Forex Trading Liquidity Trap: What It Is and How to Avoid It
August 27, 2021
Forex Trading is closely tied to the performance of the real economy. Often, these performances serve as a reference for traders, allowing them to cultivate better chances of intuiting the real movement of prices. In other cases, they act as an obstacle to serene investment activity and create genuine distortions. This is the case with the liquidity trap, a phenomenon that has been known and studied for almost a century but continues to worry traders (as well as economists).
We discuss this topic in this article, also providing some general advice on how to emerge from it with your head held high.
What is the liquidity trap?
The term liquidity trap doesn't say much, except that it concerns monetary transmission. In fact, the liquidity trap can be defined as a chronic pathology of monetary transmission. In essence, when this phenomenon erupts, economic actors do not respond to stimuli, the increase in money supply.
Instead of using the money that central banks inject into the economic system, they hoard it and transform it into savings. In this way, the effects of expansionary monetary policies, i.e., the increase in supply, diminish until they reach zero. As a result, prices do not rise, and low inflation remains unchanged or decreases further.
What is the genesis, or to use a medical term, the etiology of the liquidity trap? It usually occurs following an "abuse" of expansionary monetary policies, that is, when they have been in place for a long time and with a high degree of intensity. In other words, when interest rates are very low, close to zero, and an substantial Quantitative Easing program is active.
If these monetary policies prove to be less effective and inflation is slow to rise, economic actors become convinced that prices are destined to remain low, so they have no interest in spending the extra money. The other necessary condition for the liquidity trap to be triggered is economic stagnation - or worse - recession. Another reason why economic actors simply "do not move" and save to protect themselves from a gloomy future.
Escaping the liquidity trap is very complicated. Also because central banks have rather limited tools at their disposal. Interest rates cannot fall below a certain level, and it is always best not to overdo Quantitative Easing (to avoid causing speculative bubbles). On the other hand, some examples of liquidity traps demonstrate their extremely long life cycle. Japan, for instance, has been "trapped" for more than a decade: monetary policies are perpetually expansionary, yet inflation is anchored below the 2% target.
The damage of the liquidity trap
It is evident that the way out of the liquidity trap cannot be monetary. The good old Keynes identified a solution at the time, which is - in technical jargon - fiscal and political. It is necessary to act on fiscal policy and labor policy, which must be based on public investments. Only with substantial public investments is it possible to utilize that "dormant" and effectively wasted liquidity, and move the economy out of its torpor, or rather, from the trap that constrains it to immobility.
Also because the liquidity trap causes damage not only at the macro level but also at the micro level. These are the damages of low inflation, which in the long run contracts wages and compromises the labor market, with further consequent damage to production, the industrial fabric, etc.
The liquidity trap not only harms the economy but also investors and, in particular, Forex traders. If inflation is stagnant, the chances of currency prices also "stagnating" are truly significant.
The liquidity trap, an epigone of immobility, favors the achievement of an equilibrium between currencies. This means fewer fluctuations and less profound oscillations. Now, excessive volatility is harmful as it generates unpredictability, but "calm" can also cause damage and hinder the production of surplus worthy of the name. So yes, the liquidity trap is also a problem for traders.
How traders can defend themselves from the liquidity trap
Can Forex traders defend themselves from the liquidity trap? The answer is yes. In fact, there are mainly two methods. The first is the most draconian: change assets. Of course, economies are interdependent and often follow the same pattern. The same phenomenon is observed with central banks, to the point that there is talk of convergence of monetary policies.
However, it is truly rare for the liquidity trap to simultaneously affect a significant number of economies. Therefore, it is always (or almost always) possible to find currency pairs that are not compromised by the "trap." Of course, this solution requires study and preparation, since moving from one asset to another is no easy task, but it is still a path that can be attempted.
The other solution is not as draconian but is still complex to implement: modify the time horizon of one's trading activity. If a currency pair, being compromised by the liquidity trap, has reached an equilibrium, it does not mean that oscillations are completely absent. In the vast majority of cases, short-term oscillations are still present. Therefore, it is on those that one must focus.
It is essentially a matter of switching to short-term, fast, or intraday trading. Scalping can be an idea, but it should be considered as a last resort. In any case, as the most adventurous traders have discovered the hard way, Scalping is also very difficult to put into practice, and most of the time, it risks proving to be a counterproductive approach.
Not that changing the time horizon is simple, but it is a solution to consider. Again, study and preparation are necessary, especially if one's approach was accustomed to favoring the long term.
The advice, in these cases, is to focus on demo accounts. These are considered tools for beginners, for those who still need to practice. However, they can also be used by long-time traders if they need to experiment with new situations (such as switching to a faster approach).
