ally weakens. This has alreadybegun. The Financial Times reported on December 11, 2006, in a story titled “Oil Producers Shun the Dollar,” that the Bank of International Settlement data showed a shiftinto euro, yen, and sterling. OPEC and Russia data showed that the dollar holdings werecut from 67 percent to 65 percent. Also, the report indicated a cut by Iran of US$4 billionholdings and by Qatar of US$2.4 billion.It was not a coincidence that the 2003 highs of the euro coincided with the last knownshift of oil producers from dollars to euros. It is also not a coincidence that the Canadiandollar strengthens when oil prices increase and weakens when oil prices decline. We cansee that crude oil patterns have had wide ranges and are likely to continue to have suchswings. This will benefit the forex trader.
YIELD CURVE AND ECONOMIC GROWTHAs Arturo Estrella and Frederic S. Mishkin said, “The yield curve—specifically, thespread between the interest rates on the ten-year Treasury note and the three-monthTreasury bill—is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six
c03
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:5
Char Count=
23
Exploiting Information About Economic Growth
TABLE 3.1
Estimated Recession Probabilities for Using the Yield CurveSpread (Four Quarters Ahead)
Recession Probability (Percent)
Value of Spread (Percentage Points)
51015202530405060708090
1.210.760.460.220.02−0.17−0.50−0.82−1.13−1.46−1.85−2.40
Note: The yield curve spread is deﬁned as the spread between the interestrates on the 10-year Treasury note and the 3-month Treasury bill.Source: Federal Reserve Bank of New York.
quarters ahead” (“The Yield Curve as a Predictor of U.S. Recessions,” Current Issues inEconomics and Finance, Federal Reserve Bank of New York, June 1996).Guessing what phase of the business cycle an economy is in is a great game. Is theeconomy going into a recession? Since economic data mostly is lagging, we don’t knowwe have begun a recession until it actually has begun and been confirmed. However,sentiment about an expected recession is not stopped by lack of data. One of the mostimportant measures that traders track is the shape of the yield curve. The yield curve isdefined as the difference between the 10-year Treasury note and the 3-month Treasurybill. We see here the key role that interest rates play in reflecting expectations in themarket. The Federal Reserve Bank of New York published an important study of the yieldcurve and recessions, which included a table relating probability of recession to the yieldcurve (Table 3.1). A separate study (see Figure 3.2) shows the strong correlation of theyield curve as a precursor of a recession 4 months in advance.We can see that the yield curve provides an important barometer for the future GDPgrowth. With regard to the yield curve, what is particularly important to track for theforex trader is the shape of the yield curve. Is it flat? Is it upward sloping? Is it inverted?These are the key patterns to observe. In normal times, people are willing to pay morefor longer-term maturities and bonds. This is a natural reaction to the fact that there ismore risk over a longer period of time. But a slowdown or fear of a recession causesthe market to demand higher interest rates for short-term borrowing. The yield curvebecomes inverted. Short-term interest rates become greater than longer-term rates! A
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:5
24
Char Count=
WHAT DRIVES THE FOREX MARKET?
15Short rate10Percent
c03
GDP growth
5
0
–51955
1960
1965
1970
1975
1980
1985
1990
1995
2000
FIGURE 3.2 Four-Quarter GDP Growth.Note: The ﬁgure plots 4-quarter GDP growth together with the 20-quarter term spread (upper panel)and the 1-quarter short rate (lower panel) lagged 4 quarters.
common interpretation is that when the yield curve inverts, a recession is coming. Aninverted yield curve situation makes it difficult for the central banks to increase ratesand more likely, in fact, that rates may decrease. Such a situation becomes negative forthe dollar or any currency involved. A flat yield curve indicates uncertainty about theeconomy. On December 27, 2005, the yield curve inverted for a few days for the first timein five years. Also, there is no guarantee that an inverted yield curve will always predicta recession, but when the yield curve inverts, the forex trader should be very vigilant.Strategies favoring a weaker dollar or currency pair should be considered.
CALCULATING PROBABILITY OF A RECESSIONA quick way to discern if the United States is nearing a recession is to generate anestimate of the probability of a recession based on the Federal Reserve hypotheticalmodel. The formula (for those who want to set up an Excel spreadsheet) is (www.federalreserve.gov/releases/h15/update/):NORMSDIST(−2.17 − 0.76*(10Year − 3Month) + 0.35*FederalFundsRate)Where:10Year = 1-quarter Average of Daily 10-Year Constant Maturity Treasury Yields3Month = 1-quarter Average of Daily 3-Month Constant Maturity Treasury YieldsFederal Funds Rate = 1-quarter Average of Daily Federal Funds RatesThe easiest way to do the calculations is to link to the following web site and inputthe data required in the formula. You can easily get the value of the 10-year Treasury
c03
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:5
Char Count=
25
Exploiting Information About Economic Growth
TABLE 3.2
Bond Yield and Federal Funds Rate Data
Input Data
March 21/07
April 23/07
10-Year Treasury Bond Yield (%)3-Month Treasuy Bond Yield (%)Federal Funds Rate (%)Probability of a Recession in Next 12 Months (%)
4.565.065.2652
4.684.995.2349.5
Source: www.politicalcalculations.com.
bond, the 3-month yield, and the federal funds rate at www.federalreserve.gov/releases/h15/update/. Once you get the value of the 10-year Treasury bond and the 3-monthyield, simply input their values into the inversion calculator, available at http://politicalcalculations.blogspot.com/2006/04/reckoning-odds-of-recession.html.On March 21, according to the current model, the probability of a recession dueto the relationship between the 10-year and 3-month bond yield curve was 52 percent.Table 3.2 shows the data inputs giving this result. One month later, on April 21, the datashowed that the probability of a recession was even lower, at 45.9 percent. These probabilities are the results of models. They are not guarantees but do give insights into whatthe professional economists are thinking.A further visualization of the relationship between a recession and the yield curve asdeveloped by the Federal Reserve researchers is shown in Figure 3.3. Obviously, a great
FIGURE 3.3 Spread Required between 3-Month and 10-Year Treasuries vs. Federal Funds Ratefor 50 Percent Probability of Recession Occurring in Next 12 Months.Source: www.politicalcalculations.com.
c03
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
26
15:5
Char Count=
WHAT DRIVES THE FOREX MARKET?
deal of work is being constantly done by economists to try to pinpoint the probability ofa recession.
ASSIGNMENTUsing the Formula in this Section, Calculate the Probability of a Recession ona Weekly BasisCheck whether the probability is rising or falling as you are monitoring the results. At the sametime, ask yourself the question: Is the dollar getting stronger or weaker? Doing this assignmentwill help you sharpen your understanding of sentiment toward the dollar and whether thatsentiment reﬂects economic fundamentals.
c04
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:6
Char Count=
CHAPTER 4
The China Factor
hina is becoming increasingly important to forex traders in evaluating trading opportunities. This chapter provides a review of key China developments that everytrader should know about.Watching Chinese economic developments is likely to become a daily pastime formany traders all over the world. Since the 1970s, China’s growth rate has been approaching over 10 percent per year. In 2006, the Chinese reported that China’s gross domesticproduct (GDP) reached 20.94 trillion yuan, up 10.7 percent from the year before (Financial Times Information). Almost every day there is news on China’s economic performance. China is impacting every region of the world and every industry. For example,the Chinese Ministry of Information Industry reported that China has the world’s second largest population of Internet users after the United States, with 137 million peopleonline.In March 2007, China replaced the United States as Europe’s second biggest sourceof imports after Britain. This occurred after a 21 percent increase in imports from Chinato the 25 countries forming the European Union (Financial Times, March 23, 2007,p. 2). China’s trade with Russia is another example. The trade between China and Russiais reported to exceed the 30 percent per year growth from 1999 to 2005 and is now over $7billion per year (China economic net). Over half of China’s trade is within Asia, betweenJapan and South Korea. Regarding China and the United States, it has been reported that“from 2000 to 2005, U.S. exports to China grew almost 160 percent, while U.S. exportsto the rest of the world rose by only 16 percent. During that period, China accounted forroughly 25 percent of total U.S. export growth” (C. Fred Bergsten, Bates Gill, NicholasR. Lardy, and Derek Mitchell, China: The Balance Sheet: What the World Needs to KnowNow about the Emerging Superpower. New York: PublicAffairs, 2006).
C
27
c04
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:6
28
Char Count=
WHAT DRIVES THE FOREX MARKET?
It will certainly benefit all to become familiar with China’s economic events and howthey may impact currency moves. Let’s explore some key factors.
CHINA REVALUES YUAN: A TURNING POINT?On July 21, 2005, after more than a decade of strictly pegging the renminbi to the U.S.dollar at an exchange rate of 8.28, the People’s Bank of China (PBOC) announced a revaluation of the currency and a reform of the exchange rate regime. This was the beginningof a long-term strategy to integrate China into the world economy by easing the ability of capital to flow into and out of the country. The ability to exchange currency is akey factor in this process of integration. The revaluation signaled that China was beginning to allow the strengthening of its currency. As of March 2007, the renminbi valuewas at approximately 7.74. This means that it takes fewer renminbi (6 percent) to convert to one dollar since revaluation. Many economic studies believe that a free-floatingChinese currency would appreciate by 20 percent. Under the foreign exchange reform,the PBOC incorporates a “reference basket” of currencies when choosing its target forthe renminbi. The five currencies are the U.S. dollar, the yuan, the yen, the Korean won,and the pound. However, the exact weighting of these currencies in the basket is notbeing disclosed and there may be other currencies included.Even though the Chinese currency known as the renminbi does not float on the market, and it is tied to the dollar within a narrow price, the influence of China on globalcurrency flows is profound. This limited managed float in effect is a subsidy for China’smanufacturers and lowers the cost of Chinese goods, making competitor firms in theUnited States and the rest of the world very upset with China. There is increasing pressure on China to allow the renminbi to increase in value, either through a wider managedenvelope or through a full float. A full float is highly unlikely because the Chinese government is not interested in giving up control of its economy, which would occur in afull float. Any increase in the value of the renminbi could result in a significant benefitto exporters in the United States and Japan. In recent years, even speculation that theChinese were about to allow the renminbi to increase in value led to price moves thatstrengthened the Australian dollar and the yen.China is becoming a global economic power that impacts the economic developmentof the world. It is the processing plant of the world, wherein many product componentsare imported and then put together. According to the Bank of New York, China’s top 10trade partners (in dollars) are:European Union (18.5 percent)Japan (18 percent)United States (17.5 percent)
c04
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:6
Char Count=
The China Factor
29
Hong Kong (11 percent)Association of Southeast Asian Nations (ASEAN) (11 percent)South Korea (9.5 percent)Taiwan (8.5 percent)Russia (2 percent)Australia (2 percent)Canada (1.5 percent)In looking at China’s top trading partners, we can see that China trade is spread outamong the world, with Europe, Japan, and the United States almost equally weighted.But just over 40 percent of its trade is with Asia.The importance of watching China’s economic conditions is highlighted by the following remarks of U.S. Federal Reserve chairman Bernard Bernanke at the ChineseAcademy of Social Sciences (Beijing, China, December 15, 2006):The emergence of China as a global economic power is one of the most importantdevelopments of recent decades. For the past twenty years, the Chinese economyhas achieved a growth rate averaging nearly 10 percent per year, resulting in aquintupling of output per person [see Figure 4.1]. In overall size, China’s economytoday ranks as the fourth largest in the world in terms of gross domestic product(GDP) at current exchange rates, and the second largest when adjustments aremade for the differences in the domestic purchasing power of national currencies.
IMPORTANCE OF CHINESE DOLLAR RESERVESChina imports resources for its growth from many countries and exports manufacturedgoods. Currently, however, this process is not balanced. The Chinese export more thanthey import, and therefore accumulate a great deal of cash. China also possesses over$1 trillion of reserve currencies, and how it uses and invests this reserve of U.S. dollarswill have a major impact on the direction of the U.S. dollar. The Chinese State Administration of Foreign Exchange (SAFE) is the key agency on the future of these dollarreserves. For the forex trader, following Chinese developments and intentions on globaltrade and currency policies can be rewarding because it can point the way for new trading opportunities. One big effect could result from a possible slowdown in the Chinaeconomy. The U.S.-China Economic and Security Review Commission concluded that:A financial crisis in China would harm its economy, decrease China’s purchaseof U.S. exports, and reduce China’s ability to fund U.S. borrowing, particularly to
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:6
Char Count=
30
WHAT DRIVES THE FOREX MARKET?
RMB12,00010,0008,0006,0004,0002,000
0020
9519
9019
8519
8019
7519
7019
6519
60
019
c04
FIGURE 4.1 China’s GDP per Capita.Sources: National Bureau of Statistics, China Statistical Yearbook 2004; National Bureau of StatisticsPlan Report.
cover the U.S. budget deficit. An economic crisis in China has the potential to raisethe U.S. interest rates, thereby placing major additional costs on U.S. businessesand individual consumers and producing dislocation in the U.S. economy. It couldalso exacerbate Chinese domestic political tensions in an unpredictable fashion.This is why the condition of China’s financial system is of concern to the UnitedStates. (October 30, 2006)If a possible slowdown in China worries U.S. traders, possible changes in China’sinvestment in U.S. assets worries them even more. The influence of China was mostrecently demonstrated when during the 2006 Thanksgiving holiday, a statement by theChinese minister alluding to China’s potential for investing in nondollar assets started amajor slide in the U.S. dollar around the world. Here is an excerpt from recent Congressional testimony:The United States will run a current account deficit of over $800 billion, or approximately 7 percent of the GDP, in 2006. This is historically an extremely highlevel that no other country has been able to sustain for any significant period. Thedanger is that the U.S. economy could suffer a precipitous decline if the abilityof the United States to borrow ever-greater amounts should end abruptly. Interest rates and inflation might suddenly soar as the dollar fell and the stock marketcrashed. (“China’s Exchange Rate and the Effect on the U.S. Economy,” Committeeon Financial Services, October 1, 2003)
c04
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:6
Char Count=
The China Factor
31
Other currencies do not escape the impact of Chinese economic developments. Sincethe Chinese growth rate of over 10 percent per year GDP generates a voracious appetitefor resources such as oil, copper, steel, iron ore, cement, and Ag complex, the countriesthat provide these resources experience a demand for their dollars. When China buyscopper from Australia, renminbi must be converted into Australian dollars. This providessupport for the Australian dollar and the Australian economy. Since China imports majorresources such as copper from Australia, the aussie would be affected by a potentialChinese slowdown. Also, Japan, a significant trading partner of China, and its currencywill often weaken or strengthen on expectations of a Chinese slowdown or sustainedgrowth.Chinese influence has begun to extend also to Africa. For example, Chinese exportsare beginning to shift to the Suez Canal, rather than going around Africa. This is causingTurkey, Italy, and other nations to invest in Egypt to tap into Chinese export to Europe.In the coming years, the trading world will focus on whether China can control itsgrowth rate, avoid inflation, and increase its currency float. Therefore, China’s economicand monetary policy will be valuable to watch. Traders need to keep track of key performance parameters such as Chinese GDP and inflation projections, as well as Chineseinterest rate decisions. Between 2006 and July 2007, China increased its interest ratesto reach a level of 6.84 percent for one-year notes to try to slow down the economy.Whether this will work is unknown. But as China, which is now the seventh largest economy in the world and the second largest in purchasing power parity, becomes more of aconsumer economy, the status of the Chinese economy will become easier to monitor.Companies such as Home Depot, Wal-Mart, Kingfisher (British), and Best Buy are entering the Chinese market, and many other firms are acquiring Chinese companies. As aresult, the coming years will provide more reliable data on Chinese consumer spendingand growth.Watching China’s currency policies can also pinpoint new trading opportunities inthe China market. The Shanghai Composite Index is very sensitive to whether the renminbi will strengthen. When the Bank of China’s governor, Zhou Xiachuan, commentedthat China wasn’t interested in increasing its foreign reserves further, the Shanghai indexsoared because Chinese company land and property is denominated in Chinese currency.Their value would increase (Wall Street Journal, March 22, 2007, p. C8).To monitor activities in China on an ongoing basis, I recommend the following websites:http://research.stlouisfed.org/publications/review/06/11/Poolewww.chinadaily.comhttp://english.people.com.cn/http://en.ce.cn/main/index.shtml
c04
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
32
15:6
Char Count=
WHAT DRIVES THE FOREX MARKET?
ASSIGNMENTTrack the Current Value of the YuanGo to www.xe.com and ﬁnd the latest value of the renminbi in the quote table that is supplied.It is listed as the symbol CNY (as shown in Figure 4.2). Is it getting stronger or weaker?
FIGURE 4.2 Finding the Value of the Renminbi.
c05
JWPR051-Cofnas (JWBK051-Cofnas)
August 22, 2007
7:50
Char Count=
CHAPTER 5
The CommoditiesConnectionGold, Copper, CRB Index, Equities,and Forex
he value of a currency and how it moves is related to events in the commoditymarkets. Commodities are key resources in world growth, and they impact globalinflation. This chapter focuses on what the forex trader should know about thecommodity connection to currencies.
T
GOLDGold price movements are important for currency traders to understand. Gold acts inmany ways as a surrogate currency and a “safe haven” when money moves out of thedollar in response to geopolitical crises. But gold is also a commodity on its own, addingstrength or weakness to currencies of countries that produce gold. South Africa, ofcourse, is the leading producer of gold, but its currency, the rand, is not floating, sotraders can look to the Australian dollar and the Canadian dollar for trading those currencies when gold patterns provide trading opportunities.Gold price action can also be a misleading guide to the currency trader. In recentyears, Gold has attracted a great deal of investment demand from exchange-traded funds(ETFs). In 2003, ETFs were buying 20 tons of gold, and this rose to 500 tons in 2005. Thetrader who looks at gold prices rising may interpret it as a reaction to the dollar, whenit actually can be reacting as a function of investment demand. Figure 5.1 shows goldversus the U.S. Dollar Index (USDX).Central banks have an important role regarding gold. They hold gold as part of theirreserves (see Figure 5.2). The world’s central banks have about 3.5 trillion dollars in33
c05
JWPR051-Cofnas (JWBK051-Cofnas)
34
August 22, 2007
7:50
Char Count=
WHAT DRIVES THE FOREX MARKET?
FIGURE 5.1 Gold vs. the USDX.
reserves, and 15 percent is in gold. The key variable that can affect currency prices iswhether a central bank will increase its gold reserves and thereby decrease its reserves ofdollars or another currency. As a result, rumors of central banks increasing gold reservescan disrupt currency prices.The idea that gold is important to currency moves is sound, but needs to be qualifiedand put in the context of world events. Sometimes gold acts as a store of value in timesof crises. But the correlations between gold moves and currency moves provide a greatdeal of variation. The trader needs to be vigilant regarding what factors are moving gold.At the end of the day, in the words of Phillip M. Hildebrand (member of the Governing
JWPR051-Cofnas (JWBK051-Cofnas)
August 22, 2007
7:50
Char Count=
35
The Commodities Connection
Gold Reserves
Currency Reserves
4000
3500
3000
in USD billion
c05
2500
2000
15001000
500
0Jan 95
Jan 96
Jan 97
Jan 98
Jan 99
Jan 00
Jan 01
Jan 02
Jan 03
Jan 04
Jan 05
FIGURE 5.2 Evolution of World Oﬃcial Reserves.Source: Phillip M. Hildebrand, member of the Governing Board, Swiss National Bank.
Board, Swiss National Bank), “the yellow metal continues to have a special significancefor central banks.”
COPPERCopper is one of the world’s commodities that is strongly related to economic growth because it is a key material for global infrastructure in the building and telecommunicationsindustry. For example, copper plays an important part in the industrial development ofChina. As the world grows, more copper is in demand. The forex trader has to ask thequestion: Who benefits from copper demand?To answer this question, we should look at who produces copper. The world’s leading producer of copper is Chile; however, the Chilean peso does not float. Australia is thesecond largest producer of copper, and since its currency is freely floating, the Australiandollar can be traded. The commodity connection with currencies is particularly strongfor the Australian dollar, the New Zealand dollar, and the Canadian dollar. A closer lookis presented in our section on currency personalities. Figure 5.3 shows the synchronicityof the commodities to each other.
c05
JWPR051-Cofnas (JWBK051-Cofnas)
36
August 22, 2007
7:50
Char Count=
WHAT DRIVES THE FOREX MARKET?
FIGURE 5.3 Copper, Gold, and Oil Weekly Movement Are Often in Sync CRB Index.
CRB INDEXTraders looking to track the commodity and currency relationships should follow theCommodity Research Bureau (CRB) Index. The CRB Index consists of a basket of commodities and provides a useful measure of potential inflationary pressure. When commodity prices rise, this price increase can spread into the economy by increasing thecosts of production and goods. This inflationary tendency is closely watched by centralbanks. We can see in Figure 5.4 that at the end of 2006, the CRB Index showed a decreasing price trend due to a collapse in the energy price sector.
c05
JWPR051-Cofnas (JWBK051-Cofnas)
August 22, 2007
The Commodities Connection
7:50
Char Count=
37
FIGURE 5.4 Reuters Commodity Index.Source: www.ino.com.
EQUITIES AND FOREXThe relationship between currencies and equities is an area of interest that is becomingincreasingly evident and important for traders to become knowledgeable about. For example, when the yen is weak, Sony’s and Canon’s share values become more attractivebecause they are exporters and, in effect, dollar earners. In all equity markets around theworld, exporting sectors benefit from a weaker home currency or the expectation of one.DaimlerChrysler, Renault, and Peugot suffer share declines when the euro surges beyondexpectations. As we noted in our section on China (Chapter 4), when there is speculation that the renminbi will increase, many Chinese equities increase in stock value dueto expectations that their assets will increase in value.U.S. housing sector equities have a direct link to forex. For example, in December2006, Black and Decker warned its shareholders that it faced “significant challenges” dueto a slump in the housing market. The equity market sell-off on February 27, when the
c05
JWPR051-Cofnas (JWBK051-Cofnas)
August 22, 2007
38
7:50
Char Count=
WHAT DRIVES THE FOREX MARKET?
Dow Jones Industrial Index suffered its worst day in four years, was a direct exampleof the link between equities and forex. The sell-off was precipitated by a sudden fall inthe dollar against the yen. This decline caused a liquidity crisis as hedge funds needed tosell equities to release funds to buy back their positions in the yen. (See Chapter 1 for adiscussion of this event.) As globalization increases, strong currency moves will impactequity markets as it did on February 27. In a real sense, tracking equities where theirdollar earnings are important can benefit a trader in providing leading indicators of forexprice moves.The relationship between the dollar and the equity markets is further underscoredby the Dow Jones Industrial Index reaching historic highs. This occurred as the USDXentered into an extended downtrend (see Figure 5.5). Why has the relationship been inverse between the equity market and the value of the dollar? A deeper look reveals theanswer. As the dollar value declines versus other currencies, the companies that exportto the rest of the world benefit from increased sales, as exports become more attractiveto foreign buyers. Additionally, multinational corporations having assets abroad experience an increase in the dollar value of those assets.
FIGURE 5.5 Dollar Index vs. the Dow.C 2006. All rights reserved worldwide.Source: CQG, Inc. Copyright 
c05
JWPR051-Cofnas (JWBK051-Cofnas)
August 22, 2007
7:50
The Commodities Connection
Char Count=
39
ASSIGNMENTCheck the Weekly Crude Oil, Copper, and Gold ChartsWhich commodities are probing support or resistance? Are any of these commodities in achannel pattern?
c05
JWPR051-Cofnas (JWBK051-Cofnas)
August 22, 2007
7:50
Char Count=
c06
JWPR051-Cofnas (JWBK051-Cofnas)
August 10, 2007
15:8
Char Count=
CHAPTER 6
How BusinessConfidence andConsumer SentimentAffect the Market
powerful response force that moves forex prices, as well as other markets, is business and consumer confidence data. These reports are