Documente Academic
Documente Profesional
Documente Cultură
Vol. 1: 2004-2005
Combining
fundamentals
and technicals in FX trading
BY BARBARA ROCKEFELLER
few big European companies (such as a header when Q2 GDP was low, and euro/U.S. dollar (EUR/USD) spot
Siemens) won longer working hours low specifically because the domestic rate. The price data is inverted to
without higher pay in a settlement demand component of GDP was soft. reflect the dollar’s value. The down-
with the unions, the euro benefited Similarly, in the U.S., the dollar took trend started July 6, 2001, and has last-
immediately. Everyone knew right a bath in early August when the non- ed more than three years so far, punc-
away this was news that modified the farm payroll number (part of the tuated by corrections.
key structural concern. monthly employment report) for July Notice at the end of the chart the
Cyclical data. Cyclical data, which came in abnormally weak — even dollar made a higher low in June,
consists of the regularly reported eco- though payrolls are not correlated which is connected to the February
nomic factors such as GDP, trade bal- with any other important cyclical indi- low by an upward-sloping support
ances, producer and consumer prices, cator — because the market had line. Price is above the long-term linear
retail sales, etc., must be evaluated in become obsessed with payrolls as a regression line (see “Indicators in the
the context of structural conditions. symbol of growth. issue,” p. 58), too. This up move in the
Except for a few big items such as GDP Foreign exchange rates are correlat- dollar started in April — just when
growth, cyclical data that is not rele- ed with growth, so the U.S. recovery in high U.S. first-quarter growth started
vant in the context of current structur- recent quarters gave birth to the per- to sink in. Is the most recent up move
al conditions tends to be ignored. fectly reasonable idea that the three- another correction that could turn into
For example, when it was evident year dollar downtrend might be com- a trend reversal? The downward envi-
Japanese GDP was growing faster than ing to an end. However, if this proves ronmental bias is very strong, so it will
U.S. GDP in Q4 2003, it was a wake-up to be the case, it would be a triumph of take powerful cyclicals or other factors
call because such high growth, not seen cyclicals overcoming a deep, unfavor- to overcome it.
in a decade, potentially signaled the able structural bias — a very tough Strangely enough, a powerful factor
beginning of the end for Japanese defla- thing to achieve. could be price moves themselves. The
tion. The yen got a boost from the Q4 Trend. The market environment also FX market, like other markets, watches
and Q1 GDP reports as the structural includes the long-term trend of the itself. Market action is a factor in the
bias was being revised — but then took exchange rate. Figure 1 shows the next market move, independent of
structural and cyclical concerns —
a feedback process George Soros
FIGURE 1 — THE ENVIRONMENT: EURO/DOLLAR TREND (SPOT, WEEKLY)
referred to as “reflexivity.”
The U.S. economic recovery in recent quarters gave birth to the idea the three-year dollar A very high percentage of FX
downtrend might be coming to an end. If correct, it would be a triumph of cyclicals over- traders depend on technical analy-
coming a deep, structurally-based downward bias. sis of one stripe or another, includ-
Euro/U.S. dollar rate (EUR/USD), weekly ing ideas such as the exhaustion of
a trend pattern. It may seem
0.85 strange to include technical factors
in a list of market sentiment deter-
0.90
minants, which we normally
would think of as “fundamentals,”
0.95
like the current account deficit or
GDP. But in practice, FX technical
1.00
factors can be as weighty as the
1.05
cyclicals in any given period — and
a big enough technical trend
1.10 change can alter perception of
structural conditions, too.
1.15 In other words, we think of the
technicals as reflecting fundamen-
1.20 tals, but we have dozens of funda-
mentals, so sometimes a technical-
1.25 driven change forces us to shift our
perception of which fundamentals
Support line?
are the important ones. Technicals
2001 2002 2003 2004 don’t “influence” the fundamen-
M A M J J A SO N D J F M A M J J A S O N D J FMA M J J A S O N D J FM A M J J A S O
tals, but they influence how much
Source: MetaStock; data - eSignal
continued on p. 5
relative weight we give them. overall negative bias, just as a few bad for more than a brief period.
Institutional factors include the few numbers won’t make much of a dent in Event news operates on a different
tidbits of “dollar policy” that some- a positive bias. A string of all-bad or scale altogether. It can be scheduled
times fall from the lips of the Treasury all-good numbers can cumulatively do news, such as the employment report,
Secretary, but mostly the institutional the job, though. or it can be an out-of-the-blue shock,
component is all Fed, all the time. News comes in two flavors: regular such as the Sept. 11, 2001, terrorist
In July 2004, for example, the Fed daily news that turns the market-senti- attacks. News that rises to the “event”
chairman asserted any soft spots in the ment dial toward bullish or bearish, level is by nature wildly different from
economy were transitory and the mar- and “event”-type news that changes the consensus estimate, such as when
ket should expect “measured” rises in everything. Both garden-variety and payrolls come in at 32,000 when they
the Fed Funds rate that would normal- event-type news influence the envi- were forecast at 225,000, which was the
Except for a few big items such as GDP growth, cyclical data that is not relevant
in the context of current structural conditions tends to be ignored.
Trade numbers have a curious track nect between the data and the Fed’s now it’s right up there near the top of
record in forex analysis. They are a key actions will arouse talk of the Fed the heap, while industrial production
variable in fundamental cyclical analy- being “off the curve.” (Note that dis- and capacity utilization data, which
sis, and yet they hardly ever produce an satisfaction with the Fed is itself an was big in the late 1970s and early
“announcement effect.” This time, environmental negative.) 1980s, is routinely ignored. Oil price
though, the reaction was tremendous 2. The period right after an event moves are events in mid-August and
and constituted a second event. The shock is characterized by the market probably for a long time to come, while
euro hit a nearly one-month high and ignoring news counter to the direc- inflation data has the potential to be an
closed at its high for the day. Now all tion of the shock and exaggerating event. The stock market has a very
doubt was removed. The dollar the importance of news in the direc- inconsistent correlation coefficient with
bears/euro bulls won. The new consen- tion of the shock. In a negative-bias the dollar, but sometimes the FX mar-
sus was the bias is back — big time — environment, the market will stick like ket chooses it as a factor.
and the euro would target new highs. Velcro to bad news. Moderately bad At any one time, only a handful of
The wide-range-bar effect is some- news is blown out of proportion, truly factors are potential events and you
what reliable, but you absolutely must bad news dramatically accelerates the can neglect the rest. If you are risk-
know the bias embedded in market move, and there is almost no good averse, avoid having positions when
sentiment ahead of time and how the news with enough weight to reverse or the news contains a potential event. If
cyclical data fits into it. Of the 39 wide- even dent the move once an event has you are risk-seeking, learn to evaluate
range down bars over the past four reinforced the bias. This works in the tolerance limits of the news so you
years, the euro was trading lower 15 reverse, too. When the environment can instantly judge when news is going
days later only 40 percent of the time. generates a favorable bias, bad news is to become an event.
Of the 57 wide-range bar up moves not heeded. Remember the “Teflon 4. The bar itself is chock-full of
over the past four years, the euro was dollar” in the late 1990s? Bad cyclical information. The one-day bet against
higher 15 days after the big-bar day 60 news didn’t stick. the dollar the day before the news was
percent of the time. Currently, it would take the capture a warning the market was itching for an
Here’s where things get a little tricky. of Osama bin Laden, a major and sus- excuse to sell dollars. Because no one
If you know a news announcement will tainable drop in the price of oil, or can forecast the payrolls series with any
be an event shock if the data deviates something else from left field to gener- degree of accuracy and nobody had
wildly from the consensus estimate, ate even a wobble, let alone a reversal. inside information, this was the big-pic-
you can forecast a wide-range day and, Event shocks generally last a minimum ture, long-term bias at work.
thus, take the trade in the direction of of one week, often three to six weeks, 5. A wide-range bar with a close at the
the bias on the same day as the and in the case of an economic variable high is rarely just a meaningless spike
announcement with a better than 50-50 with implications for other economic when associated with an event. There
chance of being right, not only on the data, sometimes many months. are meaningless spikes in FX prices, but
same day but also 15 days later. (And 3. Know ahead of time which news this was not one of them. And a double-
traders know this, which is why profit- is capable of becoming an event and whammy set of big-bar days with closes
taking in the euro after the wide-range triggering a breakout move. A good at the high was pretty conclusive.
days on the chart was so modest.) trader is prepared. Fashion changes When the market is likely to trans-
regarding what news stories/environ- form news into an event, watch the bar
Lessons mental factors have the potential to as it unfolds. A price bar is as close as
The euro scenario in Figure 2 offers a goose a currency — you owe it to you can get to a direct response to
number of lessons about processing and yourself to know what they are. news — immediate market sentiment.
acting on fundamental information. As mentioned, the trade deficit hard- You should almost always enter on an
1. Cyclical news, when it consti- ly ever does it, at least not on its own. event, even though you won’t get in at
tutes an event shock, trumps the Payrolls have been at the top of the list the very beginning.
institutional environment. The Fed for about a year, deservedly or not. The
did, in fact, raise rates after the Institute of Supply Management report
employment report event and the mar- (formerly the Purchasing Managers
ket yawned. If anything, the discon- Index) was not important for years, but
BY BARBARA ROCKEFELLER
Yield
ical data set unless you col- 1.17
lect it yourself or pay a data 1.16 98.5
1.15
vendor. 1.14 99.0
1.13
Professional FX traders 1.12 99.5
1.11
have charts of 10-year note 1.10 100.0
1.09
pairs on terminals as a mat- 1.08 101.0
ter of course. In fact, they 1.07
1.06 101.5
set up such charts to show 1.05
1.03 102.0
only the yield differentials, 1.02
1.01
and overlay the relevant 1.00
currency pairs. This is illus- 2003 2004
trated in Figure 2, which Source: eSignal and Reuters DataLink
shows the U.S. 10-year T-
note/German Bund yield differential (courtesy of currency trader Bob The chart shows a daily time frame,
along with the euro/U.S. dollar rate Sinche at Bank of America). continued on p. 10
1.255
1.2800 0.20
25 Nov.
0.10
1.2600
0.00 Yield difference
1.2400 -0.10
Euro price
-0.20
1.2200
-0.30
1.2000 -0.40
1.1800
15 2 16 1 15 1 15 3 17 1 15 1 15 2 16 1 15 1 15
Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct.
Source: Bloomberg
but in practice you could display the minal, it’s the devil to get the same get an insight into the likelihood of a
information in hourly bars, 15-minute information and display it usefully. trend persisting. In this case, the dif-
bars or any other configuration. Bond However, you can construct a rough- ferential favoring the dollar was losing
traders respond to the same informa- and-ready alternative by subtracting points, but the dollar wasn’t falling
tion we watch in the FX market — pay- the CBOT bond futures contract from commensurately. The bond market
rolls, business and consumer confi- the Eurex Bund futures contract to get was setting up the dollar for a fall.
dence surveys, inflation rates, etc., in the price differential, then making an Using futures prices to derive the
both countries — and their collective index out of that (see Figure 3). Again, yield differential, by the way, compli-
judgment of fresh data is reflected on the euro slip-slides sideways all sum- cates matters somewhat, because the
the chart. mer while the index is falling, indicat- primary difference between the cash
On this chart, the euro (solid line) ing the price difference (and therefore price and the futures price is the cost of
fell from a peak in February to lows in the yield differential) is narrowing. financing the futures position.
April and May as the differential (dot- You can get the CBOT and Eurex Financing a three-month futures posi-
tion entails using a three-month
financing cost, so the three-month dif-
When capital flows are free from taxes and ferential is already built into bond
futures prices as well as currency
regulation, the country with the highest real return futures price.
Now consider that in between the
will attract the most capital inflow. three-month financing cost and the
yield on the 10-year note is all the rest of
the yield curve, and yield curves
ted line) went over -.40 points against data from many data vendors, change shape. Over the summer of 2004
the euro (right scale). Then the yield although you’ll have to pay two and into the fall, the yield curve in the
differential against the euro started to exchange fees for what really is one U.S. was flattening due to growing
move back toward zero into piece of data. Alternately, you can get expectations the “soft patch” would
September, while the euro was mostly the live data free with a time delay persist and the Fed would be slow
in an uptrend. from Internet sources such as about raising interest rates. Meanwhile,
In September, there was a curious www.futuresource.com. the European yield curve was already
divergence in which the euro fell while It’s a laborious process, but it may fairly flat, having a higher starting
the yield differential was still shrink- be worth the cost and effort when you point at the short end and reflecting the
ing. That’s a divergence that
doesn’t make sense. There
FIGURE 3 — BUND MINUS T-BOND FUTURES WITH EURO FX CONTINUOUS FUTURES
should not be a bias against
a currency (the euro) when The Euro FX (blue) slides sideways all summer while the Bund-bond index (black) falls,
its return is getting closer to which means the yield differential is narrowing.
the return on its competitor,
3.0 1.30
the dollar. Hence, if you
were watching this chart, 3.5 1.25
you could have predicted
Bund-bond differential
1.20
the euro was being oversold 4.0
and was going to rise, as it 1.15
4.5
subsequently did. The euro 1.10
Euro FX
lion in Agencies, while Taiwan also dollar earnings. At the September tion forecasts, although insisting the
sold $1.1 billion in Treasuries. Hong Treasury auction of 10-year notes, for- U.S. is not in imminent danger of a
Kong, Singapore and South Korea eign central banks bought only 2.8 per- wholesale pullout. Well, no wonder.
were all small buyers. Counties that cent of the offering, after taking 38 per- The U.S. $23 trillion bond market is the
represent speculators rather than cen- cent and 54 percent of the two previ- biggest in the world by far.
tral banks — the Caymans and ous 10-year auctions. Foreign central To some extent, the falling dollar
Bahamas — were still buyers, but in banks were back in October, taking 32 contains the seed of bond market sal-
lesser amounts.
A smaller monthly number that still
has a cushion is not cause for big
alarm, but we also need to worry When buyers put new money into a country’s
about the variability of the inflows.
The monthly number varies from as bonds, by definition they are also demanding
high as $104 billion (May 2003) to as
low as $6.2 billion (September 2003). the country’s currency.
We care about foreign inflows into
the U.S. more than any other country
because the U.S. current account
deficit is the gorilla in the living room, percent, but their mysterious absence vation. Bond traders have to offer
generating a need for $50-55 billion in September is a nagging worry. cheaper prices/higher yields to get
per month just to balance the outflow Worrywarts fret foreigners will at buyers to buy, which in turn provides
of dollar cash in trade. some point consider they have as dollar demand to the FX market. But
China made $5 billion from selling much U.S. paper as they want to hold. as we know, a trend is a hard thing to
to the U.S. but didn’t turn around and Fed and Treasury officials mention the shift once it gets going. Watch the rela-
reinvest in it in U.S. paper; China sold potential exhaustion of foreign tive bond yields for clues as to the per-
U.S. Treasuries and bought only $2.5 demand from time to time as a key sistence of the dollar downtrend and
billion in Agencies — less than half its background factor for dollar deprecia- its possible end.
FIGURE 1 — TWO CURRENT ACCOUNT PANICS: EURO/DOLLAR, 2003-2004 were willing to increase their net hold-
In late 2003 and currently, the dollar has plunged vs. the euro. ings of dollar-denominated assets by
5.8 percent in a month when the dollar
euro (EUR), daily 1.33 was falling by 1.3 percent. Crisis?
1.32
1.31 What crisis?
1.30 We have no hard evidence anybody
1.29
1.28 is unhappy about owning dollar-
1.27 denominated assets. In fact, the most
1.26
1.25 recent Treasury capital flow report
1.24 (Nov. 16) reports that net portfolio
1.23
1.22 investment rose to $63.4 billion in
1.21 September (from an upwardly-revised
1.20
1.19 $59.9 billion in August). Net portfolio
1.18 flows into the U.S. are averaging $72.2
1.17
1.16 billion per month so far this year, com-
1.15 pared to $58.2 billion in 2003 and $47.9
1.14
1.13 billion in 2002. And the cumulative
1.12 annual inflows are stunning — $649.5
Oct. Nov. Dec. 2004 Feb. Mar. Apr. May June July Aug. Sept. Ocr. Nov. billion in the first nine months of 2004:
Source: eSignal a 26 percent increase over 2003’s
$514.5 billion. Considering the actual
Street Journal to mass-market maga- would go into relatively deeper reces- rate of return on short-dated money is
zines and network TV news all sions and import even less from the zero or negative, this is quite a feat.
solemnly declare the dollar is going to U.S. This is a real Catch-22. China, for example, is sitting on $60
hell in a handbasket. So why do we have the Federal billion in dollar cash.
Traders flinch at such a consensus, Reserve and the U.S. Treasury out on The capital inflows are more than
because when everybody agrees and the conference circuit goading the for- enough to cover the current account
has already positioned himself short eign exchange market into a frenzy deficit, which is running at an annual
dollars, there’s nobody left to sell and over the current account deficit? After rate of about $665 billion. To speak of a
push the price down. all, the current account deficit has been funding crisis is to cry wolf, and
But academics and some analysts growing steadily since 2000 — the dol- Greenspan admits it:
flinch, too, because the global imbal- lar has gone up, down and sideways “Current account imbalances, per
ance is not necessarily a bad thing. during the same period. (In fact, it has se, need not be a problem, but cumula-
Besides, devaluing the dollar won’t fix done all three in the past year.) These tive deficits...raise more complex
anything — the trade deficit will not moves are not correlated with changes issues. Market forces should over time
improve by much. A 10-percent drop in the deficit, as illustrated by Figure 1. restore, without crises, a sustainable
in the dollar induces less than a 10-per- The global imbalance obviously U.S. balance of payments. At least this
cent (if any) improvement in the trade does not have a direct one-to-one rela- is the experience of developed coun-
balance. tionship with the dollar. From an eco- tries, which since 1980, have managed
Growth in the U.S. generates more nomic standpoint, in the typical trade- and eliminated large current account
imports than growth in other coun- deficit situation, importers create an deficits, some in double digits, without
tries. Even if all the major countries oversupply of the currency. In this major disruptions.”
had the same growth rate, the U.S. case, the oversupply of dollars should “Sustainable” deficits is a reference
would still import more than other make it less valuable. However, when to a study in 2000 by the Fed showing
countries would import, including demand for dollars is high for invest- the outer limit of a current account
from the U.S. Because correcting the ment purposes, the power of the trade deficit is about 5 percent, and after
current account imbalance is mostly a deficit to depress the dollar’s price that, currency depreciation kicks in as
case of correcting the trade imbalance, becomes weak, and everybody knows an balancing mechanism (www.feder-
the only way for the U.S. to export it. alreserve.gov/pubs/ifdp/2000/692/
more than it imports would be to go This is why, from a trader’s view- default.htm). Deficits become unsus-
into slower growth or even recession. point, the monthly trade figures don’t tainable when they reach or surpass 5
But the rest of the world relies on the contain useful information. These percent of a nation’s GDP.
U.S. for export-led growth, so if the days, it’s the capital flow report that The U.S. is beyond that point today.
U.S. imports less, other countries counts. In September, global investors The Q2 current account deficit stands
account panic rolling by saying the Fed The market talks about the sustain- The wildly uneven cost of labor can
wants to normalize interest rates by ability of the current account deficit. never be equilibrated by mere curren-
nudging them higher, but the relatively Financial economists talk about the cy price adjustments. China will
high dollar is an obstacle. The Fed sustainability of the inward capital always be able to compete with U.S.
wants to normalize interest rates to a flows. But the Fed and the Treasury companies and export to the U.S. more
historically neutral level, thought to be view both the current account and the than it imports.
about 3 to 3.5 percent (from the current capital account as a by-product of real Because of the unique and unprece-
2 percent). But the Fed can manage economic activity, and what they talk dented position of the U.S. in the
rates only at the very short end of the about is the sustainability of U.S. world economy and financial system,
yield curve. The relatively high dollar growth. If it takes a weaker dollar, so devaluing the dollar is not going to
draws in foreign capital that allows
rates at the longer end of the yield
curve to be artificially low. The U.S. is not only a debtor nation; it is also
The last thing the Fed wants is a cri-
sis where it has to raise interest rates to a nation of debtors.
prevent a run on the currency, which is
what happened in the UK in 1991. The
Bank of England raised rates 3 percent be it. The dollar is not the central thing. take the current account deficit to zero
in the space of a few days in an effort In this context, it’s only a unit of or transform it into a surplus. Asian
to control the pound falling out of the account. This is the sense in which all revaluation will go a long way toward
European Rate Mechanism (the occa- the hullabaloo about the sustainability reducing the horrendous size of the
sion of Mr. Soros’ fabled billion-dollar of the current account is a hoax. It is deficit, but even after China, South
profit). It may not be too fanciful to sustainable today, but as the U.S. econ- Korea and the others revalue, we will
imagine that the Fed has been deliber- omy becomes less independently still have a trade deficit for decades to
ately driving the dollar down to avoid capable of prosperity, the longer it come. The terms of trade are against
exactly this outcome — not because it relies on foreign savings. the U.S. — Americans simply have too
gives a fig about the dollar per se, but Now we have come full circle. The high a standard of living relative to the
because it wants to set rates in its own current account deficit is not really cre- rest of the world. Moreover, as
time and according to its own ideas. ating a dollar crisis — the Fed and the Greenspan said in Berlin, raising the
Consider the Fed’s mandate. Yes, it Treasury are talking it down. They savings rate in the U.S. will go toward
has to maintain financial market stabil- must know the lower dollar will not fixing the true current account prob-
ity, but it’s far more interested in cause much improvement in the cur- lem, the dependence on foreigners, but
growth and employment than in the rent account, even if other efforts it can’t do the whole job. So, even in
terms of trade, except as the terms of behind the scenes are successful in the best of all possible worlds, we are
trade influence domestic production. pressuring China to revalue the ren- stuck with a "structural" deficit. The
Here is the hidden agenda. The Fed mimbi. It’s silly to be selling the dollar next job for the market is to decide
wants to normalize rates, not for the against the euro and other European upon a deficit-to-GDP ratio it can live
sake of normalization, but to prevent a currencies when Europe accounts for with. What’s the number? Something
run on the dollar and to restore the only about 9 percent of trade. China south of 5% of GDP.
incentive to save. After all, if the U.S. alone accounts for 30 percent of the The true solution to the U.S. current
consumed less and saved more, the deficit, and a growing proportion of it. account deficit is to let it wax and wane
trade deficit would be substantially Asia, including Japan, accounts for with cyclical developments, but not to
lower and no one would feel the urge over half of the deficit. depend on offsetting foreign capital
to stage a run on the dollar in the first But negotiations to get Asian coun- inflows. Foreign capital inflows should
place. The U.S. would not need capital tries, especially China, to repeg or to be the icing on the cake, not the cake.
flow from foreign countries to fund the float their currencies are matters of The cake should be domestic savings
current account deficit — it would state, not of economic and financial adequate to fund capital investment.
have sufficient domestic savings to management. China’s revaluation, The only way to lift up the savings rate
buy all the government and corporate which will probably occur within the is to raise the rate of return. Who is in
debt instruments on offer. This is not to next year, will provide some minor charge of rates of return? The Fed —
say the Fed places a moral judgment relief in the current account, but not a but also the folks in Washington who
on saving as a social virtue, but rather permanent fix. After all, China has bil- pass tax bills. Privatization of Social
as the one truly sustainable mecha- lions of people willing to work for Security, anyone?
nism to ensure further growth and pennies in order to get a bicycle, a
employment. sewing machine and indoor plumbing.
BY BARBARA ROCKEFELLER twisting the meaning of the news to one, they consult charts on all.
match the price action they expected to A trader at a bank or brokerage firm
I
n December, the foreign see on the chart. Traders wanted a is usually in and out of the same cur-
exchange market behaved in a retracement of the upmove, so they rency at least five, and as many as 50,
peculiar way. The euro/dollar manufactured it out of the smallest times a day, with a one- to two-hour
was trending strongly upward evidence. A manufactured retracement holding period. The goal is to make a
on dollar-negative news, but the trend is very common in foreign exchange. few bucks on the spread between buy-
then wobbled and gave back some of To recognize a manufactured retrace- ing and selling with customers and
its gains on news that traders chose to ment, you need to understand how counterparts. To do that consistently a
interpret as not dollar-negative, even professional traders view FX market trader must get the price direction
though it really was just as dollar-neg- trendedness. right, not necessarily focusing on
ative as the earlier news. Why did that Most professionals trade in all time- heavy-duty economics. Ask a trader
happen? The answer lies in traders frames, but even if they trade in only whether a particular factor is impor-
After the Federal Reserve raised a warning flag contains at least two moves in the
countertrend direction.
Nobody has ever published empiri-
about foreigners potentially losing their appetite for cal evidence proving that FX moves
follow an Elliott Wave sequence, and
U.S. securities because of the huge current account there is plenty of evidence that other
patterns are more common. But that
deficit, the monthly capital flow report became the hasn’t stopped traders from expecting
and sometimes getting them –– the
most important piece of data in the world. self-fulfilling prophecy.
In fact, one of the most fascinating
aspects of the forex market is how
Every trader picks his own time- sionals do. That’s why we have indica- commentators twist and bend news
frame and therefore his own definition tors that show a currency is over- and data to fit what they think the
of a trend. The trend concept is useful bought or oversold. A simple observa- price should do, based on an unproven
chiefly to maintain perspective and tion of a loss of momentum works theory.
sanity. It doesn’t necessarily dictate the pretty well, too. But in FX, a new
next trade. You may be able to see the appreciation of how retracements Technicals and fundamentals
euro or yen is in a long-term uptrend, develop (or should develop) is becom- The persistence of trendedness is
but also perceive the trend is momen- ing widespread. On the whole, it is because of traders grabbing hold of
tarily tired and the next best trade is to based on the Elliott Wave theory one or two key ideas and hanging on
bet on a minor correction; i.e., go short. which states that a trend proceeds by like a terrier with a bone until a bigger
You can use technicals to make a impulse waves punctuated by correc- idea comes along. The big themes
countertrend trade, and most profes- tive waves, and the corrective wave don’t change much over the years,
either, so the longer you trade
the FX market, the easier it is to
FIGURE 2 — TREND IN THE EYE OF THE BEHOLDER understand why traders
respond the way they do to cer-
Unlike the euro example in Figure 1, the "retracements" in the yen could be defined as
tain types of news and econom-
trends in their own right, and they are identified as such by the crossovers of multiple
ic developments. If you can
moving averages.
forecast the news and economic
115.5 data, you can get a head start on
Japanese yen (JPY), monthly
115.0 what the majority of traders are
114.5 going to do. Anticipating trader
114.0
113.5 reaction to news allows you to
113.0 forecast the direction of a trend
112.5
112.0 and bet on it early –– when the
111.5 juiciest profits are to be made.
111.0
110.5 It might sound silly to say
110.0 “forecast the news” when obvi-
109.5
109.0 ously no one has a crystal ball,
108.5 but in practice we usually know
108.0 the probable range of any par-
107.5
107.0 ticular piece of news and can
106.5 guess how traders will act along
106.0
105.0 the spectrum of possible out-
105.0 comes. For example, after the
104.5
104.0 Federal Reserve raised a warn-
103.5 ing flag about foreigners poten-
103.0
102.5 tially losing their appetite for
102.0 U.S. securities because of the
101.5 huge current account deficit, the
March April May Judy July August Sept. Oct. Nov. Dec. monthly capital flow report
Source: eSignal
became the most important
fully priced in. If the Fed had raised punctuated by a couple of minor this willful misreading of the news,
rates by 50 basis points instead of 25 retracements (defined here as a series but technical traders just try to figure
basis points, the hike might have offset of lower lows and lower closes that out where the retracement will end so
the bad trade and capital flow data. persists for longer than three periods they can re-enter. There are two possi-
But it was obvious the Fed wasn’t in an uptrend). bilities on the chart. We can wait for
going to raise rates by more than 25, In the first week of December, the the price to break upside resistance, or
because it told us so –– rate increases euro retraced quite a lot. In fact, daily we can watch the indicator in the
would be by “measured” amounts. lows twice penetrated the lower upper window, a momentum oscilla-
Of all the news items FX traders boundary of the linear regression tor, to signal the euro is oversold. Once
may use to rationalize their short dol- trend channel. Nobody actually the indicator pops up from the over-
lar positions, the price of oil is high on thought a trend reversal could be in sold line, the trader has a bigger profit
the list. Say oil prices rise again.
Traders will interpret the news as
worse for the dollar than for other cur- When bias toward a currency is strong, all bad news
rencies, even though European
economies tend to see a bigger second- sticks to the out-of-favor currency like Velcro, while
round inflationary effect from higher
energy prices than the U.S. (or Japan, undeniably good news slides off the currency like it
which is the most energy-efficient of
all the major countries). But you can is Teflon.
“spin” the oil news as worse for the
dollar on the grounds that higher
expected inflation in Europe will pres- the works, but when prices fall by a potential than if he or she was waiting
sure the European Central Bank to large amount like this, traders who for resistance to break.
raise its own interest rates. went long near the highs are suffering Traders will line up the true weight
Funny, the market doesn’t care much and don’t want to see their losses get of the news with the corresponding
about rates when a rate hike would bigger. A wave of stop-loss selling price change. If news continues to be
seemingly support the dollar, but now takes place, complicated in this badly dollar-negative in any objective
it’s using a short-term interest rate to instance by pre-holiday and year-end evaluation but the euro fails to rise, the
justify supporting a different currency. profit-taking by position traders who price is still in the grip of the technical
It is wildly inconsistent and even hyp- had gotten in much earlier. traders who think their retracement
ocritical, but this is the kind of slant Most analysts believe the euro will hasn’t ended. If the news is only mild-
that develops when bias toward a cur- break the upside resistance line (red), ly dollar-negative but the euro rises
rency is strong. All bad news sticks to as it has done twice before. anyway, it may be time to consider a
the out-of-favor currency like Velcro, Meanwhile, the euro is in the grip of new position even if neither of the two
while undeniably good news slides off the technicals, which dictate the technical indicators on the chart give
the currency like it is Teflon. retracement should take a particular the signal –– some other technical indi-
That’s why we can’t make a list of form — the Elliott Wave sequence. cator can always be found to justify the
FX factors once and for all and give Traders twisted the meaning of fresh position the news suggests.
each one a weight. A factor has one data during the retracement week to
weight when the price is in an impulse match that expectation. Specifically, the The market makes the news
wave –– i.e., trending strongly –– but a current account deficit was not as bad It might seem odd the news doesn’t
different weight when the price is in a as expected, so the euro fell. In any dominate the price action in foreign
corrective mode. objective analysis, this is a perverse exchange. You’d think hard data
move based on a faulty interpretation. would always have the same effect on
Anatomy of a retracement In fact, it depends on looking at the price moves –– but it doesn’t. The
The euro has been trending upward data in seasonally adjusted terms; in same data is powerful during a trend
powerfully since the first week of unadjusted terms, the current deficit and feeble when a trend is either not
September 2004 (see Figure 3, p. 21), was worse. The deficit is still 6.1 percent present or in the process of retracing. It
when the current account problem of GDP, the critical number that under- pays to know what the professionals
pushed itself to the forefront of the lies the dollar downtrend in the first are thinking, and you can be sure that
news (see “The Great Global place, and the most recent data indi- a good part of what they are thinking
Imbalance Hoax,” Currency Trader, cates a third consecutive quarter of is informed by the chart itself.
December 2004). The trend picked up worsening deficits.
steam in October and November, Economists scratch their heads at
BY BARBARA ROCKEFELLER
T
have on the FX market.
he market has been hav- fundamentals, the technical factors
ing trouble deciding rule, or seem to. Unsolvable mysteries
whether the current First there were a few big trading What’s ruling the market — the cur-
account deficit is more houses (such as UBS) saying just rent account deficit or interest rate dif-
powerfully dollar-negative than the before year-end that the dollar would ferentials? This question is unanswer-
rising interest rate environment is dol- soon start to correct from the steep able in practice — or in theory, for that
lar-positive. downtrend of the fourth quarter. Lo matter. Currencies can fall despite an
The European-led current account and behold, the retracement of the dol- interest-rate advantage, and currencies
gang believes the structural deficit is a
far weightier issue than interest-rate Greenspan expressed a wish for the dollar to rise,
differentials. In contrast, Japanese and
other Asian traders are more con-
cerned with higher rates, especially
and the market was willing to oblige.
because Japan is in a technical reces- lar downtrend started on the first trad- can rise despite a current-account dis-
sion and any monetary policy tighten- ing day of the year. advantage. These are both big “envi-
ing there is postponed. To cap that off, the Euro/U.S. dollar ronmental” background factors that
So while traders slug it out over the (EUR/USD) retracement ended only become immediate, tradable factors on
4.4 percent in both 2003 and 2002), even briefly lower). This has narrowed Figure 2 shows what it looks like, cour-
Greenspan worries about inflation. the spread between the two-year note tesy of the St. Louis Fed. The index has
A falling dollar automatically raises and the 10-year note to only 70 points been on a steady upward path. Should
the prices of imported goods (at least or so, which is a historical aberration we deduce the Fed is scared, at least a
from countries whose currencies float
against the dollar), which is inflation-
ary. FIGURE 3 – SHOP TILL YOU DROP
The price of oil, of course, is a coin- The personal expenditures index has been on a steady upward path, which
toss. Oil experts say $8-12 of the recent might make the Fed nervous about inflation. But right now, the bond market
price of approximately $48 is a premi- doesn’t show that concern.
um for the risks inherent in the major Personal Consumption Expenditures: Chain-type Price Index
oil-producing countries, from Nigeria (Index 2000=100)
and Venezuela to Saudi Arabia and
Iraq. It’s unrealistic to expect those 110
risks to subside, although on the 108
demand side, the coming of spring is
an ameliorating factor. But the impor- 106
tant point is oil has been in a serious
104
uptrend for several years now and
there’s no reason to think it will stabi- 102
lize or fall (see Figure 2).
100
The bond market conundrum
98
As it has been since last summer, the 2000 2001 2002 2003 2004 2005
big issue of the day is still the mysteri- 2005 Federal Reserve Bank of St. Louis (research.stlouisfed.org)
ous refusal of the bond market to take
the yield on the 10-year bond higher in Source: U.S. Department of Commerce, Bureau of Economic Analysis
lockstep with short-term interest rates.
Since June 2004 the Fed has raised — what Greenspan calls a “conun- little, about inflation? Well, that’s its
the Fed funds rate six times, from 2 drum.” job. But if so, why does the bond mar-
percent to 3.5 percent, while the yield We know Greenspan likes the per- ket not share that concern?
on the 10-year bond has fallen from sonal consumption expenditure price Commentators say the Fed has done
4.70 percent to about 4.2 percent (and index, which is really a GDP deflator. its job too well, and the bond market
believes the Bank will succeed in hold-
ing inflation down, so there is no need
Kaufman speaks about dollar for long-term rates to rise. Others
In an interview with The New York Times, economist Henry Kaufman ("Dr. Doom") point out that when supply is relative-
had some important things to say about the dollar. ly fixed and demand rises, prices rise
— which in the case of bonds means
He thinks China and Japan will not diversify away from the dollar because it’s self- the yield falls. Because foreigners as
defeating — if the dollar drops a lot, their "export drive" to the U.S. suffers. well as domestic buyers have not
Meanwhile, the falling dollar has very little effect on exports because the U.S. can’t shown any loss of appetite for U.S.
compete with low labor-cost countries. It would take a huge dollar drop to get the paper, the drop in the 10-year yields is
desired effect, and that’s not going to happen. no surprise.
"Today, there is an enormous international disequilibrium,” Kaufman said. “For the In fact, it’s a desirable outcome,
near term, it is in the best interest of all the participants to maintain it." because last November Greenspan
fretted about foreigners losing their
This is the Golden Goose theory I wrote about in last month's article. As for a fore- appetite. This concern came in the
cast, Kaufman sees "relative stability with occasionally a little bit of give in the value aftermath of a comment from San
of the dollar." In other words, flat to down — but not up. Francisco Fed president Janet Yellen
that so much foreign demand for U.S.
—Barbara Rockefeller
paper was hindering the Fed’s desire
Click here for The New York Times article: “The Alpha Currency? It's Still the Dollar,” to get longer rates up, too. FX traders
by William J. Holstein, Feb. 27, 2005. took each comment to mean the Fed
wanted the dollar to fall, although sub-
A pause is bad for the dollar, because European traders still believe obscure meaning for the economic out-
because now the market has built in the structural deficit is some kind of look we all got wrong, anyway. The
Fed rate hikes every period. If the dol- absolute no other factor can override. jobless recovery was supposed to
lar is falling and the Fed stops raising This is not true. There are very few deliver a recession, but the canny Fed
rates, it’s a dollar negative, so the dol- absolutes in economics and almost kept rates low and fueled a consumer
lar will fall more. If the dollar is rising none in trading.) boom via home refinancings instead.
and the Fed pauses in raising rates, the Will this approach work? Yes, prob- Now we have to watch the unfor-
dollar will stop rising and could even ably. There is likely some interest-rate castable Greenspan, who makes
fall. If the dollar is rising and the Fed level that will halt the Euro’s rise. It’s ambiguous comments in the name of
pauses in hiking rates, the dollar stops possible to imagine a double-top, for central bank transparency and dances
rising. example, that would mark the dollar every noun around the room six times
rising/Euro falling when the interest before he gets to the end of the sentence.
What does Mr. Greenspan rate differential gets big enough (see This is just another example of the
want? Figure 4). This is only one of several perversity of the FX market. Of the
The Fed chairman is resolutely anti- possible outcomes, and it assumes the thousand variables that can effect
inflation and his credentials are as Fed gets its way. Alternately, there exchange rates, it chooses the strangest
high as anyone’s have ever been. could be sideways movement if a large and most difficult — payrolls. As far as
the upcoming month goes, it’s the silly
season. We often get a sea-change in
In a technically-driven market, traders interpret February-March, including vast confu-
sion over whether the yen always rises
because of repatriation of foreign prof-
the news whatever way is most convenient its (answer: sometimes it does, but not
reliably enough to trade on). This time,
for their positions. it looks like the technicals are ruling, at
least until a compelling event related
While the high-falutin talk about “nor- number of traders think the interest- to the current account or interest rates
malizing” rates is quite convincing, rate buffer is only a finger in the dike; comes along.
Greenspan is also a pragmatist, and his for them to accept a lasting dollar
job is to prevent inflation from getting improvement, the current account
a toehold rather than satisfying some does, indeed, have to fall.
academic market model. The Fed can’t In a technically-driven market,
do anything about productivity or the traders interpret the news whatever
price of oil, but it can do something way is most convenient for their posi-
about the dollar. Greenspan can’t pos- tions. When they are feeling a nega-
Related reading
sibly want the dollar to fall, which tive-dollar bias, news that is truly dol- Other Currency Trader articles
makes his “loss of appetite” remarks lar negative, such as foreign central by Barbara Rockefeller:
last fall all the more curious. banks diversifying out of dollars, is
However, it looks like traders are exaggerated. In practice, diversifica- “Combining fundamentals and
buying the 50-percent trading rule, tion is a minor factor — only a few bil- technicals in FX trading,”
and the Euro will now return to the lion dollars against a market that October 2004.
level of last December (above 1.3600), trades more than $1.3 trillion per day. “The obscure key to successful
and perhaps beyond. But this is prob- But the public relations effect is huge, FX trading,”
ably not what the Fed wants. It’s likely and the technicals set up a random fac- November 2004.
we’ll hear more inflation warnings tor such as that to have a big effect.
from the Fed, which will be aimed at “The great global imbalance
controlling inflation but also at And the winner is… hoax,” December 2004.
prompting the bond market to raise This month, bet on the technicals, even
“Trends, retracements and news
the yield on the 10-year note to get it though the current trend being formed
in foreign exchange,”
more in line with the recent rate hikes is contrary to what the institutional
January 2005.
in the Fed funds rate. The U.S. is picture seems to be — a Fed deter-
already attracting enough capital, but mined not to have the dollar fall, or not “The Golden Goose Rule,”
a more substantial differential ensures having it fall too much. February 2005.
a bigger buffer against a dollar crash. We used to have to watch the
(It needs to be a hefty buffer, too, unforecastable payrolls report, with an
How to know
when not to trade
Different indicators can help you determine the kind of market environment
you’re in and whether you should be trading at all.
BY BARBARA ROCKEFELLER
I n all securities markets, prices
are trending, mean-reverting,
or flat (going sideways). When
prices are trending, just about
any trend-following technique will
work, even the hoary old moving aver-
age. When prices are mean-reverting,
you need to determine when an excur-
sion away from the mean has peaked,
and then “fade the trend.” There are a
number of techniques to estimate
when a price is overbought or over-
sold and will likely revert to the mean.
But how do you know when a price
is going sideways and you
should do nothing? The price
FIGURE 1 — EURO UPTREND WITH LINEAR REGRESSION LINE goes up just enough to trigger
Although the trend was obviously up during this period, there were numerous a buy trade using a trend-fol-
countertrend corrections. lowing technique, only to turn
around and give you a sell
Euro (EUR), monthly signal. This is the dreaded
1.35 whipsaw loss, which can
1.30
accumulate enough to drive
you out of the trading busi-
1.25 ness altogether — especially if
you are unlucky enough to
1.20
detect a sideways period right
1.15 at the beginning of your trad-
ing career.
1.10
This discussion of trended-
1.05 ness and mean-reversion in
the Euro and Japanese yen
1.00 will zero in on a case of side-
0.95 ways prices and how a partic-
ular technical indicator can
0.90 help prevent ruinous whip-
saw losses.
0.85
BY BARBARA ROCKEFELLER
T he professionals’ “secret”
is not a trading rule like
“buy the opening break-
out if yesterday’s close
was at the high.” Each trader has his
own trading rules, and each set of rules
is equally valid — there is more than
one right (profitable) way to trade a
market.
You can find trading rules for each
style of trading, generally organized
according to how long you plan to
hold positions. Trading rules can be
roughly categorized as belonging to
the day-trading style (holding period
of minutes), swing trading style (hold-
ing period of a few hours to a few
days), and position trading (holding
period of several days to several
months).
The secret is that professionals
know the difference between a
good loss and a bad loss.
FIGURE 1 — EURO BUYING OPPORTUNITY?
The Euro has broken out above a down trendline, and the stochastic oscillator is rising The good loss
sharply. Should you buy the Euro? How can any loss be “good,”
you ask? A good loss is the
Stochastic Oscillator (46.02) 90
80 result of taking the right posi-
70 tion given the information
60 available at the time. You
50
40 weighed the information —
30 fundamental, technical, or
20
10 both — and believed you had
a realistic expectation of a
Euro (EUR), daily profit. You took the position,
1.31 but the fates intervened and
1.30
threw a fresh piece of informa-
1.29
1.28
tion into the market, or a new
1.27 participant with different
1.26 ideas. Your position turned
1.25 into a loser, and your risk-
1.24 management rules forced you
1.23 to exit with a loss. Next case.
1.22
Notice how many assump-
1.21
1.20
tions about the trading busi-
1.19 ness are embedded in the pre-
18 25 2 9 16 23 31 6 13 20 27 4 ceding sentences. First, you
May June July gathered a lot of information
Data source: Reuters; Charts: MetaStock
to make the trading decision.
The Euro failed to sustain the upward momentum. The chart offered clues the breakout
It doesn’t matter whether the was going to fail, but if you had a preconceived notion the Euro was oversold and should
rise — and you couldn’t let go of the idea — you might have stuck with a losing trade.
decision was largely or even
entirely informed by technical Stochastic Oscillator (30.63) 90
indicators. Technical indica- 80
70
tors distill market sentiment, 60
and are as valid a decision tool 50
as any other. In fact, most 40
30
forex market observers believe 20
about 90 percent of all forex 10
traders use technical analysis
in some form. Euro (EUR), daily
Second, if you had a realis- 1.31
1.30
tic expectation of profit, you 1.29
had an idea of the probable 1.28
scope of the upcoming move 1.27
— in other words, a profit tar- 1.26
1.25
get. This is an important dif-
1.24
ference between professionals 1.23
and amateurs: Professionals 1.22
know where they plan to exit a 1.21
trade, whereas most amateurs 1.20
1.19
do not. Moreover, amateurs
4 11 18 25 2 9 16 23 31 6 13 20 27 4
kick themselves for exiting a April May June July
trade too early, no matter how Data source: Reuters; Charts: MetaStock
stupendous their gain. If the
price continued to move fur- practice, they are sometimes lucky to The bad loss
ther, they mourn the lost opportunity. get 1.5:1. If a “good” loss is one where you made
Professionals make note of this, but Professionals with losing trades the right decision but lost anyway, a
they don’t get emotional about it. already know how big the loss will be “bad” loss is one where you made a
To evaluate a trade, however, you — say $350 in the case here — and bad decision and took a loss, or made
need more than the profit expectation. therefore it hurts less when they have the right trading decision but applied
You also need to know the potential to take it. The loss is not a surprise and the wrong risk-management rules. A
loss. Let’s say you can realistically it’s also not a disaster. bad trading decision, by definition, is
expect to make $1,000 on the trade. Are Professional traders are always one in which you didn’t start out with
a positive expectancy of a gain.
When you get the price direction
Professionals know where they plan to exit a trade; wrong, it’s almost always the result of
ignoring important factors or chart
most amateurs do not. indicators because you are looking for
what you want to see instead of what is
you willing to lose $3,000 to make ready to move on to the next case. really there. This is a critical difference
$1,000? No. You would soon be out of Losses are a natural part of trading. between professionals and amateurs.
the trading business if your trades had Everyone takes losses. Anyone who Professionals clearly see what they are
that risk-reward profile. can’t take losses either doesn’t have looking at and are able to restrain their
If you want to keep losses smaller enough capital to be trading in the first prejudices and preconceptions about
than gains, your stop-loss exit point place, or lacks the psychological make- what “should” be there.
has to be a smaller distance away from up to be a trader. Professionals can For example, look at the chart in
the entry point than the expected prof- ride out losses both financially and Figure 1. The Euro has broken out
it-taking level. If you expect to make psychologically; they are confident above a down trendline, and the sto-
$1,000, your stop has to deliver a loss about their trading abilities even as chastic oscillator is rising sharply. The
of less than $1,000. Traders would love they contemplate taking a loss, and rising stochastic means the Euro had
to get a 3:1 or higher reward-risk ratio, even after they take it. been oversold and is now in the
meaning a $3 gain for every $1 loss. In continued on p. 34
process of correcting upward. On the swing-trading. Unless you sit down your stop at half that, you would exit
last bar, the close is below the close the and carefully recalculate potential on a drop of 23 points below your
day before and below the open — two gains and losses for the new time- entry. As it happens, you would have
important warnings — but the upside frame, you will not have realistic made the 45 points if you had entered
breakout is compelling. You buy the expectations for the trade. at the Chicago open. But how many
Euro. (Actually, some professionals Changing timeframes is not some- traders can change gears like this?
bought the Euro, too, but they didn’t thing you can do intuitively or on-the- Professional traders can change
buy them for a sustained holding peri- fly. You need to apply a little arith- gears like this. If the market is offering
od.) What happened next? metic to arrive at new parameters. a messy situation, they develop a new
Figure 2 shows the Euro failed to sus- Otherwise, you are just guessing, strategy to take advantage of it — in
tain the upward move. The correction which is always the wrong tactic in this instance, changing the timeframe
fizzled. The next day after the warning trading. Trading is a business that of the trade. If the world is going to
bar, the Euro put in a higher high than requires business tools. (We may think hell in a handbasket, they don’t judge
the day before, but not higher than the that in the end almost every trading it — they find the currency most
previous two days. It’s an old rule that decision is little more than an educated affected, and trade it short.
you want a three-day high (and prefer- guess, anyway, but there is a vast dif- The flexibility of the professional
trader extends to the asset being trad-
Amateurs would rather be right than make money, ed, too. If their usual currency starts
trading dead flat, they can shift to a
while professionals are willing to admit they are different one. When the Canadian dol-
lar gets stuck in a sideways range, they
wrong, and make money anyway. turn attention to, as an example, the
Swiss franc. Are all the major-traded
currencies moribund? What’s happen-
ably a three-day higher close, too) before ference between an unfounded guess ing in the exotics (the lesser-traded
you buy into a new move. This is a rule and an educated guess.) currencies such as the Swedish krona
you could use if you are a swing-trader The outcome of guessing is to apply and Mexican peso)?
or a position trader. There is no doubt the wrong risk-management rules. You
that some day-traders made money could buy the Euro the day after the The big-picture perspective
going long the Euro on the day after the warning day and make a profit, but That brings us to the final point: pro-
warning day — the Euro did venture you would have had to adjust your fessionals believe there is always
higher — but they had to be nimble to gain/loss expectations considerably. something to trade. Amateurs may
exit with a gain. It was not a well-judged Let’s say you are used to swing- complain the market isn’t trending like
trade for anyone other than a day-trader. trading over a three-day period. The it used to, or it’s too choppy.
For a real position trader, it was not even daily average range is 120 points and Professionals don’t have the luxury of
tempting. The position trader would your aim is to capture 75 percent of complaining about the market. It’s
have required a close (or two or three) that (90 points) per trade. You are will- their job to make money no matter
over the 10-day or 20-day moving aver- ing to lose 45 points per trade for a what the market is doing. Amateurs
ages, too. Instead, the price surpassed gain/loss ratio of 2:1. These metrics would rather be right than make
the 10-day moving average only once, are part of your trading plan. (The money, while professionals are willing
and never surpassed the 20-day moving other part is your technique for identi- to admit they are wrong, and make
average. fying the direction and strength of the money anyway.
This move was, therefore, a false upcoming move.) Now you shift to a The lesson is that to trade like a pro-
breakout, and a pretty minor one, at day-trading mode, where you intend fessional, you have to work a little
that. The chart gave plenty of clues to get in and out in three hours. What harder (seeing the warning signs in the
that the breakout was going to fail, but is the maximum, minimum, and aver- bar configuration), be ruthless in aban-
if you were enamored of the idea the age gain you can expect? If you don’t doning preconceived ideas about what
Euro was oversold and should rise, it know, you can’t set a reasonable stop “should” happen (taking the loss), and
was easy to talk yourself into buying or a reasonable profit target. adapt your trading style (switching
it, and then taking a loss when the In this instance, the hourly average timeframes). Then you can have confi-
breakout failed. range shrinks to only 20 points. Let’s dence that the market is a playground
Let’s say you saw the warning signs say you plan to hold for three hours, in which you can make money, and not
but decided to change your usual meaning the maximum gain you could a battlefield on which you will suffer
timeframe. You thought you could eas- expect would be 60 points. To aim for more losses than gains.
ily switch timeframe concepts to day- 75 percent of that move would be to
trading when your usual style is target a 45-point profit, and if you keep
Detecting the
professionals’ footprints:
Lessons of the Chinese revaluation
On paper, the Chinese renminbi revaluation is a historic event. But the market’s initial reaction
was fairly muted (if intriguing). Find out how things could play out in the forex
market in the new world of Chinese forex participation.
BY BARBARA ROCKEFELLER
their trades are purely speculative. It’s called hot money months).
because it’s fickle and often short-term in nature. This is The market had been watching the round number for a
traded by speculators such has hedge funds, commodity while, wondering if it constituted some form of magic sup-
trading advisors, high-net worth individuals — or the guy port, as round numbers sometimes do. The breakout below
sitting just a few desks away who is trading for the bank’s 1.2000 (see Figure 1) implied further Euro losses. Sure
own portfolio, as are his cohorts at the other major banks enough, on July 5 the Euro hit a fresh low of 1.1867, but on
and brokers. Traders who trade the bank’s own money are July 8 it managed to make a low of only 1.1874 — a mere
called “prop” traders, for “proprietary.” Not all prop seven-point difference, but it was not a lower low, which
traders are in-and-out artists, but some are. didn’t escape anyone’s notice. Moreover, the bar configura-
Nobody knows the ratio of real money to hot money. tion of those few days was not favorable to a further Euro
Most traders say hot money is a bigger proportion of total drop: On the date of the lowest low, the close was higher
trading than real money, but real money is the better bet to than the open and the previous day’s close, which proved
follow — if your client is making the trade, others in the to be the configuration for most of the next five days.
same business are probably making the same trade, and This was a signal to professionals that a bottom was
thus you are going to get a price trend (or at least a longer- forming around the support area of 1.1867-1.1874, and if
lasting price move). In fact, the real money will provide you can’t sell it for a gain, you should buy. You might say
market “support” in some cases. In the extreme case of cen- the stage was set for the Euro to rise and the dollar to fall,
tral bank intervention, the real money is very real and the but at the same time resistance was well-established at the
support level is well-advertised. previous highs around 1.2225.
That’s the first clue to finding the professionals’ foot- The next move in this little saga was the mysterious rise
prints — support and resistance, which can be a specific continued on p. 37
in the Euro on July 20. Between 1 and 3 p.m. ET — when yield on the 10-year T-note soared to 4.276 percent on the
European traders have already gone home and the U.S. assumption foreign demand for Treasuries would fall. No
market is almost finished for the day — the Euro flew one knows if this is the correct interpretation of events.
upward from 1.2042 to 1.2156 by 3 p.m., an enormous move There’s no evidence of lower demand, and even if official
at any time, and downright astonishing for the time of day. demand falls, private demand may be a perfectly adequate
Everyone was caught by surprise and scratching their substitute. Remember, much of the foreign capital inflow
heads in wonderment — yes, there was commentary from into U.S. government paper comes from the UK and
Federal Reserve Chairman Alan Greenspan’s semi-annual Caribbean havens, where the banks are “fronting” for the
testimony to Congress, but he didn’t actually say anything real customers. They may be Middle East oil sheiks — or
new and certainly nothing dollar-negative. What really newly rich Chinese businessmen.
happened? One story had it that orders to sell dollars and Were the dramatic moves in the Swiss franc and Euro
ahead of the announcement evidence the Chinese revalua-
tion was leaked ahead of time? And if it was leaked, why
China’s goal is not to revalue; it’s to did the Euro rise, and not the yen? After all, the yen made
an even bigger move after the release.
build a sustainable forex regime. We will never know if the puzzling Euro rise was the
result of a pre-announcement leak, and if so, who was
behind it. Perhaps the Chinese themselves bought some
Euros, or Chinese officials with private accounts. Because
buy Swiss francs and Euros were coming out of the Chinese were emulating the Monetary Authority of
Switzerland, and perhaps from an official institution. We Singapore’s methodology, maybe it was the MAS. Since
still didn’t know why the orders had been placed, but the Hong Kong and the U.S. were alerted ahead of time, they
size of the move as well as the timing pointed to a real- might have been the source of the buying, too.
money source rather than a mere speculator. For all we know, other central banks (and therefore their
The next morning the real news broke — China was government officials) were told as well, not to mention the
revaluing the renminbi against the dollar by 2.1 percent and IMF and the Bank for International Settlements, which were
instituting a managed float based on a new and undisclosed certainly part of the pre-revaluation decision process. When
basket of currencies. When the Chinese revaluation report a big move is certain to come on an announcement, it’s too
came out, the Euro rose against the dollar immediately, tempting to resist making a few fast bucks, even if you’re a
from 1.2139 to 1.2255. The dollar/yen rate tumbled from government. One possible reason why the yen didn’t move
112.31 to 110.34 within the first hour. For a short while, at is because Japanese Ministry of Finance has been threaten-
least, it looked like resistance was broken and the Euro was ing for some time that it would intervene if it saw the yen
off to the races. move inappropriately.
In the nearly two years the Chinese revaluation was on An event like this comes along very rarely, but when it
the radar screen, two forex forecasts had become the con- does, you want to be able to jump on the bandwagon,
sensus. First, the yen would strengthen in line (or more) because there’s usually “real money” behind it. The ear-
with the renminbi, since China is now Japan’s leading trade marks of such a move is that it is large, unexplained and in
partner. Second, it was curtains for the dollar, meaning the the opposite direction of the existing trend. In the case of the
Euro would rise. The dollar should fall because the relief in trading ahead of the Chinese revaluation, the time of day
the U.S. trade deficit would be small unless China revalued contributed to the mystery.
by 30 to 40 percent, which was politically impossible, and
because a shift to pricing the renminbi against a basket of How will it play out?
currencies instead of just the dollar would reduce the need From experience, a big real-money move like this will con-
for the People’s Bank of China to buy U.S. Treasuries. A tinue in the same direction, breaking the previous trend and
drop in demand for Treasuries would cause the price to fall invalidating the old support levels. But this time the Euro
and the yield to rise, which sounds good until you realize high over previous resistance was only an anomaly, and it
higher yields could burst the housing bubble (or “froth,” as doesn’t show up on Figure 1 because the chart was taken as
Greenspan describes it). With the U.S. consumer reducing a 5 a.m. ET snapshot of the currency market, excluding daily
(or at least not increasing) spending, the U.S. economy highs and lows. If it was a real-money move, it fizzled; by
would stumble, growth would fall, and the Fed would be the next day, the price was back in the old range. The cur-
thinking about cutting rates some three to six months after rencies failed to hang on to gains and the Swiss franc, Euro,
the event. and yen all fell back in the first few days after the announce-
Sure enough, the day after the Chinese revaluation, the ment. This is quite confusing. Where’s the follow-through?
in the 12 months ending May 2005, when its accumulated continue to sterilize them by buying up the dollars and then
Treasuries totaled $243.5 billion, the second biggest official investing them in Treasuries, as before; the yield on the 10-
holder after Japan. Asian central banks and private year bond can remain constrained. The current thinking is
investors owned more than half of the $2.03 trillion of that rates would be about 1 percent higher were it not for
Treasuries held by foreigners, out of the roughly $4.03 tril- foreign (including Chinese) demand for U.S. paper. The
lion in marketable U.S. securities outstanding. Whether the housing market is safe from precipitous rate increases.
revaluation is 2.1 percent or 15 percent, China is still a major But hot capital flowing into China can spill over to
player in the capital flow picture. They have the same stake Taiwan, S. Korea, and elsewhere, in a speculative effort to
in preserving the value of their asset, which we call the get them to unpeg, too. This means outright dollar sales, so
Golden Goose argument (see “The Golden Goose Rule,” the net effect is dollar-negative. In fact, according to this
Currency Trader, February 2005). view, the dollar must fall because the 2.1-percent revalua-
The dollar is still going to be a big piece of the reserve pie tion is too skimpy. It needs to be more like 30 to 40 percent
in China. First, we don’t assume the Chinese would have to stop the interest-rate/dollar game and establish stable
left reserve diversification until after the revaluation. But relationships.
even if they did, the undisclosed basket of currencies that Therefore, the Chinese choice of a token 2.1 percent reval-
will be the basis of the new floating renminbi must consist uation is not a stabilizing influence on the global imbalance,
largely (probably about 50 percent) of dollars or dollar- but potentially a destabilizing one — and discord within
pegged currencies such as the Hong Kong dollar. The need the Chinese government about the extent and timing of
for serious diversification on a transaction basis is low. The additional moves is a frightening prospect.
only reason to diversify much or to talk about diversifica- Do the Chinese really have a plan, and what is it? The
tion would be political — to “punish” the U.S. for some Chinese announcement contained magnificent statements
other action in the military or diplomatic sphere. to the effect that China seeks “to enable the market to fully
It took a lot of wind out of speculative sails to acknowl- play its role in resource allocation,” but China’s goal is not
edge these points. Not much has changed. The U.S. will still to revalue, it’s to build a sustainable forex regime. It is in
be running massive trade deficits with China, and China this sense that what’s in China’s best interest is not neces-
will still be holding massive amounts of U.S. paper. sarily what’s in the interests of the rest of the world.
One other thing is becoming clear: By depriving specula- Because the Chinese central bank reserves to itself the
tors of a fat, one-time gain, China is only inspiring them — right to adjust the renminbi band whenever and however it
and probably a new group of speculators, to boot. Hot money chooses, we now have the tiresome task of following the
capital inflows can only rise. Because the Chinese are very pace and extent of upcoming renminbi price changes and
smart about how markets work, you have to wonder if this is how they affect trade and capital flows, if any.
not their intention. They complain about the inflationary Clearly the benchmark Euro/dollar exchange rate can’t
effect of inflows, but for some interim period, inflows must be stay stuck forever in the range shown in Figure 1, but until
what they want. Developing economies always want capital we have a better view of the Chinese thinking on the sub-
inflow, and China has had it in spades over the past three ject — and actions speak louder than words — the main
years. This is not really different from the powerhouse U.S. currencies are hostage to indecisiveness and range-trading.
economy funded by European capital inflows in the 1800s. Keep your eyes peeled for the breakout of either the sup-
If hot-money inflows into China grow bigger as the rate port or resistance line.
is seen to be managed at too tame a level, the Chinese can
Fundamentals, technicals,
and key reversals
Technical patterns don’t exist in vacuums. They must be interpreted within the framework
of the prevailing market conditions and news.
BY BARBARA ROCKEFELLER
The key reversal bar shown here bar didn’t have a lower low than the previous bar, but its
low was below the previous close. This bar coincided with the People’s Bank of China
announcement regarding the renminbi (yuan) revaluation vs. the dollar.
above resistance on the key reversal day hits the bottom of vides a seasonal inflow of money into Japan, as Japanese
the channel at .8991. The bottom of the channel forms sup- holders of foreign bonds collect their interest payments
port in its own right, and the intersection of the breakout around mid-month. Is it true the yen usually rises in
line with the channel gives it
additional strength. This may FIGURE 4 — FUNDAMENTAL SUPPORT FOR THE KEY REVERSAL
be considered a variation on
the old market lore that “old Japanese Prime Minister Koizumi’s announcement dissolving the lower house of the Diet
resistance becomes new sup- if it refused to pass reform bills privatizing the Postal Service (which also encompasses
Japan’s largest savings banks and life insurance company) triggered five full days of high-
port.” If the level were broken,
er highs and higher closes. Privatization of the savings and insurance businesses would
we would have to abandon
liberate both sectors from the heavy hand of the state and help put Japan back on the
our faith in the trend reversal road to fiscal prudence.
heralded by the key reversal
day.
We missed getting a second
bar with a confirming config-
uration, but we got three other
pattern confirmations — the
weak pullback, higher highs,
and a series of higher lows.
China’s increasing integration into the world economy favors the yen
more than any other currency.
necessarily condemned to failure for that reason. The key Next, second-quarter GDP came in below forecasts, but it
reversal day itself suffices to raise questions about the pre- contained the critical component of high private-capital
vious downtrend, encouraging traders to be willing to look spending, long the engine of Japanese growth. At the same
around for other reasons to keep the new move going. time, the central bank is now predicting deflation will be
And Japan delivered enough favorable news in the days whipped by the end of the fiscal year (March 2006), allow-
and weeks following the key reversal day to support the ing interest rates to be lifted. In the background, the finan-
yen. First, traders perceive that August traditionally pro- cial sector seems to be cured of its overhang of bad loans,
BY BARBARA ROCKEFELLER
Perceptions that central banks would reduce their dollar holdings helped push
the Euro to new highs vs. the dollar at the end of 2004.
It is not an unimportant question whether Europe will take over the mantle of world
financial leadership from the U.S., as the U.S. took over from Great Britain after
the war. But is it an immediate, real-life prospect on which to trade today? No.
bonds of the same maturity, which one would you prefer? days is about equal, and the amount of the biggest spike in
It’s a no-brainer. either direction is about the same, too. In short, trading the
payrolls release is a waste of time unless you are trading in
Same old same old terms of minutes and can exploit the spikes as they are hap-
None of this is new. Many analysts have been making these pening. This is presumably why the market is so enamored of
points for several years now. So why did the market allow this release—but for traders looking to incorporate funda-
itself to get snookered by the reserve diversification scare mentals into their trading, it’s not a worthy piece of data.
last fall? And why does the market continue to flail around At a guess, the reserve diversification story, which has so
on rumors and threats rather than hard facts and data? little meat on its bones, is like the payrolls story, only more
It is a peculiarity of the foreign exchange market that it is glamorous because it contains a tinge of high-stakes, high-
attracted to the unknown and unforecastable. Everyone can level, secret politics, and the illusion of history-in-the-mak-
get economic data and political news, and thus most data- ing. It is not an unimportant question whether Europe will
based trading is routine. If a release is expected at X and take over the mantle of world financial leadership from the
comes in at X minus 30 percent, the dollar is sold off, at least U.S., as the U.S. took over from Great Britain after the war.
briefly. If it comes in at X plus 30 percent, it will be bought. But is it an immediate, real-life prospect on which to trade
How boring. At any one time, we have three or four factors today? No.
in the market and a delicate balancing act as to what aggra-
vates or offsets something else. FX traders just want to have fun
The one big exception is the payrolls report — the least It’s no fun to trade boring old data such as the Chicago
forecastable member of the forex data pantheon. No forecast- Purchasing Managers Index or retail sales. Even top-tier
er ever predicts this report correctly, which makes it more data such as the Consumer Price Index can be tedious. With
exciting. The payroll report is the darling of the bond market, reserve diversification, it’s a thrill to imagine you are trad-
too, which partly accounts for the fascination of forex traders. ing on a partly glimpsed piece of global capital flows. Only
And it doesn’t matter that Fed officials and normally respect- about 20 people in the world know the real-money reserve
ed economists alike are declaring that an unexpected change flows — 10 central banks and their commercial bank traders
in payrolls will not affect policy or the real economy. — and they are not talking. It feels glamorous and sophisti-
Whatever the payrolls release turns out to be, the forex mar- cated to be part of the process.
ket is going to spike on it, sometimes in both directions on the But it’s an illusion. You don’t really know. Hundreds and
same day. The one time you should be sure not to have a posi- maybe thousands traded on the reserve diversification
tion in currencies is the morning of the first Friday of each cal- story last year and now we find out they were deluding
endar month when payrolls is released. You can’t win even if themselves.
you did forecast the correct number. It’s certainly acceptable to trade with the market —
In fact, according to analysis by S.A. Johnston, on the pay- that’s how to make profits and avoid losses. But it’s impor-
roll date each month from January 1999 to September 2005, tant to know a hawk from a handsaw. The reserve diver-
the Swiss franc delivered up days (close higher than the day sification story was, in the end, a hoax, nourished by pure
before) 40 times and down days 40 times. The maximum fantasy. If you had detected the story was probably
spike up during the day was 166 points; the maximum spike untrue, you might have been better prepared for the dol-
down was 179 points. In the Euro, 42 payroll date-days closed lar rally that started immediately after the start of the new
up, while 36 days closed down. The maximum spike up was year.
240 points and the maximum spike down was 249 points. For So here’s the question: What do we believe today that
all the major currencies, the number of up days and down will turn out to be untrue tomorrow?
Fundamentals duel
the technicals
Fundamentals may rule the den in the long run, but short-term reactions
in the market are often based on anything but rational analysis.
BY BARBARA ROCKEFELLER
The Euro/dollar up move in early September quickly failed, and the market formed a that removed 0.5-1 percent of
double top. growth from German GDP
would be an economic disas-
ter, too. But in the U.S., with
GDP at 3.3 percent in Q2 and
headed for 4 percent or more
in Q3, the temporary reduc-
tion in growth from the natu-
ral disaster is manageable.
Here is where context
counts. Anyone observing the
dollar fall on Sept. 1 and 2
could deduce the move was
unjustified based on the fun-
damentals and that the
“news” was being interpreted
incorrectly. And the chart
immediately began to exhibit
a double top, which is one of
the more reliable standard
patterns (Figure 2). If the price
falls below the lowest point of
the “M” (see mid-August), it
almost always follows
Source: Chart — MetaStock; Data — eSignal and Reuters through with a substantial
drop. (A little move back
numbers and this was an especially easy one to spot. The upward, such as the one that occurred on Oct. 6, is also very
bounce up off the retracement line was facing a heavy head- common.)
wind in the form of talk about upcoming interest-rate To draw a tentative conclusion: Currencies are joined at
increases in the U.S., so traders needed a better-than-usual the hip to the fixed-income and money markets because,
after all, real capital flows are based on competing real rates
of return. But real capital flows constitute only a small por-
Forex prices move more on each of tion of total forex trading and we often see forex price
moves that are contrary to the rational comparison of finan-
the five days leading up to a FOMC cial returns.
Other markets, such as equities, oil, and gold, are only
sporadically decisive factors in forex prices, and even then
meeting than they do afterwards. can be exploited for their shock effect rather than any rea-
sonable and plausible economic scenario.
excuse to keep the move going. Hurricane Katrina fit the You want to know what is right and reasonable in the
bill nicely and had the added benefit (for dollar shorts) of fundamentals, but you shouldn’t always trade on it right
creating the spectacle of the world’s richest country failing away when the market is in a perverse frenzy.
to provide timely and adequate relief to its own citizens.
The can-do country couldn’t. This is an instance where the Institutional news
giant miasma of anti-U.S. sentiment that hangs over the dol- Institutional news has the potential to be the biggest mover
lar took concrete form. of them all but, again, it is often used for shock effect to get
It quickly became clear, however, that the hurricane a move that was already pre-ordained by the technicals on
would take away only 0.5 to 1 percent of GDP in the near- the chart.
term — and actually add to GDP in later quarters as re- Consider the rejection of the European Union
building began. Germany, the Eurozone’s biggest economy, Constitution. The first “no” vote came from France on May
will get 0.8-1.2 percent growth this year. A natural disaster 29. The Euro had already swooned from above 1.3600 to
big Kahuna of events. FOMC meetings marry economic and would indicate higher oil prices are no more damaging to
financial expectations with hard institutional news. the U.S. economy than elsewhere, and maybe less so.
Everyone knows when the Federal Reserve will release its Another case comes from the institutional side of the
decision, and since it started raising rates in June 2004, the news. Last February when the Euro was falling, European
outcome has not been a surprise. All the same, you’d think Central Banks (ECB) President Jean-Claude Trichet warned
the Fed’s periodic decisions would deeply influence prices that the central bank could raise interest rates specifically to
in the forex market. protect the Euro from free-fall. The threat carried very little
Alas, you would be wrong. Using data prepared by credibility but the Euro spiked upward anyway. Again in
Stuart Johnston at TimeandTiming.com, forex prices move October, both Trichet and another ECB policy board mem-
more on each of the five days leading up to a FOMC meet- ber have made the same threat, this time with a little more
ing than they do afterwards. The Swiss franc, for example, credibility since inflation is indeed on the rise in Europe,
has consistently moved although most money market
down more often than it observers think an actual rate
has moved up in every The best — but by no means hike is not going to occur
five-day, four-day, three- until after the new year, if
day, two-day and one-day
period ahead of the past 62
satisfactory — conclusion is that the then. And even if the ECB
does raise rates, the U.S. will
FOMC meetings. The aver- still have a decisive yield
age move over the five fundamentals do not rule the market advantage (200 or more basis
periods is 11.3 points. points) over Europe. Still, the
On the day of the meet-
ing, and in the one-day,
consistently and reliably. possibility of an ECB rate
hike raises the riskiness of
two-day, three-day, four- holding a long dollar posi-
day, and five-day periods after the 62 meetings, it has also tions, so the “news” of a possible European rate hike
moved down more often than up, but by tiny amounts — prompts a dollar sell-off.
3.9 points, on average. Note that in those 62 meetings, the But the market has again showed it likes the thrill of
Fed was not always raising rates; on many occasions, it was uncertainty, and it responded by buying Euros even in the
lowering them. last few days leading up to an FOMC meeting, where the
The same conclusion arises from examination of the data outcome is known. It is perverse to buy the Euro when the
for the Euro, Japanese yen, Canadian dollar, Australian dol- next real-life central bank outcome favors the dollar; a sign
lar, and Mexican peso. The Japanese yen moves (usually the market is not operating on hard facts and clear-eyed
down) by an average of 13.08 points per day on each the five analysis, but rather thrill-seeking — and using a rise in “risk
days ahead of meetings and by a mere 4.32 points the day of aversion” to justify it. It’s no wonder the chart sometimes
a meeting and the five days after it. In the Euro, the pre- seems to rule the interpretation of serious economic materi-
meeting move is 29.4 points per day, and the post-meeting al instead of the other way around.
move is 6 points. Of course, the swings are far wider — the
average disguises the range — but the principle holds that Long run vs. short run
pre-meeting swings are bigger than post-meeting swings. The best — but by no means satisfactory — conclusion is
This means more than the market anticipates a move and that the fundamentals do not rule the market consistently
buys on the rumor. It means the rate-change FOMC event is and reliably. Maybe the fundamentals rule in the long run,
not “news” because it is not also a shock. This is a testament but the long run is nothing more than a series of short-runs,
to the good public relations of the Fed, but at the same time, and in the short run, the market is often in the grip of a chart
it deprives traders of what should be a value-laden news pattern that tickles the imagination, a rumor that defies
item. common sense — a story or scenario that is patently false,
The forex market has a preference for big events that are or just plain thrill-seeking.
also shocks, whether they are true and useful information or In the end, the duel is not between the fundamentals and
not. Some commentators in the forex market have taken to the technicals, but between rational decision-making based
combining all three sets of factors and weighting them on facts and analysis, and traders who need to make money
according to “riskiness.” An abrupt rise in the price of oil, for by going with the flow, even when that means taking seem-
example, raises the level of risk. Risk-averse FOREX market ingly irrational positions.
participants would sell dollars on a rise in the overall riski-
ness of holding dollars, even when sound economic analysis