Forex trading conventionally has involved fundamentals intertwined with technical analysis. The trader’s goal was to use these two analytical lenses to arrive at trading decisions. That was in normal times.
Conventional fundamental analysis collapsed in the wake of the financial crises. Much of the world entered a near-zero interest rate environment where interest rate differentials became irrelevant. Traditional economic-based fundamentals on currencies were trumped by the psycho-dynamics of market fear. The challenge for the trader is to detect and filter those fears in order to shape the correct trading strategy. In effect, the trader has to form a fear portfolio.
There have been three predominant fundamental fears influencing weekly price action. The first was and still is fear of Greek default. Fueling this fear was the analysis of leading economist Martin Feldstein, who predicted an inevitable Greek default on its sovereign debt. Currency trading legend George Soros added to the speculation that the Eurozone would break up as well.
Here in the United States, fear of a downgrade in the U.S. credit rating, as well as an actual default, has become a political instrument. Any nervousness about a negotiated approach to the U.S. debt financing has resulted in market gyrations.
The final component of the fear portfolio is China. This has two subparts. First is fear of China selling U.S. dollars, and the second is fear of a Chinese economic slowdown.
Given this context, fear is the new fundamental force that needs a fresh kind of analysis, and trading strategies have to be formulated in response. There are key steps the trader can take. The first step is facing the fear with a contrarian point of view and using a modicum of political science analysis. Whenever fears are at such extremes that only one point of view pervades, the best approach is to go the opposite way. When the EUR/USD sinks in response to sovereign debt problems, it’s time to buy. Watch the DAX as it has moved in tandem with the EUR/USD reflecting the oscillation between optimism and pessimism (see "Sympathy pains").
Similarly, trading with regard to the U.S. debt and the chaos that would result from a default is an opportunity to buy the U.S. dollar. The trading strategy should be to buy U.S. dollars when the worst is feared.
This brings us to perhaps the fear most rooted in economic reality — fear of China. Once again it’s overstated and a bit of political science is warranted. China’s greatest value is stability. A precipitous decline in the U.S. dollar destroys that stability because China holds over $1 trillion in U.S. debt and more than that in its cash reserves. China won’t abandon the U.S. dollar, but rumors of that will persist.
Fear of a China slowdown is the only one that is valid from an economic point of view. China cannot sustain nearly double-digit growth without inflation, and it cannot suppress the pressure of wage inflation as its middle class increases.
The resulting strategy for approaching China would be to become adept at trading the AUD/USD, because the Aussie is a surrogate for Chinese growth expectations and will be impacted severely by any change in China growth. A clue to following China sentiment and its impact is to track the Shanghai Index against the Aussie currency (see "Crouching tiger"). The chart shows how weakness in the Shanghai index is holding the Aussie down despite its high interest rate differential from the other currencies.
Abe Cofnas is the author of "Sentiment Indicators" and forthcoming (fall 2011) "Binary Option Trading: Strategies and Tactics" (Bloomberg Press). He holds a master’s degree in political science and public policy from the University of Calif., Berkeley and can be reached at firstname.lastname@example.org.