Archive for April, 2009
Swine flu framing
The news dominating headlines across the globe is the so called, “Swine Flu,” which started with pigs but is deadly and contagious among humans as well. The spread of reported cases from Mexico to Spain has got the Eurozone worried and Asia as well, due to their recent painful first hand experience with the SARS epidemic in 2003. What I intend to say in this short post is: don’t buy into the media stories that flight to liquidity (Dollars, Yen) will dominate because of fear that this outbreak will put a big dent into the economy.
The market fears that people will stay at home and if 100 million people die due to an epidemic like in 1918 then the global economy would accelerate into a giant depression. This is scary, and there is a small possibility that something like this could happen as history teaches us. However, it’s our job as traders not to trade coulds, woulds, and shoulds. What’s happening right now is a classic example of “framing” behavior. I explain this in the special report, but basically this means that the market has a bias to focus on too narrow of a view of available information and use that to draw conclusions or predictions about price. There are other big problems in both Europe and the US that must be considered: the debt situation in the US, how far the Eurozone is willing to go with pumping money into the economy, etc. We saw market reactions to the SARS outbreak in 2003 and the Foot and Mouth disease in the UK in 2007. In both cases there was an initial flight to liquidity and then return to initial levels and higher.
Any further fast moves down in EUR/USD will be illiquid ones. Even though sentiment seems to lean toward USD strength, there may be a possibility to enter long on the Euro after a spike down and hold for a couple hundred pips profit after price swings in this random zone driven by fluctuating market sentiment. The key is to keep leverage small and limit your risk to the downside in case the epidemic does indeed turn out to be what everyone has feared. Note this is only for a spike down due to the swine flu outbreak, NOT news on bank failures or the ECB implementing massive money injections. It is important to have a reason for entering other than just price.
I would like to close by saying that I am by no means making light of the situation. I was living in Singapore during the SARS outbreak of 2003 and can relate to the unfortunate circumstances. My prayers are for protection of people across the globe.
All the best in your trading,
Kris M
An imbalance is developing in GBP/USD
Yesterday UK Chancellor Darling announced in the country’s budget plan address that the British government will be issuing 220 billion pounds of loans in the form of UK gilts. This is an enormous amount of funds that the British government needs to raise to sustain the economy. The UK Gilts futures market (the British equivalent to the US treasuries market) realized this yesterday and sent Gilt prices tumbling from 123 down to near 120. Strangely enough, the pound did not fall that much against the dollar (less than a 200 pip fall compared to its recent 1000 pip range). This is definitely a gestalt shift for the bond market and would normally be expected to affect the currency market as well, however the Pound has remained resilient. This resilience suggests that the market is not immediately eager to drive the pound lower. The UK seems to have gone through the worst in this global economy the fastest and may possibly heal earlier as well. The UK has three things that may offer it an earlier recovery:
![UK Gilt futures vs. British Pound futures chart [source: Bloomberg data]](http://thegestaltshift.com/wordpress/wp-content/uploads/2009/04/bp-uk-gilt-futures-chart-april-092-300x225.jpg "bp-uk-gilt-futures-chart-april-092")
UK Gilt futures vs. British Pound futures chart [source: Bloomberg data
- The fact that the government has been strongly proactive in repairing the financial system (it guaranteed two of it’s largest banks
- The British economy doesn’t depend heavily on the manufacturing sector, which has hit other economies really hard, such as Asia and Europe
- The Pound fell the hardest last year, however its weakness has really helped UK exports
Mini macro trade
One of the themes I tend to reinforce is that you must think outside the box and look where the majority isn’t looking to make money. I see a trade opportunity today on the Euro using this idea. Before I begin, please realize that this one trade has no guarantee of making money, but over time these kind of trades will have a profitable edge.
The Euro at the time of writing is 1.3274 dollars. The 1.30 figure seems to be an anchor in recent times. An anchor is a level that tends to magnetically attract price just because people think it is important. It is not support or resistance (for the technical analysis people in the audience) per se, but rather a reference level. In Gestalt psychology there is a tendency for the human brain to make sense of the unknown by using other things as a reference. Anyway, despite the emergence of risk-taking mentality that has been driving currencies up, nothing has changed fundamentally to support the idea that the world has recovered yet. Sure, stocks are up due to some positive earnings, but is this enough proof ? Let’s look at some other indicators: Eurodollars (futures contracts that represent the price of US dollar deposits overseas) have not decreased in price–this indicates that risk sentiment is still there. German factory orders are dismal at -3.5% m/m, and Euro Zone retail sales are stagnant at -0.5%. The market will range until there is a fundamental stimulus that will shift traders’ perceptions. Look for Euro to possibly target 1.3000 if it continues to range.
What is sentiment and how to profit from it
How price and events show sentiment
Most macro instruments follow sentiment rather than fundamental factors such as supply and demand. The problem with strict fundamental analysis is that the economic data is very noisy and doesn’t provide a clear relationship of cause and effect between information and exchange rates. Furthermore, the efficient nature of such markets as foreign exchange makes it difficult to trade based on this information when everyone else knows it as well. It is often touted that currencies trend for very long times and thus we can stick to the fundamental trend and be profitable. Well, we all know what happens to those who follow the crowd (especially those souls who did so in Q3 2008).
The trader’s job is to anticipate what the focus of the market could potentially become. Events and information entering the world will cause the major drivers of the market (hint: central banks) to make decisions which will move the market. When information and events begin to suggest that the focus as evidenced by the current positioning of the market may change to a new concern, a stronger than 50 % chance that price will adjust presents itself.
Enter the concept of sentiment. Any macro trader worth his salt will tell you that timing the market is rather difficult because of the randomness that pervades price movement. However, we can come close by using sentiment as an indicator. Suppose that the Euro has been climbing due to good news coming out of Europe and dismal economic figures coming out of the U.S. Eventually, even as more good news comes out of Europe, the single unit simply ranges at current levels. Before long, one piece of good data comes out of the US such as a Chicago PMI (Purchasing Manager Index) and then the Euro falls quickly. What happened? Shouldn’t good news be good for the currency? This is sentiment in action. Every piece of information that enters the market is discounted long ago by instiutional traders and their research teams. What matters is how they “feel” the rate of return on a currency position could be. This depends on what their focus is. The focus shifted entirely in the above example, and we could see this by observing how the market reacted to the same, recurring information. This is the gestalt shift on a small scale.
A sentiment change can be gauged by several means:
- If price falls on good news the sentiment is negative
- If price spikes up on good news but cannot breach an important level and comes back down, sentiment could become negative
- If news headlines start to change focus to something that could affect the health of the economy but price is just ranging after a big steady rally, sentiment is worried and could easily become outright negative
- If an event or statement ocurrs that devastates the currency and then occurs again except worse, but the currency unit does not make a new low, sentiment is positive and the market is looking for a catalyst to drive up price.
I hope this helps explain sentiment better. This is an important topic and I’ll write more on it later. In the mean time I’ll leave you with some market wisdom. John Maynard Keynes once remarked,
“we devote our intelligence to anticipating what average opinion expects the average opinion to be”
