Some traders like to trade the data, counting on a bounce one way or the other as other traders react to outcomes that differ from the forecast—without regard for how that data fits into the Big Picture. Others trade the chart, assuming that if news is important enough, the response will be reflected on the chart and that’s what makes a news event tradeable. It has gone out of fashion for retail traders to take positions on the basis of Big-Picture fundamentals.
And no wonder, since the FX market has the “disconnect puzzle,” whereby big events that in theory should result in one outcome all too often result in a different one. FX has too many theories—purchasing power parity, current account imbalances, relative interest rates, etc.—and none of them do a good job. Besides, reconciling them all into a single coherent theory of exchange rate determination has eluded the economics profession, so it surely must defeat even the savviest of retail traders.
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But it’s a pity that retail traders have given up on the Big-Picture material, because the top players in the FX market, the fund managers (including sovereign wealth funds and central bank reserve managers) do base their decisions on the Big Picture. Therefore, traders at the big banks and brokers that execute trades for the big players are in sync with their thinking.
We argue in The FX Matrix that making the effort to read the mind of the fund managers can pay off. Two cases are front and center today.
First is the dollar/yen rising to the highest since 2009 on the new Japanese government’s “Abenomics” and a new central bank governor clearly intending to make a big deal about the beginning of a new stimulative regime. Even before Abe actually won the election, the market was preparing for new policies and bought the dollar from a low of 77.13 on Sept 13, 2012 to a high (so far) of 96.71 on March 11, 2013, or almost 2000 points. In addition to specific statements saying Japan would seek a far weaker yen, officials confirmed they were also seeking a stronger Nikkei stock index. Japan escaped censure for currency war rhetoric at G20 only by the intersession of G7, which held an unprecedented special meeting to define “currency war” and to insist nobody in G7 would ever engage in such a thing.
The new administration strong-armed the BoJ Governor into agreeing to a doubling of the inflation target and then into early retirement. And various officials have been carefully feeding the press with nuggets of proposals for buying foreign bonds as well as JGB’s, adding to the tenors the BoJ may buy, even having the BoJ buy equities. There was a rumor that incoming BoJ chief Kuroda would hold an “emergency” policy meeting ahead of the regularly scheduled one (April 3-4), perhaps the very next week after taking office (March 26-28). Since Kuroda takes over March 19 and that is the date of the beginning of the next FOMC, we could be in for some serious fireworks on that date.
Abe and Kuroda have made it clear they firmly intend to knock the socks off market players. They seek a Shock as a catalyst for a deep change in risk sentiment domestically and internationally. After all, various forms of QE over the past two decades have failed to do the trick. Whatever is coming, it’s not going to favor a rising yen unless they chicken out. Too weak an initiative has been the fault in the past, as Bernanke himself pointed out years ago. We expect Abe and Kuroda are fully aware of it and perception of chickening out is going to be avoided, whether the Something Big can actually work or not. Appearances are not everything, but they are more important than the sum of the specific policy proposals. To use an outdated term, the Japanese government is aiming for synergy.
No economy has escaped a deflationary recession without a war in modern history, so Abe and Kuroda need to do something to jump-start the Japanese economy that is just short of war. Not only does it have to be big, it has to shock markets out of the perception that the dollar/yen is on a decades-long downmove. See Figure 1, the dollar/yen from 1985, when the yen was over ¥250. We could go further back to 1974, when the dollar/yen was ¥300.4 (average for Dec 1974), or even before the dollar was floated to Jan 1970, when the yen was ¥357.70. In the floating currency era, the dollar/yen has demonstrated a persistent downtrend. The Abe government has 39 years of built-in bias to overcome.
From 1985, the dollar/yen has managed five instances of counter-trend strength, the biggest of which is the move from 101.26 (11/26/99) to 147.65 (01/31/02), or 4639 points. The 1913-point move so far this time is about 40% of that move. Assuming that the Ministry of Finance and Bank of Japan are looking at a long-term chart like Figure 1, they must want the dollar/yen to keep going to the commensurate level this time, too, or 123.52. At the least, they must want the dollar/yen to break resistance at about 108. Since the market likes round numbers, we should be looking at 100, 105, and 110 as built-in targets. If the market needs new policy fodder for each hurdle, Japanese policy-makers are going to be very busy keeping the chatter going. And if the effort falters or the market comes to believe it’s an impossible task, we should not doubt the MoF and BoJ will intervene. Japan has intervened more than any other country, most recently in 2011 after the tsunami and before that, in 2003-04, when it spent over $85 billion.
This is the historical perspective in which to view any trade in the dollar/yen today. It is very high-risk to fade the trend, not that it can’t be done on a short-term basis. But any yen-buying should be supported by specific immediate reasons and with the acknowledgement ever-present that the trade should be short-lived. This kind of analysis is almost certainly what the big players are looking at, and the retail trader should, too. Many traders who trade on an hour-by-hour basis become bored upon seeing a chart that covers over 20 years. But there’s gold in them hills.
Another lesson for the retail trade in The FX Matrix is “be careful what you read.” The financial press likes to show punchy headlines like any other newspaper, and sometimes they get carried away. A good case is a currency section article in the Financial Times (March 12, 2013) with the headline that a dollar rally is “in the stars.” The thesis is that the US economic recovery is so much better than conditions in Europe and Japan that the dollar is starting to be positively correlated with growth data.
In recent years—since the financial crisis—good US data was taken to mean the world was safe for risk, so sell dollars and buy something risky. Now that “rule” is changing and good US data means buy the dollar, despite all the other US problems, a return to pre-crisis thinking.
Can this be true—a sea-change in risk sentiment? After all, there are good reasons to sell the dollar independent of economic performance. And economic performance is always relative. It’s possible that if Europe were not contracting and flailing at bailouts, the euro would be prospering even at 1% growth while the US does get 4%. We have seen exactly this situation before, so the good US performance so far is not a decisive factor—it takes misery on the other side of the Atlantic, too. If Italy were to clean up its act in the next week, for example, the euro would soar. So let’s not be to quick to accept a new environment in which demand for dollars is a given. It’s far from a given.
The FT notes the higher dollar has been due to “a wave of upbeat economic figures” that sent the 10-year yield over 2% and the S&P just 1% under the high. But it’s not the stars that determine currency levels, it’s the thoughts and feelings of the big money managers, who have had an anti-dollar sentiment for decades, for reasons both silly and fully justified. To point to the rising S&P as evidence of a coming dollar rally is not consistent with the recent inverse correlation. The only way to get evidence that foreigners are buying dollars and US equities is to consult the monthly Treasury report on capital flows. Assuming that foreigners are demanding more dollars because the S&P is on the rise is not warranted.
The only thing that works in this scenario is rising US self-sufficiency in energy and rising 10-year yields. As for energy, nobody knows for sure what effect this has on the dollar. In the 1980’s and 1990’s, rising energy costs were negative for Europe, not for the US. The so-called inverse correlation of the price of oil and the dollar is hardly an enduring truth. Besides, what we know about Chinese demand for energy can be put in a teaspoon. We do not get credible data from China on anything having to do with energy–demand, supplies, stockpiles, or efficiency. And you can’t forecast energy prices without China. The best we can say about greater US energy-independence is that the link between the dollar and crude oil is considerably weakened. This is not exactly something you can trade on.
As for the 10-year over 2%, that’s a function not only of better growth but also the expectation that the Fed will soon start retreating from QE. But we have zero evidence this is the case and we do have strong evidence, from Fed Vice-Chairwoman Yellen in a recent speech, that even if unemployment were to meet the target 6.5%, the Fed may still not taper off QE—it may just choose some other employment-related metric. This is not to say the Fed won’t whisper some sweet nothings in the ear of the bond market at the next FOMC on March 19-20. But the Fed herding the bond market is not the same thing as an actual policy change. For that we almost certainly have to wait a lot longer.
Besides, the decline in the euro that the opposite side of the dollar-rising coin is not due to anything going on in the US economy, but rather a bout of the heebie-jeebies over the sovereign debt problem as well as a contracting economy. Again, a long-term chart of the euro shows it in a persistent uptrend, punctuated by dips. Recently the dips have been occasioned by the serial debt crises, first Greece and then Ireland and Portugal and most recently, Spain and Italy. But the euro enjoys a favorable bias among fund managers that allows it to weather storms that would fell a lesser currency. Even after China declared in 2012 that it would stop investing in EFSF/ESM bonds because of a dysfunctional institutional bailout process, the euro was able to hold on to gains.
Why does the euro get away with it? Easy. The founding principles of the eurozone are to prevent inflation either through central bank money supply management or excessive public deficits. No sovereign has ever made such a commitment to the global saving and investing world. It pours magic over the euro. Fund managers are able to discount any number of political and economic problems because of the magic. And the guy with the magic wand is ECB chief Draghi, who single-handedly pulled the euro out of one of the dips with the “whatever it takes” speech on July 26, 2012. He was referring to bailing out the Spanish banking sector, but he was talking about the commitment to saving the euro from all comers.
It didn’t hurt that the euro has already bottomed a few days before (July 23) at 1.2068. But the euro managed a run to 1.2931 on Feb 1, 2013, or 863 points in six months. Even a trader on the one-hour chart needs to respect the Big Picture of the pro-euro bias and incorporate an expectation that Mr. Draghi will always respond aggressively to any serious dip.
The Big Picture, accurately read, can help the retail trader avoid mistakes, like targeting a gain that is not likely when it exceeds a previous high that was occasioned by a Big Picture event. Similarly, should we see a new low (like the pre-Draghi 1.2068 low of last July), we know we have a breakout point of tremendous importance. Even better, adding the Big Picture perspective allows you to keep adding to winning positions or re-entering a winning position multiple times. Nobody knows how, exactly, to follow the annoying dictum “Buy low and sell high,” but we can certainly figure out when to buy high and sell higher. So don’t dismiss long-term charts. It’s true that you can’t trade them but they still contain a lot of information that is useful for shorter-term trading.