Archive for October, 2009
Forex Fundamental Analysis Forecast for the Pound, October 26 2009
I started the “Outside the Box Trading Report” to help traders and investors following my material to make a more clear, objective decision on whether to have a long or short bias. I hope that by regularly submitting these videos the decision becomes more logical, less emotional, more profitable, and less confusing. These posts are intended to complement Paul Stafford’s weekly briefings. His latest one is here.
Sincerely,
Kris Matthews
The Third force
In addition to looking at fundamentals and sentiment, there is another force at work in the markets, and that is the central banks. They have significant power to move markets, at least temporarily. They most often “jawbone”, or talk about what they want, or what is right, or what they might do. Less often, because it is expensive to do, they actually intervene in the markets. For example, if a central bank wants their currency to weaken, they will sell their own currency and buy something else (commonly a basket of currencies). It takes billions, but it does work. Here are a few recent examples.
Roth, the chairman of the Swiss National Bank (SNB) declared back in March of this year that the CHF had risen too high against their trading partners in the rest of Europe (the EU25 constitutes 62% of their export market), imperiling their Current Account balance. The SNB actively intervened; selling Swiss francs and buying Euros to maintain 1.51 or so. You can see the initial effect (EUR appreciating against CHF), and the resulting tight trading band (+/- 150 pips) in the succeeding 6 months.
Another example is the $/JPY. The Japanese economy is export-driven, and their largest trading partner is the US (22% of the total). The BoJ is famous for actively intervening in the markets. You can see from this chart the level at which they get rather uncomfortable- about 88 or so. They actively intervened back in February. I am not sure about in October, but it certainly was a good level from which to be bullish.
Trichet has made many comments recently about the TWI (trade-weighted) strength of the Euro, and the weakness of the dollar. While the ECB is not likely to intervene, I imagine that any approach to the previous high of 1.60 will be met with a lot of jawboning.
While trading limits like $/JPY of 88 can be done with the spot, options offer alternatives when the spot exhibits very low volatility like the EUR/CHF. You can actually profit from no movement at all with spread structures, and very limited downside risk. The topic is beyond the scope of this article, but you can reach me at stafford.paul1@gmail.com.
Please visit my website at www.4Xtradertools.com to sign up for my weekly Currency Briefing
Sentiment measures
The value of a currency is driven by two things- the country’s fundamentals, and currency sentiment. It is fairly obvious how to measure the fundamentals (central bank rate, current account balance, budget balance, GDP growth etc), although care must be taken, as governments distort these numbers to their own purposes. Gauging sentiment might appear to be harder. Perhaps reading what Bloomberg has to say, or listening to CNBC? Frankly, more objective measures are needed.
I have found a number of sentiment measures that indicate what the major market players- banks, large traders, market-makers- are thinking. Add in a few indicators for risk sentiment, and you have a useful set of sentiment measurements.
Risk Reversals
Risk reversal refers to the manner in which similar out-of-the-money call and put options, usually FX options, are quoted by marker makers and dealers. Instead of quoting these options’ prices, dealers quote their volatility. The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge the market-makers directional sentiment- they will set implied volatility higher in the direction they think the currency will go.
Sovereign Credit Default Swap (CDS) Rate
A credit default swap is a bilateral contract between a protection buyer and a protection seller. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction. In basic terms, the lower the rate, the lower the possibility of default. They are quoted in basis points, or bps. Thus, a CDS rate of 42bps (Current UK rate) carries twice the cost of the US rate, 21 bps, reflecting a higher possibility of default on UK government bonds (Gilts).
Currency Futures
This very useful metric indicates the number of contracts – long, short and spreads- taken out on the Chicago Mercantile Exchange. Obviously, if there are more longs than shorts, the sentiment is positive for the currency. There are actually two different series- one is for banks (reported monthly), the other for all other parties (reported weekly). I like looking at both, because the banks are often the market makers and must hedge their positions.
Risk appetite is a term used to reflect the appetite of the market for the higher-yielding/higher risk currencies (AUD, NZD, GBP, INR). Its opposite is Risk aversion, and reflects appetite for lower-yielding/lower-risk currencies (JPY, USD, CHF). I have found a number of useful gauges of risk sentiment.
TED spread
TED (an acronym from T-bill and ED, the sticker for Eurodollars) spread is the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.
The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the risk of default is considered to be decreasing. An increasing TED spread is a risk aversion indicator.
Counterparty Risk Index
There are two (that I know of) indices, one compiled by Credit Derivatives Research, the other by Markit. The indices measure the current risk (mainly by surveying dealers) in the derivatives market that one party will default.
VIX or volatility index
VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market’s expectation of volatility over the next 30 day period. An increasing VIX is a risk aversion indicator.
I used to count the VIX as a good risk sentiment indicator, but the VIX has been corrupted (IMHO) by the large component of program trading in the US equity market. I sill include it in my sentiment indicators but do not give it the weight it used to have.
So there are 5 or 6 good measures of sentiment in the market. Rather than look at them instantaneously, I prefer to look at their trends (eg what has the risk reversal done over the last month), which matches my longer-term trading horizon.
Paul Stafford is an FX analyst, and writes a weekly Currency Briefing, which includes all of the above metrics and much more. Visit 4xtradertools.com
Paul Stafford on the Dollar
Hello everyone. Thanks to Kris for allowing me to share my fundamentals views on a weekly basis. I thought it might be interesting to think about the dollar and where it’s going long term. As it is the basis or counter currency for most FX volume, it behooves us to have a good handle on that.
Since almost everything we look at is valued in dollars, it is sometimes hard to separate the effects of a strong or weak dollar from real economic trends. For example, gold is hitting record levels vs. the $, and oil may finally punch through the $73 level. Are these real effects? Well, one interesting measure is the Gold/Oil ratio. Historically, it has hovered between 10 and 15. In February of 2009, it rose to nearly 30. Now it is back to about 14.7, or well within its historical range. If you look at gold vs. other currencies, it is not at historic highs- for example it remains 30% below its highs in AUD. In actuality, demand for commodities is still very low. Witness the “ghost fleet” of 500 freighters (20% of the fleet size) idled off Singapore due to lack of international shipping, or the Baltic Dry Index, etc. High commodities prices are simply the result of a weak dollar.
The S&P is now trading at a massive 27:1 trailing P/E ratio, and 140x trailing P/E on reported earnings. This is three times the levels of the tech bubble. I believe one reason (amongst others) is the depreciation of the dollar. Another direct indication is the $ index, now at 76 (nearly its 10 yr low of 72 in July of 08), and a far cry from its highs over 117.
We must ask- is this a low from which the $ stages a comeback, or just the beginning of a long term slide? I fear I must come down on the side of further depreciation over the long term.
- USA budget deficits will inevitably worsen due to lack of political will
- The inexorable move away from the $ as the reserve currency due to its mismanagement. This has already started (China, oil producers)
- Implicit monetary policy- the Fed will not move strongly against inflationary pressures
- Carry trade effects as other countries exit QE and raise interest rates earlier ($ becomes a funding currency)
- Sentiment- when markets lose confidence in a currency (witness the Pound when it withdrew from the ERM), sharp declines and high volatility will dominate
I always try to look for disconfirming evidence, and one positive element for the dollar might be an improvement in the current account deficit due to a weaker dollar driving exports. However, the continued offshoring of manufacturing, and import of energy argue against this having a large net positive effect.
This doesn’t mean that the dollar index will drop monotonically in the next 6 months or year. Exogenous events, black swans (think Iran and nuclear missiles aimed at Europe) can all reverse direction for many months. After all, the $ index reversed its decade-long decline from 117 to 72 back to 89 in only 4 months as risk aversion set in, in late 2008. But the future cannot belong to the dollar.
Paul Stafford is an accomplished investor, business expert, and trader. He performs practical fundamental currency market analysis in his weekly “Stafford Weekly Currency Briefing” at 4xtradertools.com
