Archive for Behavior
Shift from “Green Shoots” perception of economic recovery: look at USD, CAD
![Daily chart of WTI Crude Oil [source: Dukascopy]](http://thegestaltshift.com/wordpress/wp-content/uploads/2009/06/crude-300x225.jpg "crude oil daily chart")
Daily chart of WTI Crude Oil [source: Dukascopy
Last week marked a turning point in perceptions of a global economic recovery emerging (a.k.a. “Green Shoots”) especially with this week’s FOMC meeting on the horizon. The new sentiment in the markets is captured well by today’s headline in the Financial Times: “Recession Worries Rattle Markets.” Let’s take a look at what going on across multiple markets to get a clue for currency trades: Oil tried to rally upon the increasing instability in Iran but couldn’t hold above the $70/bbl figure. Stocks went down upon several weak figures, including industrial production, empire state manufacturing, and others. The remarks by the IMF that China could recover soon and pick up global demand was also not well received.
The Euro has been trading in a declining range against the dollar (see my previous post about factors weighing Euro outcomes for more information) and particularly hasn’t been able to respond positively to good news supporting the “green shoots” perception such as last week’s larger than expected and increasing ZEW survey outcome. The pound has been ranging at high levels due to a perception that the UK may still turn around fast and the political situation is now under control, however the sentiment shift is affecting its upside as well. Traders who got in in the 1. 40s and 1.50s when I originally started speaking about the imbalances should start reducing their longs and move toward a more neutral bias or take their big 1000 pip profits altogether.
In short the shift in perception away from economic recovery has led to Dollar strength if it is looked at as an individual currency (this can be done with a mathematical algorithm and I will start posting my plots of this, especially if I get reminders). Currencies are starting to show signs of weakening but have not yet given way to Dollar strength yet. A trigger that could reverse currencies would be a remark from the Fed that although there have been signs of recovery, they will not tighten for a long time or that housing has shown no clear signs of bottoming. Traders are focused now on the Fed’s exit strategy and the housing market. If the housing market doesn’t show convincing signs of a recovery, other sectors such as jobs and retail won’t be able to recover either. These are just possibilities, but traders should consider any catalysts that could start driving currencies down and supporting the dollar. Remember our formula: imbalance + sentiment shift = price movement. In this case, I believe a medium term imbalance is the behavior of traders: they started bidding up currencies dramatically over the last couple of months due to a framing bias (focusing solely on the notion that the economy was recovering). It is not a strong imbalance, although there needs to be a newer, stronger belief to emerge in the market before the dollar weakens further. Meanwhile, the Canadian dollar (CAD) has weakened rapidly, no doubt due to weakening crude prices. Because of greater risks to the downside in crude oil after its rapid increase on the recovery story and the BOC’s concern of Canada’s ability to export with a stronger currency during this time, the CAD is particularly vulnerable.
Green Shoots: a sentiment shift toward currency strength again
A number of weeks ago I wrote a post entitled, “An Imbalance Developing in GBP/USD.” We were waiting for the sentiment shift to come and it has arrived. I’m not saying that the Pound will definitely be higher some time from now as in some “the trend is your friend” context, but rather our bias for trades should be long due to this sentiment shift. Last month the Fed for the first time acknowledged that they are confident about an economic recovery occuring. This is what they said in March:
Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract.
This is what they said at the latest FOMC meeting:
Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.
For those of you new to central bank parlance, this means the Fed expects a turn around. The market had been pricing this in beforehand as a result of signs of slowing deterioration in economic data, however, there is no evidence that this view has been fully priced in yet. This supports a positive bias for currencies against the dollar along with the Gestalt Shift of a perception for an economic turn around. The logic behind this is that money flowed in to US treasuries and other assets after the violent asset deleveraging last year with the idea that US assets are safe and the US Fed was most proactive in flooding the markets with money, thus giving the US the best chance to recover first. However, as risk appetite improves due to this gestalt shift of a perceived economic turnaround, investors are becoming more choosy and putting their money in countries with better yielding assets and taking it out of a country where inflation could put the deficit in an even worse condition. That said, the UK is not that much better, but they were also proactive and were over punished due to the carry trade unwinding of last year. Some other clues supporting this view are falling Tbond prices and Eurodollar interest rate futures showing some weakening.
The Euro would also be a good candidate for a long bias because it’s viewed as second in line as a world reserve currency but I would not recommend putting a lot on a long EUR/USD position just because the economy is still trying to recover and would be really sensitive to Euro strength as it is an export economy.
As always, don’t take this as investment advice, but rather as strategies to think better about approaching markets.
The market is being optimistic again- how should you trade it?
All currencies except for the Yen have been moving up against the dollar. This classic signature of risk-taking sentiment is reflected by traders’ attention to news events which are indicating the possibility of an economic recovery. What’s happening here is a “confirmational” behavioral bias. This is the tendency for people to filter out facts from an incoming stream of information that don’t agree with what they want to believe and to focus on facts that confirm their pre-conceived notions. To be more specific, the market started to become immune to bad news over the course of time, and then developed this notion that the worst of the crisis is over. It didn’t take long for the market to find “confirming evidence” to prove this assertion. A good indication of sentiment is found in the media: the Financial Times publishes a headline with: “Glimmers of Hope for the US Economy,” and the Wall Street Journal remarks, “Investors See Silver Lining.” However, there are still companies failing, poor employment, a recent -6.1% plunge in quarterly GDP, and problems with personal unsecured debt. The problem is not over yet.
What I would like to convey is that this optimism is fragile and there are still risks to the downside. As you may know, I don’t claim to predict anything, and successful trading is about forming “IF-THEN” statements, not making “UP/DOWN this week” statements. We can say whether the dollar will strengthen or weaken based on considering what the current factors are. Here are the things arguing against dollar strength:
- A tremendous amount of inflation generated from stimulus packages, etc.
- The dollar strengthened too quickly on risk aversion and the worst of the global crisis *may* be over
Here are the factors for dollar strength:
- Any risky events or information entering the market will lead to dollar buying because the US is still considered to be a harbor for safe haven assets.
- The US has recovered the swiftest from past global recessions so money could flow into US equities and prop up the dollar initially.
The IF-THEN statement for trading is the following:
IF a catalyst happens that absolutely convinces the market that global growth has recovered THEN start buying Euros and other currencies. This could be a surprise, dramatic increase in the non-farm payrolls value on Friday, or a sharp increase in Pending Home Sales. Granted this is still a confirmation bias, but it will be supported by more significant evidence and the market will definitely lend credence to it, perpetuating the increase in positive sentiment.
On the flip side, IF no significant fundamental information enters the market in the mean time, THEN short the Euro above 1.30 and buy it below. The Euro should continue to anchor 1.30 until it finds a fundamental reason to go higher. Just remember not to extrapolate any movement in one direction or the other as the start of a new trend, because the market has a low signal-to-noise ratio.
I would like to caution using this analysis, because things could change very quickly. Points 1 and 2 regarding weakening of the US Dollar could very well come through sooner than expected. In fact, we are already seeing signs that the market is losing correlations with equities and ceasing to respond to certain news events that were previously important. This dynamic often suggests that a trend may be forming (weaker USD), so consider that to be a possibility in the medium term and keep leverage low.
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
