not come out and say:

“We will be hawkish for exactly three months, starting…now!”

OK, they might. But you will usually have to infer that from their public statements.

But then they could change their mind tomorrow.

…or they could be straight-up lying.

Keeping that in mind, let's get into the definitions…

Definition of Hawkish

A hawkish stance is when a central bank wants to guard against excessive inflation.

I'm sure that you understand the simple definition of inflation, which is: the overall price of goods and services increases. 

Inflation happens when the economy is growing. This leads to an increase in wages and/or the cost of raw products. This could happen for a variety of reasons, some of which you can read about in detail here.

Obviously, if everyday goods and services good too expensive, too quickly, people will be unable or unwilling to buy things. This prevents money from changing hands and slows down the economy.

Central banks don't want the economy to grow too quickly, because it is not sustainable.

So they try to keep the economy growing at more reasonable pace by being hawkish, or watching over inflation. They usually do this by raising interest rates. 

When money becomes more expensive to borrow, it slows the growth of the economy because it makes it harder for businesses to grow by using borrowed money to expand, and people will spend less through borrowed money, like credit cards.

How a Hawkish Monetary Policy Affects Forex Traders (in theory)

When interest rates increase, that will usually cause the value of a currency to rise.

No surprise here.

International investors will move their money to a place where they can get higher interest rates.

You would do the same thing, right?

It's like if Bank A paid an annual 1% interest on their savings accounts, but Bank B paid 4% per year. You would probably move your money to Bank B to get the extra 3%.

Keep in mind that just because a central bank increases interest rates, that does not mean that a currency will automatically rise in value.

There are many complex factors at play in a national economy.

It can also depend on the amount of the increase, the post-increase rate relative to other countries and if the increase was expected or not.

But if you want to keep things really simple, a hawkish stance can be a clue that interest rates may increase and thus, the value of the currency might increase too. 

Remembering the Definition of Hawkish

If you are having trouble remembering which is which, remember that hawks fly much higher than doves.

So everything hawkish has to do with things going up:

• A hawkish stance is guarding against inflation getting too high. Think about a hawk circling to protecting the upper limit of inflation.
• To curb inflation, a hawkish policy will increase interest rates, or some other equivalent action.
• An increase in interest rates can cause an increase (strengthening) in the country's currency.

Definition of Dovish

Dovish is the opposite of hawkish. This is when an economy is not growing and the government wants to guard agains deflation.

…which is a decrease in the cost of goods and services.

Learn more about deflation here.

In other words, they want to do something to stimulate the economy. In order for people to start spending more money on goods and services, the central bank will usually lower interest rates.

When it is easier (cheaper) to borrow money, businesses can expand more easily and consumers will usually spend more money by using credit cards or other types of debt, to finance purchases.

How a Dovish Monetary Policy Affects Traders (in theory)

So, as you probably know by now, a dovish monetary policy will lead to lower interest rates (or an equivalent action) and a possible weakening of the country's currency.

Although a lower interest rate will usually weaken a currency, what also matters is the interest rate, relative to the interest rate of other countries.

If an interest rate is lowered, but it is still much higher than the interest rate of other countries, then the reduction probably won't have a very big impact on the value of the country's currency.

Remembering the Definition of Dovish

You usually see doves on the ground. 

Therefore:

• When a central bank is dovish, they are guarding against deflation, or the cost of goods and services getting too low.
• Interest rates might be lowered
• If interest rates are lowered, then the value of a currency may decrease

Where to Get Monetary Policy Information

Now that you understand the two terms, it's time to learn where to get this information. It would be nice if you could go to a website that told you the current bias of every central bank in the world.

But as I mentioned in the beginning, it's not that easy. To understand if a central bank is hawkish or dovish…or neither, you have to read their public statements.

Here are the websites of the biggest central banks, to get you started.

• US Federal Reserve Monetary Policy Report (FOMC)
• European Central Bank (ECB)
• Swiss National Bank (SNB)
• Bank of Japan (BOJ)
• Reserve Bank of New Zealand (RBNZ)
• Bank of Canada (BOC) 
• Bank of England (BOE)
• Reserve Bank of Australia (RBA)

Conclusion

At this point, you may be wondering where central bank interest rates fit into the overall picture of a nation's economy.

This interest rate is the rate at which other banks in a country can borrow money from the country's central bank.

For example, in the United States, the central bank is the Federal Reserve.

The central bank interest rate determines the rate at which other banks like Chase can borrow from the Federal Reserve.

This has a “trickle down” effect and determines the rates of everything from savings account yields, to credit card interest rates, to mortgage rates.

See current central bank interest rates here.

If you were confused between hawkish and dovish before, I hope that this post cleared things up.

The post Hawkish and Dovish Meaning (Monetary Policy) appeared first on Trading Heroes.