Exploiting arbitrage opportunities in spot forex markets is a rare enterprise available to retail investors. Trading on the prices of multiple market makers and on firms providing “no dealing desks” can help generate upside potential for the active day trader. Paying close attention to the highs and lows of futures and spot forex prices also can help gain a momentary advantage in price direction.
However, here we’re aiming for a longer-term perspective. Using the activity in gold futures, along with close charting of the Japanese yen, equities and volatility measures can help pick clues for what could be the next source of dynamism that dictates forex market activity in G-10 currencies.
The year 2007 has witnessed a shift in the underpinnings of the currency markets, transitioning from flows based largely on expectations of Federal Reserve policy, to flows driven by risk appetite. Examples include frequent episodes of carry trades into higher yielding forex, equities and metals and the subsequent partial unwinding of these trades. Capturing the next catalyst to currency market dynamics is neither a science nor an art, but a continuation of the patterns seen in the first half of 2007 and may help prepare for moves the rest of the year.
Before outlining these factors, it is important to shed light on the drivers behind the market developments of late February through early March, which triggered a 5% decline in the yen, a 6% decline in the S&P 500 and a sharp slide in high-yielding currencies in less than two weeks. More significant, gold dropped more than 9% during the same period amid a sharp reduction in risk appetite following a one-day 9% drop in China’s main equity index.
The surprise element of the Asian sell-off prompted an unwinding of risk-based carry trades, whereby investors borrowed low-cost yen and Swiss francs to take part in higher yielding currencies (Aussie, Kiwi, sterling, euro) as well as participate in rallying equities, gold and oil. The Chinese correction and fallout in the U.S. subprime market sent a jolt across these trades, prompting a sharp, yet brief, reduction in risk appetite and an unwinding in those trades.
As for the dollar, the impact was mixed. The unwinding of carry trades saw a rally in the U.S. dollar against the Aussie, kiwi, euro, sterling, Canadian dollar and gold, as traders unwound positions, which drove the preceding dollar sell-off earlier in the year. Once risk trades were re-established, equities surged to new highs and the yen slumped to multiyear and record lows. Complacency returned to the market, along with renewed pressure on the greenback in most of the second quarter and into the third.
YEN-FINANCED EQUITIES
But an additional pattern began to form in July, which was not solely driven by carry trades chasing high yielding plays, but also driven by a broad loss of confidence in the U.S. dollar. Rising concerns about the U.S. economy were intensified by downgrades of subprime-backed debt by S&P and Moody’s, prompting worries that the subprime fallout had extended toward consumers (falling home prices and anticipated mortgage resets); companies (depending on construction and home improvement); and banks/hedge funds (holding downgraded paper).
The resulting market impact translated into fresh carry trades favoring the Aussie, kiwi, sterling, euro and loonie against the yen, but with a conspicuous absence of a rally in USD/JPY. That the Japanese yen was at or near all-time lows against its high-yielding counterparts, but standing at five-week highs against the U.S. dollar, underlined the dollar-specific nature of the emerging currency theme.
To gauge the continuity of these dollar-centered developments, traders must follow the relationship between the Japanese yen and U.S. equities (S&P), the Commitments of Traders (COT) report for gold futures and the overall relation between the price of gold and the U.S. dollar.
“In tune with equities” (below) illustrates the clear acceleration in the positive correlation between the USD/JPY rate and S&P 500 since December 2004 as investors became certain that the Fed’s rate hikes were not posing a threat to the
U.S. economy, while persistently low interest rates in Japan encouraged taking low-cost yen loans to participate in record-breaking rallies in equities. By the same token, the continuation of the relationship is illustrated during the late February sell-off in both USD/JPY and S&P 500 as investors covered their yen shorts during the equity market slide.
But as mentioned, a gradual dissipation in this relationship had started to be noted by July, when a rebound in U.S. equities by more than 1.5% to 1.8% triggered a mere 0.4% to 0.5% rally in the USD/JPY. That was a far more modest reaction than the 0.8% to 0.9% gains the USD/JPY had seen throughout the second quarter.
The explanation was two fold: Emerging reports of Japanese politicians and Bank of Japan officials were no longer seeking a weak yen policy; and rising worries of a protracted slowdown in U.S. consumption were paving the door for a possible Fed easing in 2007.
SPEC DEMAND FOR GOLD
In addition to the yen-equities relationship, traders can gauge the dynamics of risk appetite via the interaction between the price of gold and the weekly COT report for gold futures. “Golden commitment” (below) shows two bull phases of increased net longs in gold futures, with the first phase occurring in the first half of the second quarter, leading to a brief but sharp sell-off. The second phase took place in April,
culminating in $693 per ounce, the highest level since May 2006.
Traders must take note of what could be the second phase of the 2007 rally, seen in a pick-up in gold speculators’ net longs from their five-and-a-half month low. The build up of net longs appears to be at its infancy, considering that gold is already 5% up from its late June lows. A situation where the net longs are relatively behind the price action in the asset is bullish for the asset, rather than the contrary case where a build up in speculators’ longs is not reflected in an upward move. Considering that we are in early stages of an expected build-up in speculative net longs in gold, an extended price rally in the metal is deemed to follow.
As for the fundamental driver for a prolonged rally in gold, it is already here. The aforementioned economic concerns weighing on the U.S. dollar are especially being manifested in the dissipation of the yen’s ties to the S&P 500, which will likely help boost the secular nature of the gold bull. With prices currently at $666 per ounce and the average duration for net long accumulation lasting six to seven weeks, look for gold to touch the $700 mark by the end of the third quarter.
YEN VALUE OF GOLD
Traders also can use the yen value of gold for a clear perspective on the value of gold and on whether the gold-yen relationship is affected by carry trades into the metal or an unwinding into the currency.
“Priced in yen” (below) illustrates gold’s 2007 year-to-date performance in terms of the Japanese yen, whereby a rising trend shows a decline in the value of gold against the yen. A falling gold/yen chart (yen per one value of gold) is a reflection of overall yen strength or a corresponding retreat in gold prices (or both).
In the event that a falling chart occurs during a period of stable gold prices (as measured against other currencies), we can conclude that a period of overall decline in the dollar is prevailing.
The fundamental dynamics of G-10 currency markets have predominantly been one-dimensional, based on carry flows, whereby their unwinding saw a rally in the dollar against the Aussie, kiwi, sterling, euro, loonie and gold.
But as the Fed appears to be in a policy straitjacket when overseas central banks raise interest rates without any negative policy implications on their economies, markets lose confidence in the dollar. Hence, we see the second dimensional aspect of forex market dynamics: broad dollar weakness.
Accordingly, pursuing a medium- to long-strategy in gold, along with an incremental long yen position versus the dollar, aims at capturing the ongoing bull in gold and riding the eventual gains in the yen following the normalization of Japanese interest rates. In the event of fresh yen resulting from intensified carry trades, the strategy is likely to sustain itself via the accompanying rally in gold, which has proven to be part of recent carry trades. The strategy must be exercised with enough capital to ride out any short-term corrective moves of advances in the dollar versus gold and versus the yen.
The case for a 2007 interest rate cut throughout this year has been capital market-oriented, as well as macro-oriented. The capital market rationale is highlighted by reduced risk appetite affected liquidity in a highly leveraged financial landscape, which spells the probability of contagion.
The risk of such contagion could occur via the following: A sharp rebound in the yen would jeopardize billions of dollars worth of what were initially low cost yen loans; higher interest rates on U.S. mortgage owners after interest rate resets; and deterioration in the values of subprime securities as these are unloaded from the portfolios of banks and hedge funds.
These are the avenues through which the dollar is expected to continue charting a broad but manageable decline, highlighted by a continued recovery in gold. As long as hopes of a U.S. recovery remain dim, so will be the chances of a dollar recovery resulting on the back of carry trade unwinding. But with the Japanese currency acting as a determinant of pricing risk appetite, traders should also pay close watch to the gold-yen relationship for a benchmark of risk appetite and its opportunity cost.
Ashraf Laidi is the head FX strategist at CMC Markets, where he oversees the analysis and forecasting functions of G-10 currency pairs and trends in global central banks. Laidi also is responsible for education services. He can be reached at: a.laidi@cmcmarkets.com.
