If 2007 provided any lessons, they were on the emergence of intermarket relationships. No matter what kind of trader you were, currency movements crossed your radar screen. The synchronicity of the dollar/yen pair and the Dow Jones Industrial Average became apparent many times and the upward moves in crude oil pushed the Canadian dollar to parity with the U.S. dollar and beyond.
Another force in 2007, one to monitor into 2008, is interest rate policies of central banks. The U.S. Federal Reserve Bank began a trend of cutting rates, while most of the rest of the world stopped raising rates. Let’s explore some forex dimensions and scenarios for 2008 that could help shape forex traders’ trading plans.
Decline of global interest rates: As 2007 ends, the signs are already there for the topping out of rates and the beginning of a decline in rates. The United States has been the leader, but the projected slowdown of the world economy by the Organization of Economic Cooperation and Development (OECD) and others will lead to an environment of global rate cutting. The Bank of Canada and Bank of England both recently cut rates by 25 basis points, and Germany, Australia and New Zealand will likely cut rates next. Traders can play these fundamental shifts in interest rate policies by looking to sell these nations’ currencies. The unanticipated beneficiary of this scenario is the U.S. dollar. When currencies weaken due to their weakening economies, they could very well weaken against the U.S. dollar.
China contraction: After the 2008 Olympics in China, forex traders should keep an eye out for contraction in the Chinese economy. If U.S. and global growth slows, demand for Chinese exports and services will be lower. A slowdown in China, or even a rumor of a slowdown, can be played by selling Aussie dollars.
The rise of the dollar: If global interest rates drop, the dollar will benefit. Lower interest rates weaken a currency. If the central banks of the European Union, Great Britain and Canada lower rates, the U.S. dollar would strengthen in relative terms. And if the Fed decides that inflation vigilance is still important, that would help the dollar as well. “Breaking the trend” (below), shows the possible beginning of a U.S. dollar recovery in its global Trade Weighted Index (TWI). If the TWI breaks above its current downtrend, it may signal a shift toward a stronger dollar.
Opportunities to trade non-correlated currencies: The tendency of currency movements to cascade across the dollar pairs presents a risk because currencies are interconnected. However, data shows that there are variations in correlations. Superderivatives, a global leader in currency analytics, generates real-time correlation data that shows that there are variations in correlations. For example, one of the most traded currency pairs is the EUR/USD. The EUR/USD is 90% negatively correlated with the USD/CHF (Swiss franc) but only 6% correlated with the EUR/NOK (Norwegian Kroner). The EUR/USD is only 0.31% correlated with the USD/MXN (Mexican Peso) pair. The Norwegian Kroner, the least correlated currency, is a solid commodity currency. “Currency correlations” (below), shows the various one-month correlations among currency pairs, which will allow them to trade the fundamentals of a currency. By using correlation data, the trader can find trades that minimize exposure to the global emotional contagion in the dollar pairs and may be a useful strategy in 2008.
Abe Cofnas is president of learn4x.com LLC and author of The Forex Trading Course: A Self-Study Guide To Becoming a Successful Currency Trader (Wiley Trading). E-mail: learn4x@earthlink.net.