yen to invest in kiwi and other currencies (see thenext section on the carry trade).This uncertainty in the Japanese economy creates a great deal of increased ranging behavior in the currency. Traders of the yen should almost always expect the unexpected because economic news from Japan has a built-in greater potential to surprise us.Also important to consider is the growing impact of China on the Japanese prospects forgrowth. China has now surpassed the United States as Japan’s largest trading partner. Asa result, if the yen were to move toward a strengthening, Japan’s exports could be hurt. Aweak yen, in contrast, stimulates Japanese export growth. Export growth data thereforebecomes very important in affecting sentiment toward the yen.With regard to Japan, perhaps the best word to describe current conditions is uncertain. The uncertainty whether the Japanese consumer economy is strong enough togrow, combined with the uncertainty of whether Japanese interest rates will rise, dominates trading of the yen. The complexities facing the Japanese economy also involveaging workforce and potential shortages in labor. All these factors make trading the yenmore challenging than the other currency pairs.
c07
JWPR051-Cofnas (JWBK051-Cofnas)
58
August 10, 2007
15:10
Char Count=
WHAT DRIVES THE FOREX MARKET?
CARRY TRADEThe Japanese big picture implications are profound. With interest rates at 0.50 percent,the difference between Japan’s rates and those of other countries may continue to resultin huge outflows of capital in the form of carry trades. This is where Japanese investorscan borrow at extremely low rates and place the capital in bonds of other nations andreceive a net gain in interest rates. New Zealand and Australia have been major beneficiaries of the carry trade. For example, New Zealand interest rates are almost the highestin the world, at 8.0 percent. It therefore is a major attraction for the low-interest-ratecosts of borrowing yen. A popular way to do this is called the Uridashi bond. The WorldBank is a major issuer of these bonds, issuing over 2 billion yen’s worth. The total flowof such bonds is in billions more. These bonds are of short duration, most being two tothree years. If the market perceived that Japanese rates will increase, the huge amountof carry trade money outflow could suddenly decline. On February 27, 2007, this is exactly what happened, with a sudden sell-off of the dollar against the yen. This causedsimultaneously a sell-off of the Dow Jones Industrial Index as big funds got out of equitypositions to cover losses in their previous selling of yen. Even gold sold off during thiscrisis. Refer back to Figure 1.1, which shows the yen and the Dow on February 27. Butthe sell-off didn’t last, as the interest rate differential between the Japanese rates andother countries continued to attract carry trade investors.The big picture on Japan is one that focuses on uncertain growth and relatively lowinterest rates. Here is what the OECD Economic Outlook report stated at the end of 2006:The current economic recovery, the longest in Japan’s post-war history, has matured into a self-sustained expansion driven by private domestic demand. Theexpansion is projected to continue, with growth of about 2% in 2007–08, thanks tobuoyant business investment underpinned by record corporate profits and privateconsumption. Inflation is expected to increase only gradually (“Developments inIndividual OECD Countries and Selected Non-OECD Economies: Japan,” OECDEconomic Outlook, No 80. Preliminary edition, November 2006).During 2007, the yen had a wide range between its index lows and highs andended near its lows (see Figure 7.9). Its value largely depends on what happens inthe economies and the currencies of the United States and Europe. Refer back toTable 7.2g.Let’s summarize several fundamental strategies that emerge from the conditions ofthe Japanese economy. The first is the bet that the interest rate differences betweenJapan and the rest of the world will continue. For the forex trader believing this andlooking to trade the yen, imitating the “big” money and putting on carry trades as a strategy in a small retail account is one strategy that can be pursued.
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
Char Count=
Fundamental Personalities of Currencies
59
FIGURE 7.9 Trade-Weighted Index of the Yen.iBoxx® is a registered trademark of International Index Company Limited.
An additional strategy is simply to be selling yen until the key fundamentals changeand the trade-weighted index reverses toward the mean of 100. The fact that the tradermay observe that the yen is weakening, even in the face of good economic news, shouldnot be a surprise. Instead, the trader looking to buy yen would wait for the period oftechnical strengthening to run its path and then look to go long the yen. Any surprisenews that is positive for the yen can just mean to be prepared for a reversal towardstrengthening. The USDJPY pair and the EURJPY pairs are the best trading instrumentsfor the yen.A third strategy is to buy into the longer view that the Japanese economic recoverywill continue and that interest rate increases are inevitable. The trading strategy is to buythe yen (sell USDJPY)—of course, at the right technical locations, which we discuss inPart II.
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
60
Char Count=
WHAT DRIVES THE FOREX MARKET?
EUROThe euro as a currency is the most complex in the world. The creation of the euro wasa tectonic event in world economic news. Other currencies reflect one unified economy,whereas the euro reflects 13 economies comprising the Eurozone:
r Belgiumr Germanyr Greecer Spainr Francer Irelandr Italyr Luxembourgr The Netherlandsr Austriar Portugalr Sloveniar FinlandWhen combined, the Eurozone economy presents a powerful part of world trade.Table 7.4 snapshots the key measures of the regions, such as population, GDP, sectorsof production, and unemployment rate.This increased level of complexity introduces more uncertainty on the currency’s behavior. Managing to control the multiple economies of the Eurozone makes the missionof the European Central Bank (ECB) one of the most challenging of all central banks. Tosucceed, the policies of the ECB need to succeed in all of the member countries. Keepin mind that this is not easy. Each country has its own domestic policies, and its ownTABLE 7.4
Economic Proﬁle of the Eurozone
Population (millions)GDP (share of world GDP) (%)GDP per capita (thousands in euro)Sectors of production:Agriculture, ﬁshing, forestry (% GDP)Industry (% GDP)Services (% GDP)Unemployment rateSource: European Central Bank.
Euro Area
United States
Japan
313.214.825.5
296.720.135.6
127.66.425.9
2.226.671.38.6
0.721.178.25.1
1.220.269.64.4
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
Char Count=
61
Fundamental Personalities of Currencies
TABLE 7.5
iBoxx® Euro Trade-Weighted Index
Basket Currencies
Weights (%)
U.S. dollarBritish poundJapanese yenSwiss francSwedish krona
38.742628.372816.93799.33436.6124
inflation rates. Events in any country can undermine, achieving the average inflation ratethat the ECB sets. The forex trader has to expect the unexpected in regard to the euro.The personality of the Euro as a currency is based on which countries are theEurozone’s trading partners. We can observe these trading relationships in the TradeWeighted Index for the euro (refer to Table 7.5). The U.S. dollar has the greatest weight,with the British pound and then the yen following. There is more than one trade-weightedindex that the trader should be aware of. For example, we also have a fairly new tradeweighted index for the euro called the Dow Jones Euro Currency 5 Index (Table 7.6).The DJEC5 places a greater weight on Japan and less weight on the United Kingdom. Italso includes Australia, which is ignored by the TWI. For those traders interested in themathematics behind this new index, the following equation is used to calculate it:n
Index =
( pit × qit )
i=1
Dt
=
MtDt
where Dt = divisor at time tMt = the sum of component midprices multiplied by their respective weightfactors at time tn = the number of currencies in the indexpit = the midprice of currency i at time tqit = the weight factor of currency i at time tSource: Dow Jones Indexes.com.TABLE 7.6
Dow Jones Euro Currency 5 Index
Currency
Weight (%)
U.S. dollar to euroJapanese yen to euroBritish pound to euroSwiss franc to euroAustralian dollar to euro
44.2824.9121.556.292.98
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
62
15:10
Char Count=
WHAT DRIVES THE FOREX MARKET?
In any case, trading the euro in the absence of knowledge about which countriesthe euro trades with will undoubtedly lead to misjudgments about the performance ofthat currency. The importance of the euro as a currency reflects the fact that its tradingpartners are global, and as a result the euro as a currency may become less dependenton U.S. economic prospects. Traders have many choices of pairs to shape the trade. TheEURUSD pair is the most popular, followed by the EURJPY pair and the EURGBP pair.The fundamental picture of euro performance at this point in time is that of sustainedstrength. It has been probing trade-weighted highs, which reflects strong economic performance in its member countries. The economic growth of the Eurozone has led tointerest rate increases by the European Central Bank to contain inflation near a 2 percent level. This increase in rates has served to further strengthen the demand for thecurrency. The ECB raised its benchmark interest rate seven consecutive times, from2 percent in December 2005 to 4.0 percent now, and is in a position where it can order up more rate increases in 2007 without squeezing growth. The issue for the Eurozone’s future direction will significantly depend on whether its high interest rates willcontain inflation or fear of inflation and lead to market expectations of no further rate increases. However, the Eurozone also faces a relatively high unemployment rate of nearly8 percent.If the currency continues to have strength against a weakening yen, the Eurozonemay face a slowdown on exports, of which Japan is an important trading partner (Figure7.10), which would result in a slowdown in its economic performance. The trader shouldcarefully watch the EURJPY pair (Figure 7.11) if it presses on to new weekly and monthlyhighs. Fundamental forces will kick in and provide the impetus for a sell-off.
BRITISH POUND (CABLE)Great Britain remains a vigorous part of the global economy. Consider the fact that overhalf of the profits coming from the Financial Times and London Stock Exchange (FTSE)100 are profits from overseas activity. The British economy is intimately linked to globaltrading patterns. The TWI of the pound as tracked by iBoxx® (see Table 7.7) shows thatthe major trading partner is the Eurozone, followed by the United States.This immediately suggests that in trading the pound, the EURGBP and the USDGBPpairs would be the main pairs to trade. The British pound’s fundamental personality isthat it is more oriented to European economic events than the United States.We can see in Figure 7.12 that 2006 was a key year showing increasing strength ofthe pound as a currency that has underlying strength. In 2006, it broke the index numberof 100. We can also see that the pound is getting close to topping out in global strength,and traders need to watch for a possible probing or trend break in its TWI, as we can seein Figure 7.13.
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
Fundamental Personalities of Currencies
FIGURE 7.10 Trade-Weighted Euro Index.
FIGURE 7.11 Trade-Weighted Euro Chart.
15:10
Char Count=
63
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
64
15:10
Char Count=
WHAT DRIVES THE FOREX MARKET?
TABLE 7.7
iBoxx® Trade-Weighted GBP
Basket Currencies
Weight (%)
European euroU.S. dollarJapanese yenSwiss francSwedish krona
66.590021.47005.91003.14002.8900
The British economy at the end of 2006 was growing at its fastest rate over the previous two years nearing 2 /9 percent annualized GDP growth. The Bank of England (BOE),in response to the hot British economy, raised rates in a surprise move in August 2006,and raised rates again to 5.75 percent as of July 2007. These actions of the BOE showthat its policy on raising rates is very sensitive to data and that the central bank is notideological about it.
FIGURE 7.12 GBP Trade-Weighted Weekly Chart.iBoxx® is a registered trademark of International Index Company Limited.
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
Char Count=
Fundamental Personalities of Currencies
65
FIGURE 7.13 GBP Trade Weighted Daily Chart.iBoxx® is a registered trademark of International Index Company Limited.
The key factor for traders to watch will be what the BOE does on interest rates.As indicated in the section on fundamentals, housing continues to be a major component of decisions of central banks. Figure 7.14 shows that the hot housing market of Great Britain has not, as of this writing, experienced a downturn like theUnited States.With regard to inflation, the BOE’s target is 2 percent, and it is now at 2.7 percent, which leads to significant pressure and expectations that interest rates will notgo down. But any data that shows a slowing of inflation would translate into a sellingof the pound. Beyond the critical components of interest rates and GDP, Great Britainhas unique economic challenges due to an increase in migration levels. The surge inmigration can affect inflation and employment levels in a variety of ways, and thosewho watch and trade the pound must not ignore these aspects of fundamentals andGreat Britain.
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
66
Char Count=
WHAT DRIVES THE FOREX MARKET?
30Nationwide25Halifax20
15Land Registry (a)10
5
02001
02
03
04
05
06
FIGURE 7.14 House Prices (Percentage Changes from a Year Earlier).(a) Lagged by two months to reﬂect the fact that the index is based on completions whereas thelenders’ indices are based on mortgage approvals.Sources: Reproduced with kind permission of Land Registry. The house prices data being used isCrown copyright and is reproduced with the permission of Land Registry under delegated authorityfrom the Controller of HMSO.
SWISS FRANCThe Swiss franc represents an interesting niche among the global floating currencies.Over the years, it has been used as a safe-haven currency because it had a link ofconvertibility. This link was abandoned in 2000, but the Swiss National Bank (SNB), thecentral bank, still holds 30 percent of its assets, about 1200 tons in gold. Even though itis more than 70 years after the global collapse of the gold standard in 1936, there is stillan association of gold and the Swiss franc.In a speech commemorating this anniversary, John Pierre Roth, chairman of the governing board of the SNB, said the following:As I said at the outset, the role of gold has faded over the years. But gold had anafterlife long after it ceased to be relevant in any form for the conduct of monetary policy. First and foremost, the legal link between the Swiss franc and gold
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
Char Count=
67
Fundamental Personalities of Currencies
continued to exist until very recently. The constitutional changes that severedthis link took effect in 2000, followed, within the same year, by the corresponding changes in the relevant law. The new law no longer includes an obligationon the part of the SNB to redeem banknotes for gold—an obligation which—inpractice—had been suspended for decades. Moreover, it has abolished the minimum gold coverage of the banknotes in circulation and the gold parity of the Swissfranc. With these changes, gold finally became a normal and marketable asset forthe SNB. In May 2000, the SNB began to sell part of its gold stock. About 50 percentof the gold once owned by the SNB has now been sold. I should emphasise that theSNB will continue to hold gold as a monetary reserve, but the legal relics of the goldstandard era no longer immobilize the gold stock as they did for decades (Openingremarks, conference, “Seventy Years After: The Final Collapse of the Gold Standardin September 1936,” University of Zurich).The Swiss franc’s personality is not limited to an orientation to gold. It reflects thefact that it is embedded in the European economy. From a trade-weighted point of viewthe most important currency impacting the franc is the euro followed by the U.S. dollar(see Table 7.8).Trading this currency offers several alternative strategies. It can be used as a hedgeagainst the EURUSD trade; it can also be used as a method for buying dollars. In fact, intrading the news, the hedge effect of the USDCHF against the EURUSD is employed toimplement a trading the news strategy. The Swiss franc also can be used as an alternativeto the yen for those traders looking to construct a carry trade. They would be selling theSwiss franc, which has an associated low interest rate of 2.5 percent, and then buyingcurrencies that have higher interest rates such as the New Zealand dollar, the Australiandollar, and even the British pound. Finally, by understanding the state of the Swiss economy and evaluating the trade-weighted index charts (Figure 7.15), the trader can decidewhether to buy or sell the Swiss franc (“Export Accessibility in Switzerland,” SwitzerlandEconomic Studies, 2000, p. 21 [AN 5847930]).
TABLE 7.8
iBoxx® Trade-Weighted Index CHF
Basket Currencies
Weight (%)
European euroU.S. dollarBritish poundJapanese yenAustralian dollar
70.430415.03637.40085.15371.9788
c07
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:10
68
Char Count=
WHAT DRIVES THE FOREX MARKET?
FIGURE 7.15 CHF Trade-Weighted Index Daily Chart.iBoxx® is a registered trademark of International Index Company Limited.
ASSIGNMENTTrack the Trade-Weighted Indexes of the CurrenciesGo to www.iboxx.com and register. You will then be able to generate the latest TWI charts ina few simple steps.
c08
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:11
Char Count=
CHAPTER 8
The Personality andPerformance of theU.S. Dollar
aining a fundamental understanding of the U.S. economy is a critical part of beingprepared fundamentally for forex trading. The U.S. economy is still the largestdeveloped economy in the world, and therefore the U.S. dollar reflects this importance. Much of the world’s trade is denominated in dollars, and global reserves ofcentral banks hold over US$4 trillion, which is about 60 percent of all reserves, according to latest data. It is true that we are in a period when the world economy is growing,particularly with the growth of Asia. This growth may mean that in the coming years,the preeminence of the U.S. economy will diminish. However, as the U.S. economy remains the critical pivot point of the world economy, forex trading will continue to payclose attention to U.S.-based economic events. In particular, the forex trader, in tradinga currency pair involving the dollar, is actually making a judgment or a bet about thedirection of the U.S. dollar with regard to the other pair. This can be a five-minute bet orone that goes substantially longer in duration. But the fundamental question the traderhas to answer is whether to be bullish or bearish on the dollar for his next trade.A first approach to getting a picture of the global position of the U.S. dollar andgauging whether it is strong or weak is by looking at the Trade-Weighted Index (TWI).In Figure 8.1 we can see that the “health” of the U.S. dollar has declined significantly.It is probing the lows of this index, and if it breaks below 80, the world, through globaltrading forces, will demonstrate an unprecedented decline in dollar values.This 30-year chart certainly provides a perspective missing from day-to-day trading,but a forex trader can zoom in on the U.S. dollar performance by generating a nearerterm chart. For example, in Figure 8.2, we see the U.S. Dollar Index–TWI recent patterns.The trader can use this chart and generate strategies to prepare for future moves if theyoccur. The next time you are asked the question, “What do you think of the U.S. dollar?,”
G
69
c08
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:11
70
Char Count=
WHAT DRIVES THE FOREX MARKET?
FIGURE 8.1 Trade-Weighted Exchange Index: Major Currencies (TWEXM).Source: Board of Governors of the Federal Reserve System.
FIGURE 8.2 USDX Day Chart.Source: www.ino.com.
c08
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:11
Char Count=
71
The Personality and Performance of the U.S. Dollar
based on a review of Figure 8.2, you can answer that the U.S. dollar is in a compressedtriangle and that it is testing historic support near 80 on the TWI. One can also go furtherand develop a trading strategy and state: “If it breaks below 80, I will be a seller of dollars, but if it stays above it, I will be a buyer.” This kind of strategy, which comes from afundamental perspective but also reflects good technical strategy, is a recipe for success.Gaining insight into the strength of the U.S. dollar can also be done by looking at theNew York Board of Trade’s (NYBOT’s) U.S. Dollar Index (USDX). This index is tradedat the NYBOT and is a weighted index. It is not trade weighted and therefore does notreflect the dollar’s strength or weakness in the context of global trading patterns. But theUSDX is traded by major funds and is considered an important barometer of sentimentregarding the dollar. It can easily be tracked at www.ino.com. Let’s take a closer look.
STRUCTURE OF THE USDXThe USDX has its own basket of currencies, just like the TWIs. But notice the differencesin the weights between the USDX’s basket and the Federal Reserve’s in Table 8.1.The question arises of which is better? The answer really depends on how you useit. The USDX is more popular and provides a trader an accepted way to track dollar sentiment, though it is less accurate from an economic point of view. When the USDX isshowing a dollar decline, it may be exaggerating the real decline from a global tradingpoint of view. In Figure 8.2, we can see that as 2006 ended, the dollar had retraced somewhat on better housing news and was testing a key 50-day moving average. The USDXchart provides a good way of checking dollar sentiment.It should be clear that there are many ways to evaluate the dollar. In fact, new measures are always being introduced. Citigroup recently introduced its own dollar indexcalled the Citigroup Flow-Weighted Index. This index scrutinizes international capitalflows, which have become an important influence on forex. Additionally, there is the
TABLE 8.1
New York Board of Trade’sU.S. Dollar Index
Currency
Weight
European euroJapanese yenBritish poundCanadian dollarSwedish kronaSwiss franc
0.5760.1360.1190.0910.0420.036
c08
JWPR051-Cofnas (JWBK051-Cofnas)
72
August 10, 2007
15:11
Char Count=
WHAT DRIVES THE FOREX MARKET?
J. P. Morgan Dollar Index, which looks at the dollar in terms of a basket of 18 currencies. The bottom line is that the forex trader has now an improved ability to answer thequestion of how well the dollar is doing in terms of its fundamentals by looking at thedifferent TWIs of the dollar.
U.S. FOREIGN DEBT AND WHO BUYS U.S. ASSETSOne of the fundamental variables that affect sentiment regarding the U.S. dollar is thefact that as a nation the United States has huge foreign debt. For example, economistDavid Levy said recently:The current account deficit measures the difference between what U.S. residentsspend abroad and what they earn abroad in a year. It now stands at almostsix percent of GDP; total net foreign liabilities are approaching a quarter ofGDP. Sudden unwillingness by investors abroad to continue adding to theiralready large dollar assets, in this scenario, would set off a panic, causing thedollar to tank, interest rates to skyrocket, and the U.S. economy to descend intocrisis, dragging the rest of the world down with it (www.foreignaffairs.org/20050301facomment84201/david-h-levey-stuart-s-brown/the-overstretch-myth.html).Another way to look at the current account deficit is that it reflects the excess of imports over exports. The question is: Why is there a current account deficit in the UnitedStates, and why do nations such as China have a current account surplus? The answer isthat the fundamental personality of the U.S. economy is that it is the world’s greatest consumer economy. The issue that is relevant for the forex trader is not the fact that there isa current account deficit; it’s the fact that it results in the U.S. Federal Reserve’s issuingnotes to finance this deficit, and foreign ownership of these securities generates fear inthe market. The fear is that if foreign investors of U.S. Treasury notes suddenly becameunwilling to buy these notes, the U.S. economy would suffer. Here is what happenedin 1997:Foreign ownership of U.S. Treasury securities has often been the subject of considerable public debate. Discussion of this issue arises particularly at times ofuncertainty about either the outlook for the exchange value of the dollar or theneed for cash in countries holding large stocks of Treasury assets. In June of 1997,for example, there was a flurry of activity in the U.S. financial markets when thePrime Minister of Japan, Ryutaro Hashimoto, suggested that Japan might find itnecessary to sell some of its large Treasury holdings.On the day following Mr. Hashimoto’s remarks, the Dow Jones industrial average fell by 192 points, its largest decline in a single day since the 508-point
c08
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:11
Char Count=
73
The Personality and Performance of the U.S. Dollar
falloff on October 19, 1987. While the Prime Minster’s clarification of his remarkssubsequently calmed the markets, it did nothing to alter the potential vulnerability of the U.S. financial markets to sudden decisions by foreign holders of U.S. debtto undertake large-scale sales of their dollar assets. (Laurence H. Summers, “TheU.S. Current Account Deficit and the Global Economy,” October 4, 2005, The PerJacobsson Foundation,www.perjacobsson.org/2004/100304.pdf)The U.S. Treasury issues a report called “Major Foreign Holders of U.S. Treasury Securities (www.treas.gov/tic/mfh.txt). The fear that someday foreign ownership of U.S. Treasury securities will stop and cause interest rates to increaseand destabilize the U.S. economy. The trader will find that this fear continues toresurface in newspaper headlines and will likely become part of the U.S. nationalpolitical dialogue.When the U.S. Treasury report comes out, it can move the forex market. We can seefrom the latest reports that the United States has over $2 trillion of foreign holders ofU.S. securities (see Table 8.2). From a fundamental view, this is supportive of the dollar.We can see that the Organization of Petroleum Exporting Countries (OPEC) accumulatesdollar surpluses from its petrodollars. It also purchased more U.S. treasuries. Monitoringthe levels of foreign owners of U.S. securities is an important part of sensing the truedollar sentiment in the world. Forex dollar bulls can point to the fact that essentially aconsistent stream of buyers of U.S. treasuries has provided a floor against a steep andquick fall of the U.S. dollar.
TABLE 8.2
Major Foreign Holders of TreasurySecurities (Billions of Dollars)
Country
As of Jan-07
JapanChinaUnited KingdomOil exportersKoreaTaiwanCaribbean banking centersGermanyHong KongBrazilTop 10 Total
648.8353.6249.3102.465.663.162.956.454.753.717