The market moves of Feb. 27, when the Dow suffered its worst day in more than five years, demonstrated the reality of intermarket phenomena and the illusion of a disconnect between fundamentals and technicals in market moves. Those who claim that fundamentals don’t count need to reassess their claims. No one really knows what triggers a sell-off until after it is over; and we can’t predict the next one. But during the sell-off of Feb. 27, we saw some of the inner realities of market structures reveal themselves in a triangulation of factors.
First, the significance of the forex market as a force in world capital flows and market moves became apparent when the USD/JPY pattern started sliding. Its vibrations caused a remarkable synchronicity, as if both markets were dancing to the same beat. The Japanese yen, in effect, became the leading indicator for the equity markets (see “Market drops,” below).
Feb. 27 also reminded equity investors that markets are not linear and can suddenly enter into chaotic patterns. Forex traders, particularly carry traders, had a rude awakening.
Carry traders have had profitable conditions for more than three years by selling yen and buying currencies from countries with higher interest rates, such as the New Zealand dollar, and the British pound. Having committed yourself to a winning strategy it is hard to separate yourself from it. But on Feb. 27, many traders were reminded that there is no free lunch.
Many of those who held carry trade portfolios saw more than 20% drawdowns in one day. There were reports that the yen strengthening caused equity investors to liquidate positions to meet margin calls on carry trades as the yen surged. The carry trade involves global assets of more than $100 billion, and a lot of this money is borrowed. The sell-off was a threat to liquidity. That is also why gold prices did not go up and sold off. This is just the opposite of conventional wisdom where gold is hyped as a refuge in crises.
A third factor was that Chinese equity markets sold off 9% partly due to concerns about a U.S. slowdown. This generated concerns of a Chinese slowdown. China will have great difficulties sustaining recent growth. Chinese GDP is projected to be at 8% for 2007. Rather than fearing a Chinese slowdown, it would be better to look at its impacts.
The Australian dollar could become weaker as global demand slows for commodities. The catalyst triggering a convergence of these factors may have been the remarks of Former Federal Reserve Chairman Alan Greenspan about the potential of a U.S. recession. On March 5 another yen surge triggered an emotional contagion as equity markets in Asia and Europe sold off and triggered more weakness in the U.S. equity markets.
These events provide a glimpse into the future of global markets and important lessons. Global markets are connected more than ever and are subject to waves of emotional contagion. A statement by a foreign minister or central banker can create the equivalent of a chemical reaction-diffusion in the market. Events in one market will cascade into other markets. Equity traders focusing only on intraday charts are missing the big picture. We have truly become a 24/7 trading world. Forex markets act as the jet stream of the world money flow and any shift in it affects all other markets. Equity traders and investors should have forex accounts that could be used to create an effective hedge.
A final lesson regarding Feb. 27 is that chaos creates opportunity. You didn’t need sophisticated indicators to see the compelling opportunity to sell USD/JPY during the afternoon of Feb. 27. The warning signs were found in simple technical tools. Even when the yen surged, the trendlines came alive acting as invitations to the join the party. No other indicators were necessary.
We should learn from Feb. 27 and its aftermath that understanding forex is a necessity in our current era of global capital markets. Yet knowledge has to be actionable. Watching the USD/JPY fall on the sidelines, without taking advantage of trading it, can be a painful experience.
Abe Cofnas is president of learn4x.com LLC and author of Understanding Forex: Trading to Win. E-mail: firstname.lastname@example.org.