Those trading forex during this past year certainly have gained some combat stripes as the global equity and commodity markets rocked through a major shift in valuations. The impact on currencies was a significant increase in volatility. Among the majors, realized volatility grew exponentially by the beginning of December (see “A new ball game”). These increases in volatility have posed greater challenges for the forex trader whose trading strategies, honed in calmer conditions, may no longer work as well. These conditions impose the necessity to examine strategies and tactics that go beyond a simple review to changing one’s view about the forex market. There are several areas worth exploring.
First is the view of what moves currencies. In normal conditions currencies decline and increase in value as interest rates increase or decline. In this world of fundamental forces, if a central bank decreased interest rates, the currency would weaken. But these have not been normal times. In early December, the Reserve Bank of Australia cut rates by 1%, yet the Aussie rallied and the market showed a flight to the U.S. dollar as U.S. interest rates declined further. This has been a pattern except for the USD/JPY pair, where the yen has benefited from the unwinding of the carry trade.
Traders shorting the dollar on the assumption that a weaker U.S. economy would create a flow away from the dollar have been disappointed. But the cause of such disappointment is not market forces not working, it’s the nature of trader expectations. The fundamental expectation of currency values following interest rate expectations was trumped by a larger force of “risk appetite.” This force is a psychological response based on finding a safe haven during times of high uncertainty.
The U.S. dollar rose because of a global deleveraging and as investors pulled money out of metals and crude oil due to the expected global downturn. Short-term fear overcame long-term return on interest rate evaluations. But as 2009 begins with a worldwide recession, forex traders have to learn that the most important fundamental expectation is the end of the U.S. recession. It is likely that the dollar will rally on such news. This leads to two scenarios for a dollar rally: one based on globalization of bad news and the other based on a U.S. recovery.
However, the second scenario would tip the inflation/deflation debate in favor of inflation and at some point the massive infusion of capital into the system by the Federal Reserve should take a toll on the dollar.
Dollar rallies on bad economic news are psychological and much less fundamental than rallies on underlying changes in economic conditions. But it’s important to remember that a rally is real no matter what the reason. The challenge for forex traders is to detect the nature of these rallies. Forex traders can help themselves by arming their analysis with quantifiable observations about dollar sentiment. It will be useful to check the Philadelphia Housing Index (HGX) compared to the U.S. Dollar Index (DXY). The HGX was in sync with the dollar until Sept. 30, shortly after the credit crunch expanded. After Sept. 30, the dollar and HGX became negatively correlated (see “A perfect fade”). This divergence cannot last. Playing a narrowing of the spread between the HGX and the DXY may be a profitable strategy. A narrowing of this spread also may be a strong indicator of a bottom of the recession and a return to a climate where the dollar follows traditional fundamentals rather than fear.
But don’t forget the price yet to be paid for the policies to keep our banking system solvent by the Fed and Treasury. Expect a large bill to be coming due soon.
Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at abecofnas@gmail.com.