Forex markets are fascinating because they constantly change, yet always seem to provide examples of enduring patterns. This phenomenon often has been referred to as the "fractal" behavior of the markets because self-replicating patterns evoke the equations of Benoit Mandelbrot (founder of fractal mathematics). As the year 2011 begins, traders are seeing the emergence of a particularly interesting pattern or alignment of three currencies in relation to the U.S. dollar. The Aussie dollar (AUD/USD), Canadian dollar (USD/CAD) and Swiss franc (USD/CHF) have reached and surpassed parity with the U.S. dollar. Let’s explore the potential impact.
First, parity with the U.S. dollar is an important landmark that shapes market forces. It means that more volatility will surround the currency pair because the parity price point becomes a psychological resistance, support and pivot line. For example, entering the term "U.S. dollar parity" as a Google search item results in more than 2 million hits, and more frequently traders are seeing headlines such as "Australian dollar conquering U.S. dollar parity," or "Loonie parity — The new reality."
In this digital age, headlines and key words increasingly become clues and even forces that contribute and augment market sentiment. As a result, U.S. dollar parity may become the "new normal" valuation point. This should not be surprising because markets often try to revert to a mean. In response, traders may be wise to consider scripting their trades to a reversion to mean strategy: if these pairs move too far too fast from the parity point, fade the move.
Of course, the key challenge will be to determine where exactly the point of under- or over-valuation is. There are many sources that drive big changes in currency valuation. Initially and most observable is the force of sentiment when the market expresses "risk aversion" and moves capital into currencies in times of uncertainty. Most recently the Swiss franc has achieved historic strength against the dollar and the euro because of market fears of global slowdown. The U.S. dollar also acts as a safe-haven in times of uncertainty, and most notably soared after the September 2008 financial crunch. However, traders looking for deeper fundamental answers often might use the concept of "purchasing power parity."
Accordingly, they may have to revisit the "Big Mac" Index," which for decades has been used as a rough indicator to detect whether the U.S. dollar is over- or undervalued based on the price of a Big Mac in certain countries. Basically, if currencies were fairly valued, then the cost of a Big Mac would be the same around the world. For example, in October, based on the Big Mac Index, the euro was overvalued by more than 20% and the Chinese yuan was undervalued by nearly 40%.
A modernized version of the Big Mac Index is iPod and iPad indexes. Because Apple iPod and iPad products are identical throughout the world, they become a virtual high-tech equivalent to the Big Mac for comparing price variations among countries. The CommSec iPod Index (launched in 2007) and the more recent iPad Index, accomplished this role. The iPad Index reported in May that the price of the Apple iPad was 20%-25% more in Europe and the UK than in the United States, thereby indicating that the U.S. dollar was undervalued. The CommSec iPod Index showed in November 2008 that Australia was the cheapest place to buy an Apple iPod. In October 2010, the same index reported Australia as the second most expensive place to buy an iPod, with Switzerland as the most expensive. Following the logic of the iPod index, traders would expect a decline in the Swiss franc and the Aussie against the dollar.
These purchasing parity analytics give a big-picture perspective often ignored by traders and perhaps a sense of trend change and direction. But traders rely on technical analysis to locate current market extreme valuations and to time entries. This brings into play technical tools. The first is stochastics and the second is Bollinger Bands. When we combine stochastics and Bollinger Bands to a monthly AUD/USD chart (see "Coming together") we see a greater level of granularity shaping a trading strategy. Stochastics show the pair obviously overbought at the same time as the top Bollinger Band has flattened (an indication of a top) with the monthly candles probing the upper band. This technical confluence, together with the overvaluation purchasing power confirmation signals coming from the iPad and iPod indexes, indicate strong headwinds for the Aussie rally. Add that to the fact that the Aussie is sitting near a strong pivot area, and you have a powerful set-up.
Abe Cofnas is the author of "Sentiment Indicators" (Bloomberg Press). He can be reached at firstname.lastname@example.org.