really are not certain.“I guess it is one of those mysteries,” said Christopher D. Carroll, an economics professor at Johns Hopkins University. “I don’t think anyone knows whatthe answer is.”Nevertheless, mortgage equity withdrawal is closely watched as an indicator of the general economy because, Mr. Carroll said, “there is a lot of concernthat a cooling housing market could result in a sharp fallback in consumerspending.”A recent paper that Mr. Carroll helped write contends that for every $1,000change in housing wealth there is an immediate propensity to consume about $20more. The wealth effect, as the phenomenon is called, is twice as high for housingwealth as it is for stock wealth, Mr. Carroll and his associates said.
At the end of 2006, the data on MEWs showed a large decline from the year beforein the United States. This was an early indicator of a slowdown in the U.S. economybecause it is estimated that two-thirds of the money from MEWs goes for consumption.So the forex trader seeing signs of an MEW slowdown can get ready for its effect to takeplace months in advance.The importance of housing data as a factor in shaping currency moves has beenhighlighted further by the events relating to subprime mortgages in the United States.These mortgages were issued during the housing boom/bubble, without the traditionalcredit requirements. Economic forces ultimately worked to create mortgage delinquencies and a collapse in this market. For the forex trader it is a clear case where fundamentals affect the dollar. More housing weakness translates to weaker consumer demandand that translates to lowering the probability of interest rate increases. It’s difficultto be bullish on the dollar in this environment. However, if the housing market starts
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The Fundamentals of Forex
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recovering, the pressures to increase interest rates (or not decrease them) will help attract dollar buyers.
ASSIGNMENTFind the MEW Rates in Canada, Australia, and the United KingdomThis will take some exploration on the Internet, but it is worth tracking.
HOUSING DATA AS A LEADING INDICATORWhat is important to realize about fundamental analysis of housing sector data is that thetrader can identify pending changes in trends and direction of the economy. Of course, itis true that forex prices move all the time in reaction to news and the like, but economiesdon’t change direction overnight. By understanding housing data, one can develop a fundamental viewpoint that leads to trading strategies before technical price patterns reflectthe change.For example, in Table 1.1 we see data on U.S. new housing starts. The year 2005 wasa year of a high level of housing starts peaking in February at 2.2 million units and thentesting that peak in January 2006 (see Figure 1.2). After January 2006, the data showeda decline, and by August 2006, the decline in housing starts reached levels of 2003. Theforex trader may not have picked the start of the slump by looking at this kind of data, butclearly would have seen that right after the start of 2006 new home starts were in a periodof weakening. When housing starts reached a peak and then started declining, it wasdifficult to be pro-dollar. Although housing data showed a slump, the Federal Reservedidn’t stop the increase in rates until August 2006. In this case the new housing start datawas a very reliable leading indicator that interest rates would not increase.
HOUSING SENTIMENT INDICATORSOne can argue that economic data on housing activity is lagging and that a trader needs tofind indicators that are more coincident with activity or even leading. A valuable sourcefor assessing housing activity in the United States is the survey releases of the NationalAssociation of Housing Builders (NAHB). According to the NAHB, “The Housing MarketIndex (HMI) is based on a monthly survey of NAHB members designed to take the pulse
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TABLE 1.1
WHAT DRIVES THE FOREX MARKET?
Number of New Privately Owned Housing Units Started (Seasonally Adjusted)
Year
New PrivatelyOwned HousingStarts (Unit =Thousands)
Year
New PrivatelyOwned HousingStarts (Unit =Thousands)
Jan-00Feb-00Mar-00Apr-00May-00Jun-00Jul-00Aug-00Sep-00Oct-00Nov-00Dec-00Jan-01Feb-01Mar-01Apr-01May-01Jun-01Jul-01Aug-01Sep-01Oct-01Nov-01Dec-01Jan-02Feb-02Mar-02Apr-02May-02
16361737160416261575155914631541150715491551153216001625159016491605163616701567156215401602156816981829164215921764
Jun-02Jul-02Aug-02Sep-02Oct-02Nov-02Dec-02Jan-03Feb-03Mar-03Apr-03May-03Jun-03Jul-03Aug-03Sep-03Oct-03Nov-03Dec-03Jan-04Feb-04Mar-04Apr-04May-04Jun-04Jul-04Aug-04Sep-04Oct-04
17171655163318041648175317881853162917261643175118671897183319391967208320571911184619982003198118282002202419052072
Year
New PrivatelyOwned HousingStarts (Unit =Thousands)
Nov-04Dec-04Jan-05Feb-05Mar-05Apr-05May-05Jun-05Jul-05Aug-05Sep-05Oct-05Nov-05Dec-05Jan-06Feb-06Mar-06Apr-06May-06Jun-06Jul-06Aug-06Sep-06Oct-06Nov-06Dec-06Jan-07Feb-07
1782204221372213185620792034207820702075215820462131200222652132197218321953183317601659172414781565163315651525
of the housing industry, especially the single-family industry. The survey asks respondents to rate general economic and housing market conditions.”By looking at the HMI data for 2005 and 2006 we can discern an increasing pessimism on the health of the housing market (see Tables 1.2 and 1.3). The survey resultsin the summer of 2005 were at a peak on all HMI component measures. The FederalReserve stopped increasing rates in August 2006, reflecting their judgment that the economy didn’t require more rate increases. Using the HMI index, the forex trader saw a
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The Fundamentals of Forex
TABLE 1.22005May702006Mar54
Housing Market Index (Seasonally Adjusted)
Jun72
Jul70
Aug67
Sep65
Oct68
Nov61
Dec57
Jan57
Feb56
Apr51
May46
Jun42
Jul39
Aug33
Sep30
Oct31
Nov33
Dec32
Source: National Association of Housing Builders.
significant weakening in the housing market, which was an omen that increases in rateswere increasingly not likely. At the end of 2006, the HMI survey shows that the previousrate of decline in housing starts was slowing down. This can be interpreted as possiblebottoming out of the housing market. Using this data, those traders expecting an interestrate decrease would have to reconsider their confidence in a rate cut.The importance of housing data as an indicator for traders is reflected in the fact thatnew sources of data on housing are being developed for investors. One of the more recent sources is the Standard & Poor’s (S&P)/Case-Shiller home price index. It is a benchmark measure for housing prices. It tracks the value of single-family homes in the UnitedStates. Twenty metropolitan areas are tracked, and the index is measured monthly. The
TABLE 1.3
Housing Market Index Components (Seasonally Adjusted)
2005MayJunJulAugSingle-Family Sales: Present76777673Single-Family Sales: Next 6 Months77807777Traﬃc of Prospective Buyers535555502006MayJunJulAugSingle-Family Sales: Present59555047Single-Family Sales: Next 6 Months62595551Traﬃc of Prospective Buyers40393329
Sep
Oct
Nov
Dec
Jan
Feb
72
74
67
64
62
61
70
73
65
65
66
64
49
51
46
40
41
40
Sep
Oct
Nov
Dec
Jan
Feb
43
37
32
32
33
33
46
41
37
42
45
48
27
22
22
23
26
23
Source: National Association of Housing Builders.
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last Tuesday of each month at 9 A.M. is the release time of the announcement. Traderslooking for leading indicators of a housing recovery will likely see it in increases in housing prices tracked by this monthly index, posted at www.indices.standardandpoors.com.Detailed housing data can also be found at www.macromarkets.com.
ALSO WATCH HOUSING EQUITY SECTOR STOCKSAnother way for the forex trader to get a grip on housing data is to watch equities that arehousing related. For example, Lennar Homes is a leading home builder. Its stock priceand earning forecasts offer good clues regarding the direction of the housing market andby inference interest rate policies (Figure 1.3). In April 2006, Lennar homes broke downbelow its support at $55 per share. Lennar Homes’ weakness was an omen about theend of interest rate increases. Interestingly, when the forex market begins to conjecturewhether the Federal Reserve will raise rates in the future, the trader following LennarHomes’s stock price or another housing equity leader will be helpful in shaping an opinion about the likelihood of an interest rate increase.
FIGURE 1.3 Lennar Homes Trying To Recover.Chart courtesy of Aspen Graphics, www.aspenres.com.
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Here is what the Lennar chief executive officer (CEO) said as 2007 started (WallStreet Journal, March 1, 2007):Lennar Corp. (LEN) Chief Executive Stuart Miller is seeing no signs that the deteriorating home-building market has bottomed, and Lennar expects to take landrelated write downs of between $400 million and $500 million in its fiscal fourthquarter to reflect the weak conditions.“Market conditions continued to weaken throughout the fourth quarter, andwe have not yet seen tangible evidence of a market recovery,” said Miller, in astatement.
ASSIGNMENTFind Other Equities that Provide Insight into the Housing MarketIn this assignment, the trader should select the top equities that represent aspects of thehousing sector and start watching their weekly performance. When these housing equity stocksstart probing their weekly support, resistance, and trend lines, the trader will have clues as toa potential change in the housing market.
HOUSING DATA AND GREAT BRITAINAs discussed earlier, housing provides a strong indicator regarding interest ratesthroughout the world. For example, as 2006 ended, the situation in Great Britain regarding housing indicated a very strong housing market and therefore supported sentiment of interest rate increases by the Bank of England. In 2006, housing prices inflated by nearly 10 percent in Great Britain. Economist Diana Choyleva believed pricescould rise by as much as 15 percent in 2007. But she warned that if the Bank of England did not prevent people’s taking on excessive debt by raising interest rates, it riskedlaying the foundations of another major collapse. In January 2007, she said, “The Bankcould risk finally spawning a house price bubble in 2008” (Edmund Conway, economicseditor, “House Prices at Their Most Overvalued for 15 Years,” Telegraph, January 2,2007).In other words, expectations of an interest rate cut in Britain would require evidenceof a slowdown in housing price increases. The trader trading the British pound shouldwatch British housing data very carefully and gain an edge in shaping trading strategy. Auseful web site for staying on top of British housing data is www.hometrack.co.uk/.
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SUMMARYTracking changes in how an economy is growing is clearly an important part of gaininga sense of whether a currency will be strengthening or weakening. The relationship ofgrowth and currencies applies throughout the world. While there are many aspects toeconomic growth, the forex trader’s main focus should be on interest rates. An increasein interest rates tends to strengthen the currency. The trader needs to go further than justknowing what the rate levels are. They trader needs to assess whether the economy isstrengthening or weakening. Housing data is one of the most important areas that affectthe decision to increase rates, keep rates the same, or decrease rates. The forex tradershould keep track of housing data when trading a currency.
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CHAPTER 2
The Role of Inflation
nflation is in many ways the elusive enemy of central banks throughout the world.Much progress has been made over the decades. In the period of 1973 through 1987,inflation levels in industrialized countries were near the 7.5 percent range. A decadelater, in 1989, inflation levels ranged at the much lower level of 3 percent. Today, allyou have to do is read the central banks’ public documents to realize that their majormission is to contain inflation. Many central banks, in fact, announce inflation targets. Infact, Bernard Bernanke, the successor to Alan Greenspan, has favored formal inflationtargeting for the U.S. Federal Reserve, and this is a significant change from Greenspan’sfamous verbal ambiguity in his communications strategy.Central banks around the world monitor inflation and raise interest rates to try toslow down inflation. Central banks often include in their statements accompanying interest rate decisions that they will be vigilant over potential risks of inflation. This iscommonly known as being an inflation “hawk.” Whenever inflation is feared to be lingering in the economy, traders interpret this fear as raising the probability that interest rateswill increase.A fear of lingering inflation tends to generate in the market the anticipation ofhigher rates, and therefore works to support the buying of a currency. That is also whystrong retail prices tend to undermine bond prices. Bondholders fear increased ratesbecause they reduce the attractiveness of the bonds they hold, and the market lowersthe prices of the bonds in order to equalize the yield of the old bonds with the newinterest rates.Inflation is the ever-present yet stealthy ghost that spooks the forex market and challenges central banks. It is particularly difficult to track. There is ongoing controversy
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even among the best economists on how to measure and detect inflation, and as a resultthere are many data sets relating to inflation. Central banks all over the world are tryingto get an accurate answer to the question of what is true core inflation?This level of complexity in measuring inflation sets up the forex market for surpriseswhen data comes along that inflation has not been contained. If central banks can’t beaccurate in measuring inflation, why should an individual trader? Surprises can be expected. For example, in December 2006, when inflation data rose the highest in 30 years,it provided a boost in the dollar value as more traders were betting that the Fed wouldnot decrease rates, or might even increase rates.Speaking of the challenge in interpreting monthly inflation numbers during his tenureon the Federal Reserve Board, former vice chairman Alan Blinder said, “The name ofthe game then was distinguishing the signal from the noise, which was often difficult.The key question on my mind was typically: What part of each month’s observation oninflation is durable and what part is fleeting?” (Commentary on “Measuring Short-RunInflation for Central Bankers,” Federal Reserve Bank of St. Louis Review, May/June1997).The challenge to getting a true measure of inflation has also been a focus of recentactivity in Britain. The Office of National Statistics is introducing a new inflation calculator that allows persons to calculate their own inflation measure! In other words, theother measures [such as the Retail Price Index (RPI), the Retail Price Index excludingMortgage Payments (RPIX), and the Harmonized Index of Consumer Prices (HCIP)] arestill in force, but there is recognition that inflation needs more measures for an accurateassessment. This confusion and debate over how to detect inflation in Great Britain underscores the issue is an international one. The Monetary Policy Committee of the Bankof England (www.parliament.the-stationery-office.co.uk/pa/ld199899/ldselect/ldmon/96/9615.htm) offers more details on this subject.The good news is that the forex trader doesn’t have to become a Ph.D in economicsto follow inflation data. There are many key measures of inflation that are tracked. Butyou have to check the central bank web sites.
ASSIGNMENTFind Out the Target Inﬂation Rates of Central BanksTraders need to keep track of inﬂation rates and targets in each country. The best way to dothis is to ﬁrst check the web site of the central bank. They contain a great deal of informationon inﬂation and inﬂation policy.
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The Role of Inﬂation
INFLATION MEASURES IN THE UNITED STATESThe Federal Reserve Bank of the United States measures inflation using something calledthe Core Personal Consumption Expenditure Index, or Core PCE Index. Core inflationrefers to the components of inflation that are more durable and not a result of temporaryevents, such as a hurricane. Core inflation excludes food and energy prices, which varytemporarily.The PCE is now the favorite measure used by the Federal Reserve. However, in an attempt to be even more accurate, economists have gone further and developed a trimmedPCE, which is designed to give a truer view of inflation. Table 2.1 shows three measuresof PCE, but what is really important is to realize that any rate above 2 percent is considered to be a signal of too much inflation in the economy by most central banks, and thesekind of levels lead to expectations of central banks’ increasing interest rates or at leastnot decreasing rates.The Producer Price Index (PPI) is another key measure that is reported and tracked.The PPI measures what businesses charge one another for everything from iron oreand diesel fuel to cases of soda pop. The U.S. Bureau of Labor Statistics generates PPIdata for over 8000 different product categories, reflecting price pressures among different industries. A net PPI figure, of course, is more general in nature (www.bls.gov/). InNovember 2006, the PPI surprisingly rose 2 percent higher than the month before. Theindex had not risen by that much in a single month in more than 32 years, since theenergy and stagflation crises of the mid-1970s. The fact that the PPI and the core inflation may differ adds to the uncertainty of the true condition of the economy regardinginflation.The Consumer Price Index (CPI) tracks consumer price changes given a fixed basketof goods and is part of the data set watched by traders in all countries. The U.S. Bureauof Labor Statistics provides comprehensive data on inflation and, in fact, tracks the various inflation rates. It conducts extensive sampling of 87 urban areas, 50,000 homes, and23,000 retail establishments. Persons interested in getting deeper into their methodologyfor generating inflation data will be rewarded by going to the Bureau of Labor Statistics’web site. From time to time, the CPI basket changes to more accurately reflect new items
TABLE 2.1
12-month PCE Inﬂation
PCEPCE excluding food and energyTrimmed mean PCE
Jun 06
Jul 06
Aug 06
Sep 06
Oct 06
Nov 06
3.52.32.6
3.42.32.7
3.22.42.7
1.92.42.5
1.52.42.5
1.92.22.4
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WHAT DRIVES THE FOREX MARKET?
available in the economy. The problem with CPI is that it doesn’t reflect housing pricesand therefore may underreport inflationary pressures.Tracking gold, the Commodity Research Bureau, and other commodity indexes andpatterns will also help you get a handle on inflation. We look at the commodity-currencyconnection in Chapter 5. The main point here is that the forex trader needs to pay seriousattention to inflation rates and expectations of inflation rates, because they are a key todiscerning what the central banks fear, and a clue to whether they will raise interestrates.
ASSIGNMENTFind the Latest CPI per Country and Compare It against Their Target Rate.Which Countries Have Inﬂation above the Target Rate?Take the indicators or economic data releases coming out and group them. Which are leading?Which are lagging? Which are coincident?Which countries have inﬂation rates over 2 percent?Which country has a central bank policy to increase inﬂation?
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CHAPTER 3
ExploitingInformation AboutEconomic Growth
nterest rate and inflation levels are the main ingredients of forex price movements,and economic growth data follows closely in shaping the currency flows. Countriesthat are experiencing economic growth generate more jobs in their economy. Consumer spending therefore increases. In turn, the demand for housing increases as people have more disposable income and can better afford housing. Other sectors, such asthe auto sector, also experience changes in demand as consumers’ propensity to spendreflects greater confidence regarding their economic conditions. The transactions of amodern economy intimately involve global flows of capital as exports and imports arepart and parcel of the vitality of an economy. The term economic growth is really a widecategory. How is economic growth measured and tracked by the forex trader?The rate of economic growth or development of a country is mainly measured essentially by its gross domestic product (GDP), so news about GDP becomes an essentialingredient in shaping trader sentiment about the value of a currency. A slowdown or expected slowdown in GDP translates into anticipation that interest rates will not go higheror may even decrease. This anticipation results in pressures to lower a currency’s value.The importance of economic development statistics in currency trading is evidenced bythe fact that whenever an economic data release is scheduled, the currency market hesitates in its price movements and then often moves vigorously when the news surprisesthe market. In fact, one of the best times to trade is after a news release. Technical strategies for trading the news will be thoroughly explored in a later chapter.Traders can gain insight into economic growth and development data by followingseveral sources that track global economic growth, such as the Organisation for Economic Co-operation and Development (www.oecd.org), the International Monetary Fund
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(www.imf.org), the Group of Seven, (www.g7.utoronto.ca), and the World Trade Organization (www.wto.org).
IMPORTANCE OF JOB DATAEmployment data is used to determine how fast the economy is growing. A growing economy has new job creation and lower levels of employment. An economy that is slowingdown (or showing signs of slowing down) has increased jobless claims, a declining rateof job creation, and higher unemployment levels.Whenever job data is released by governments, the forex markets react. The forexmarkets look at whether the data is positive or negative for expectations of whether thatcountry’s central bank will increase rates, keep rates the same, or decrease rates. Thereare many layers of information regarding employment data. The following list illustrateswhat’s trackable in the United States:Aggregate Weekly Hours Index: private nonfarm payrollsAggregate Weekly Hours: private nonagricultural establishmentsCivilian Employment: 16 years and olderCivilian Participation RateCivilian Labor Force: 16 years and olderEmployment Ratio—Civilian Employ/Civilian Index of Help Wanted Advertising inNewspapersU.S. Manufacturing EmploymentPayroll Employment of Wage and Salary WorkersTotal Population of the United StatesU.S. Employment in Service-Producing IndustriesCivilian Unemployed for 15 Weeks and OverCivilian Unemployed for Less Than 5 WeeksMedian Duration of UnemploymentUnemployed: all civilian workersUnemployment RateU.S. Employment in ConstructionU.S. Employment in Finance, Insurance, and Real EstateU.S. Employment in Goods-Producing SectorsU.S. Employment in Government
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U.S. Employment in MiningU.S. Employment in ServicesU.S. Employment in Transportation and Public UtilitiesU.S. Employment in Retail Trade IndustryU.S. Employment in Wholesale Trade IndustryFor more information on job data, visit the following web sites:www.economagic.comwww.globalfinancialdata.com
THE ROLE OF CRUDE OIL AND PETRODOLLARSCrude oil and its derivative products fuel the engine of economic growth. As long as theworld is dependent on hydrocarbon-based energy, oil prices become a factor in stimulating or delaying economic growth. Economic studies demonstrate that for every $10per barrel rise in oil prices, real GDP in the United States is reduced by about 0.4 percent economic growth (Federal Reserve Bank of St. Louis Review, November/December2006, http://research.stlouisfed.org/publications/review/06/11/NovDec2006Review.pdf).In the near term, higher oil prices result in reducing economic growth expectationsas well. Higher hydrocarbon prices portend increases in transportation costs and the perunit cost of outputs in the economy, and therefore become an inflationary factor in thecosts of goods. More importantly, crude oil prices’ moving quickly higher disrupts anticipated prices and further encourages fears of slowdowns. One of the most important aspects of oil prices is that the market reaction to oil price increases often tends to overemphasize its importance, particularly for the U.S. economy. Recent studies by the FederalReserve show that an oil price shock can be easily absorbed in the $14 trillion U.S. economy. Recent research shows that “a 100 percent increase in the price of crude oil . . .translates into only a 3.2 percent price increase in the typical basket of consumptiongoods. Since unrefined oil is not a consumer good, the oil price shock is passed throughindirectly in the prices of many other goods and services” (Federal Reserve Bank ofCleveland, November 2006, www.clevelandfed.org/research/commentary/2006/Nov.pdf).A quick rise in oil prices, or even just the fear of a rise, offers trading opportunities. Hurricane Katrina is a good example, as we saw some countries benefit from highcrude oil prices, while others did not. The result impacts currency prices as well. Closelytracking oil is important in shaping currency-trading strategies. See Figure 3.1.Oil has another impact. Oil-producing countries have amassed huge sums of money,and what they do with their increasing petrodollars impacts currency values. TheInternational Monetary Fund (IMF) reported that the surplus of dollars to oil producers
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FIGURE 3.1 Crude Oil Weekly Patterns.Source: CQG, Inc. Copyright © 2006. All rights reserved worldwide.
amounts to $500 billion! The economies of Organization of Petroleum Exporting Countries (OPEC) nations are accumulating current account surplus due to petrodollars thatare nearing 30 percent of their GDP! If oil producers start to shift into nondollar assetssuch as the euro and pound sterling, the dollar fundament