It’s the continuous pursuit of most traders: Find a trend and ride it for most of its length. Getting off the bandwagon, well, that’s entirely different.
Becoming enamored with a trend is nothing new, as history shows us. The late 1990s trends were about tech stocks, and in the middle of the first decade of the 21st century trends are about commodities. Tech stocks were about the pioneering applications of the Internet and subsequent overinvestment. The commodities boom is about the historic industrialization of China, which has become the supplier of goods to the world, and years of diminishing investment in the infrastructures that produce commodities.
In both cases currencies were left in the background, more overlooked than forgotten. However, besides pulsating to its own rhythm, forex is the blood of the international markets. When things go astray in the commodity markets, currencies will feel the shock as well. The USD/JPY had a splendid run higher alongside the rallying commodities in 2005, but a relatively small shock was exacerbated by special conditions and this triggered a three-day tsunami that left returns in a shambles.
UNFURLING AN UPTREND
The USD/JPY enjoyed a strong uptrend in 2005. The pair bottomed early in the year on Jan. 17 and then made a choppy up-move until July 20. However, a move up from 1.0167 to 1.1372, bumpy as it was, was nothing to smirk about.
It took an aggressive slide back to 1.0876 on Sept. 5 before the uptrend resumed — a classic 38.2% Fibonacci retracement. When an uptrend corrects by approximately 38.2% and then resumes its initial direction, this is a strong sign the market can make new highs. “Time delayed trend” illustrates this initial uptrend and its retracement, which was indeed followed by new highs.
The last leg of the uptrend, which occurred between Sept. 12 and Dec. 5, was strong, clean and avoided significant correction, rewarding disciplined technical traders. The USD/JPY reached its key targets at 1.1832, which was a 1.382% extension of the original uptrend. Then it hit 1.1974, or the 1.5% extension and finally the 1.618% extension at 1.2117, a rare occurrence.
The final high, nearly a three-year top, was 1.2138 and occurred Dec. 5. Several days later, the pair tumbled. The rate of its slide was exceptional. Three days of trading turned hard-earned returns to ashes, as the USD/JPY gave back nearly half of the gains made within its last leg of the uptrend (see “Easy come, easy go,”).
It’s becoming old-fashioned to trade solely based on technicals or fundamentals. Trading markets means trading information, and leaving unused information on the table is a definite no-no.
The fundamentals may look quite positive for the Japanese yen. Japan’s gross domestic product is flourishing, the stock market is rising and exports remain strong. Does this mean you should buy the yen immediately? Not at all. It’s important to remember that strong exports require weak currencies. The 16.24% weakening of the yen against the dollar in 2005 clearly boosted the Japanese exports to the United States — regardless of the state of the dollar, Americans still shelled out the same amount of cash to lease their coveted Infiniti and Lexus automobiles. So, while it sounds bad, a weak yen is perfect, even in a strong Japanese economy. Of course, it didn’t hurt that the major Bank of Japan intervention through March 2004 put the fear of God into yen bulls.
But none of the above macroeconomic reasons carried much weight outside Economics 101 classes. What the market focused on when it dumped the yen was that Japan’s overnight interest rates were hemmed near zero. This meant, outside the demand for cheap financing, local investors had to search for sources of profit beyond the Japanese stock markets; hence, they needed to sell yen for dollars and euros.
This is when commodities came in to play. And, boy, did they ever. Japanese investors finally followed in the footsteps of other money managers and jumped on the flavor of the year, gold. Gold seems to have longer legs in its uptrend than even the political-, industrial- and weather-related price of oil. But in mid December 2005, gold margins increased sharply.
The Tokyo Commodities Exchange (Tocom) raised trading margins on gold on Dec. 12, and the overbought shiny metal plummeted from a 24-year high. The USD/JPY, also massively overbought, nose-dived as well. Irreversible damage was done, even though the exchange soon back-pedaled on its decision. The Tocom announced that as of Dec. 20 it cut in half the trading requirements on new contracts to 25,000 yen (approximately $215). Gold surged once again, but the USD/JPY did not follow suit. Traders were too beaten up to recover at the end of the year while the chief dealers were circling furiously and bonuses were evaporating into thin air.
There were plenty of signals that the USD/JPY needed to correct. The pair fell in value in December 2002, 2003 and 2004, (see “Weak season,”). December 2005 followed suit, but this time it was different. In the previous three years the pair was in a downtrend, so closing the year lower simply extended the prior move. In 2000 and 2001 the pair rallied and was up in December as well. But 2005 was an up year overall, so the weak December was uncharacteristic of recent price activity.
The true technical warning signals came from the overbought conditions that the USD/JPY showed vs. its 20- month moving average. “Weak season” shows a monthly chart along with a 20-month moving average. The three red downward-pointing arrows indicate overbought areas, while the three blue upward pointing arrows show oversold areas. In all instances, the USD/JPY reacted with massive corrections.
Warnings are great, but signals are better.
The first signal came from the weekly chart, which showed a doji bearish reversal pattern just at the highest point (see “Doji danger,”). The next week, the overbought pair collapsed.
The second big signal indicating the magnitude of the USD/JPY slide was the long liquidation of yen crosses. The most popular cross, EUR/JPY, was also overbought, and “Euro trashed” (below) shows its overbought condition vs. its averages. Traders should have used the intersections of the cross with averages as both targets and entry/exit points.
In the same vein, so-called “commodity currencies,” such as the high yielding Australian and New Zealand dollars, came under fire as well against the low-yielding yen contributing to USD/JPY’s three-day thrashing.
The USD/JPY formed a bearish reversal on the monthly chart and remains overbought in the long term. Both of these technical elements suggest the pair will encounter further weakness. But this weakness should not last long.
The trigger for the USD/JPY annihilation was removed when the Tocom cut its gold margins after its grossly ill-timed increase. Japanese investors can resume their investment in gold, and they have already started. Moreover, the relatively high level of U.S. interest rate will continue to hover around the near zero rates in Japan. This alone will prevent an extended USD/JPY decline.
The USD/JPY should stabilize above 1.1290 and then attempt to climb back up. But breaking above the historically strong 1.2000 area should be a daunting task.
Cornelius Luca is a currency analyst at Global Forex Trading. He is the author of Technical Analysis Applications (McGraw-Hill, 2004), Trading in the Global Currency Markets (Penguin Books, 2000), Technical Analysis Applications in the Global Currency Markets (Penguin Books, 2000) and Introduction to Technical Analysis (Euromoney, 1997).