From the April 01, 2007 issue of Futures Magazine • Subscribe!

Finding your focus in forex

Most charting services offer traders the choice of looking at charts with different time intervals. What is telling about currency charts is that many come in intervals of minutes such as one-, five-, 10-, etc. If it is a matter of responding to a need, then those needing to monitor movements by the minute could not be expected to have any interest in trading long-term trends.

In fact, long-term currency trading may be considered a misnomer. A better term would be long-term investing. As in stocks, long-term currency investing may last several months to several years. The core driving forces causing the ebb and flow of any currency pair are dependent on the relative state of the two countries’ economies. These may include many factors, such as fiscal policies, inflation, interest rates and deficit/surplus comparisons. Most of these factors move at a glacial pace and rarely affect trends contemporaneously.

At times, nominal interest rate differentials take center stage due to short-term influences in the flow of funds that are looking to capture a small carry. At other times, traders are pre-occupied with deficits and fiscal policies.

What influences short-term gyrations the most are the perceptions involved in sizing up the outlook for the two economies, and perception evolves slowly, feeds on itself, gathers momentum and goes from one extreme to the other. In the process, it causes prices to fluctuate around the slow and steady progress, or lack thereof, between the economies and the inflation adjusted rate differentials.

HEART OF THE MOVE

These excessive moves normally referred to as overbought and oversold reactions have remained regular occurrences but typically vary in terms of intensity and duration. Over the relatively short history of the retail forex market, there have been two major changes that have taken place. First, up until the late 1990s, dealings in forex were limited to the privileged few: financial institutions, commercial interests and large pools of funds with access to the banking network.

Advances in technology and the arrival of electronic brokering together with changes in regulations have paved the way for small traders. In the early 2000s, the stock market’s tech bubble burst, leaving many day traders looking for alternatives. The forex market, coupled with the new and improved technology, was a welcoming platform. Not only was the currency market liquid, but it also afforded leverage that was much higher than stocks.

The second important change that took place relates to how central banks’ participation has evolved. The currency market is the only financial arena in which governments can openly influence the direction of prices by acting to reverse or enforce a trend.

During the first 20 years since currencies floated, central banks would announce their intentions as they interfered to prop up one currency against the other. They would even go a step further by disclosing the cash amounts they employed. At times, one central bank would enter the market on behalf of one currency. At other times, groups of central banks would act in unison.

In the last 10 or so years, such activities have all but disappeared. They have been replaced by periodic rumors of central bank involvement. No official statement is made by any government relating to changes in policy of their central bank’s intervention activities.

However, those who closely follow currency markets can attest to curious currency moves, especially, for example, those occurring immediately after meetings of the G-7 finance ministers. Lately, after such gatherings, a statement of policy is usually issued and no intent for action is pronounced. That’s in stark contrast to two noted meetings that took place in the 1980s.

In 1985, it was deemed that the U.S. dollar’s rise was unacceptable and had become excessive. At the time, the G-7 (which then was only the G-5 and met in New York at the Plaza hotel) decided to devalue the dollar. What became known as the Plaza Accord was followed by massive central bank intervention. This resulted in the depreciation of the dollar by an amount in excess of 50% against the Japanese yen and the German Deutsche mark.

The drop lasted for three years, at which time the G-5 met again and decided that enough was enough. Another wave of intervention began in support of the dollar. This latter effort had the effect of stabilizing the markets.

In the last few years, only verbal expressions of displeasure can be heard when excessive moves occur in one currency or another. Otherwise, nothing is said other than the usual statement from U.S. officials stating that the U.S. adopts a “strong dollar policy.”

CHANGES THROUGH TIME

As in the case of most financial markets, currency trends are governed by the elements of greatest interest at the time. And those may vary from one period to another.

In April 1982, the highest priority to stock traders was the money supply numbers that were released every Thursday at 4 p.m. The S&P 500 futures, which were just being introduced at the time, were allowed to trade until 4:15 p.m. so traders could react to those numbers. To this day, the S&P futures close at 4:15 p.m., but hardly anyone mentions the money supply numbers, and even the Fed stopped releasing M-3 figures, which are just one of the supply numbers they release.

In the late 1980s, the U.S. trade deficit greatly influenced the dollar trend. At that time, the trade deficit was running between $8 and $12 billion a month.

The Commerce Department considered the number so large that they introduced the services sector (which was in surplus) to the trade balance to limit the damage. Today, the combined figure shows a deficit more than six times that size, yet currency traders are preoccupied elsewhere. Their focus is on interest rate differentials.

When the Fed funds rate went to 1% in 2003, the U.S. dollar was punished against the euro. The depreciation from 2002 to 2005 amounted to more than 37%. Once rates came back up, traders migrated to higher yielding currencies. They continued to heavily borrow Japanese yen and Swiss francs and favor the pound sterling, euro and dollar in what is referred to as carry trades.

And as the attention swings from interest rates to deficits and back, the U.S. currency is likely to periodically come under pressure when various countries declare that their intention is to diversify their reserves away from dollars and into other assets.

WHAT’S NEXT?

Those who wish to consider investing in long-term currency trends need to be aware of where the psychology of the major players is focused. As in the past, a time will come when carry trades will take a back seat and deficits will be emphasized again. This appears to have started in the last days of February. The best examples of long-term trends can be found when examining monthly charts.

“Yen for pound” (below) shows the GBP/JPY during the past 25 years. In mid 1978, the pair registered a high close to 565 when the yen started appreciating. The trend carried the pair below 135 in 1995, a 17-year move that produced a yen rise of more than 76%. Interest rates were of no concern then. That changed in early 2000 and the yen began to lose ground. By early 2007, it had lost more than 43% of its value against the pound.

At times, what are referred to as commodity currencies are highlighted. Countries rich in raw materials see their currencies swing to reflect a rise or fall in the commodities’ prices. “Oh, Canada” (below) shows the dramatic moves in the Canadian dollar vs. the U.S. dollar through the past 30 years. During the last 16 years alone, the pair went from 1.12 to 1.61 and back to 1.10, a round trip that produced 30% each way. Even if only a portion of either move was captured, a modest leverage of five-times leads to an eye-opening return.

WATCHING THE DOWNSIDE

Of course, no trend goes straight up or straight down. More often than not, important long-term trends are punctuated with violent short-term counter moves. There is no quick fix to protect against such financial air pockets. The impact can be minimized by undertrading or by the use of stop-loss orders. And if positions have been established early enough in the move, the counter trends may be withstood without much damage.

Long-term trends, by definition, do not require urgency. They develop over weeks and sometimes months. This allows participants to phase into and out of positions. What’s more, these moves are large enough that if only part of the move is captured, the results could be quite rewarding, given the leverage afforded in forex.

Long-term charts depict many instances of moves in excess of 30%, extending from one to four years and starting from 1975. Admittedly, long-term investors will also encounter periods of stagnation when markets go trendless for six months or longer. But once a trend takes hold, the rewards could overweigh the aggravating long days of inactivity.

In any case, participants in the currency markets are encouraged to keep an eye on the big picture.

Perhaps less attention to minute charts and more to weekly and monthly ones may yield better long-term results, less stress and afford occasions for long-term cruising.

Osman Ghandour runs forex education firm www.theforexedge.com. He previously ran a managed currency program for Shearson, Lehman, was a trader for the Kuwaiti Ministry of Finance and specialized in asset allocation for Clark, Dodge.

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