With an estimated $4 trillion daily, forex trading dwarfs other markets in terms of volume. And stock market chaos is driving more investors to the currency markets. Frank Hemsley says forex trends are prone to overshoot. That means the British pound could fall much further against the US dollar in the coming months. It may be a bold call, but Frank says pound-dollar parity by the end of the year is a real possibility.

This from Fleet Street Daily:

Investors tend to fixate on the stock market as a way to make money. When stock markets are in chaos, they see no way out. I’m surprised that so few investors pay attention to the currency markets. After all, in terms of volume and value, the Forex dwarfs the equity markets. But I get the feeling that’s going to change.

Currency stories are all over the financial pages at the moment — and investors are starting to realise that there’s a way to play it. For the more adventurous investor, spread betting offers easy access to a once out-of-reach market. But then not everyone is into that kind of leveraged speculation.

There are safer ways to play this new-found interest in the currency market. I’ll introduce you to a colleague who’s found a conservative way to do it in a moment. But let’s just talk a bit about context first.

The Bank of England has little choice but to cut interest rates and cut them aggressively. We could even see an emergency cut ahead of the next scheduled meeting on 5th/6th November.

That’s bad news for the pound. Money chases yield. So if the UK base rate falls from the current 4.5% to, say, 2%, then sterling becomes a lot less attractive to yield chasers.

The pound was worth two dollars in August. It’s now worth not much more than 1.5. I’ve even seen calls for year-end pound-dollar parity — one pound for one dollar. And why not? I mean already in just the last three months, the pound has fallen almost 50 cents. Why shouldn’t it fall a further 50 cents in the next two months?

When Forex trends take hold, they can run and run. And they can overshoot, just like all markets tend to overshoot. With the picture as bleak as it is for the UK economy right now, it’s got every chance of doing that.

We’ve got rapidly rising unemployment. We have a burgeoning trade deficit. The housing market will continue falling. And the whole financial crisis is drawing investors away from the UK.

“Sterling has long been particularly vulnerable because the imbalances in the UK economy — notably the dire state of households finances and the large external deficit — are just as severe as those in the US,” said Julian Jessop, chief international economist at Capital Economics.

And we should remember that UK rate cuts are likely to be much more aggressive than in the US. That’s because we have more room to cut. Our base rate is at 4.5% compared to the current 1.5% in the US.

Of course, this is largely priced into the cable rate already. Even so, sentiment is against the pound. We’ve seen what sentiment has done to stock markets recently. In these extraordinary times, we could quite easily see extraordinary moves.

Pound/dollar parity is certainly a bold call. But then so, it seemed, was calling the FTSE at 3,500 just a few months ago — and it’s not far away from that level right now. And colleague, Bill Bonner’s “Dow 5,000″ call suddenly looks very “on the money”.

The last time the pound came close to parity with the dollar was in February 1985, Back then, cable touched $1.02 at one point during trading. It might not get there this time, but it could certainly have another go.

Source: When Stock Markets Are In Chaos…