Archive for Paul Stafford
Forex Fundamental Analysis: View on the Yen with Paul Stafford
I must admit that I have a hard time maintaining an open mind on the yen. I see so many issues impacting the currency relative to the other G-7 that when good news does happen, I tend to discount it (my own “confirmatory bias” peeking through). So let’s start with my predilection that the Yen is due for a fall, and then try to discredit it.
The fundamentals certainly do give one pause. The central bank rate has been 0.1% for years, and of course gave rise to the Carry Trade. With the recent increases moving short term US interest rates above Japanese rates, a resurgence of the Carry Trade will drive the Yen lower. Other measures of the economy are woeful too. The GDP took the worst fall of all the G-7 last year (-12.7% annualized in March 2009), and monthly change in GDP remains negative, although improved from a year ago. Amongst the G-7, the budget deficit is third worst (behind the US and UK) at -7.8%.
The CPI has been negative for over a year, and remains so even though other nations are have been seeing positive numbers for a while now. Of and by itself, a negative CPI is no crime, but the deflation it indicates has plagued Japan for several decades now, and unless policy changes, will sap the strength of the economy.
The last few years of Yen strength have severely impacted Japan’s export economy. As you can see from the chart, the Yen is still near historic highs against the $. That is important. The US, consuming 20% of Japanese exports, is Japan’s largest trading partner by far (China comes in 2nd at 15%, and the Yuan is pegged to the $).
USD/JPY Chart
The recent $56B increase in the borrowing limits for the foreign exchange special account indicates to me that intervention is a distinct possibility. The Bank of Japan has done it before, they will do it again.
Sovereign risk, as measured by CDS rates, remains among the highest in the G-7 (recently 63 bps, compared to the US at 48 bps, Germany at 34 and France at 43 bps), only recently being eclipsed by the UK. This is probably a result of the absolutely huge public debt that Japan has, forecast to exceed 225% of GDP by the end of this year. In a similar measure, Standard and Poors recently downgraded the outlook from stable to negative. While Japan’s debt still carries an AAA rating, the UK is the only other G-7 country with a negative outlook.
The long term macro view is hardly any better. Everyone is familiar with the serious demographic issues facing Japan. Its population is both shrinking (forecast -.2%/yr) and aging (30% of the population is over 60). Because of its unique culture, net immigration is negligible. Japan imports more than 80% of its energy needs, and so is very sensitive to the price of oil. The huge public debt overhangs it all. The Nikkei 225 is 25% of its 1990 high (chart courtesy yahoo finance)
Japan Nikkei Chart
A good trader always looks for data opposing his view. On the plus side, unemployment in Japan is only 7.8%, and Japan also carries a positive current account balance. Sentiment indicators are still bullish Yen, with the last 25 Delta risk reversal I saw on the $/JPY at -1.25 (quote from Super Derivatives), and CME futures are roughly 2:1 long Yen. The huge public debt is mainly held domestically, as opposed to the huge US public debt, which is mainly held offshore. With a growing China as a trading partner, exports should strengthen, and the recent increase in renminbi short-term forwards indicating a potentially stronger Chinese currency should also help.
In spite of those contra indications, my expectation for a weaker Yen remains. A stronger Yen hurts the export economy, and exacerbates the deflation currently strangling Japan. Monetary policy must move for a weaker Yen. Only risk aversion, which paradoxically (to me) benefits the Yen) can keep the Yen in its current range.
Paul Stafford
For more strategies on how to capitalize on this move go here
Increase Your Certainty Before Trading Forex Options
How to trade forex options objectively
Paul and my “Trading Forex with Options” ebook will be up for grabs tomorrow and I wanted to prep you for options trades before you learn the material. Paul sent me a copy of his trading planner that he uses for every single one of his trades so he can remain completely objective when putting on his trades and be certain about his decision. Would it be helpful to you to know how to gain this certainty and significantly reduce those feelings of doubt and frustration? Let’s walk through each of the components of the planner that he filled out recently:
Forex Option Trading Plan
Look at the chart
The first thing you should do is bring up a chart of the currency pair of interest and note what it’s been doing and the current price level/range it’s been in. This will give you a context of what’s been going on and will immediately show you the current sentiment. You should be answering, “Is sentiment positive, negative, or neutral right now?”
In this case price has tested lows and failed and is starting to develop a positive sentiment.
Weigh positive and negative factors for sentiment to decide on a direction
Ok when you first look at what’s filled out in the “supporting reasons” box, you may freak. But it’s actually not difficult if you can read. Like Paul said in his interview, he just goes to trusted financial sites like bloomberg.com or ft.com, or even investment bank reports and looks at what economic news is coming out and what the market cares about. You can follow the same strategy and simply list what you find here. After listing all of the reasons why a currency pair should increase in the “supporting reasons” box, you can list all of the opposing reasons in the box below it. If you have more strong reasons in the upper box, then you can put on a trade with the confidence that you are riding on a large fundamental driving force. How to do this is all covered specifically in the ebook, but if even after reading that you are still confused, reading Paul’s weekly briefing or reading certain investment bank analysis reports can help you decide on a direction supported by fundamentals.
In this case headlines indicate that stock market crashes are causing the Yen to benefit against the Dollar, but in the long term evidence is overwhelming that the Yen has to weaken (i.e. USD/JPY strengthen).
Decide what the best structure is for the current market environment
Sometimes price has been in a range and you want to profit from an explosion in one direction, or you may only expect it to increase weakly because sentiment is only weakly positive. Or, you may expect price to remain confined to a range. Each one of these possibilities requires a different options strategy. If this seems like greek to you right now, the book covers the basics of how to choose the right options for the right environment.
In this case, the call option is bought near the entry price to express a long view of the USD/JPY, and another call option is sold with a strike price way up at 100 to reduce the amount of money risked on this trade. For a similar reason, a put option is sold below the entry price and has the backing of strong technical support near the strike price.
Plan your exit and be prepared to deal with negative outcomes from the beginning
It’s amazing how most traders spot what they perceive to be an opportunity in the market and only see the positive outcomes that could occur, and think that risk management is as simple as putting a stop loss on.
But let’s think about it: if you went through all that work performing analysis to find an opportunity to profit, what makes you think that you don’t need to go through the same work to anticipate possible negative outcomes and plan your exit strategy?
VAR stands for “Value at Risk” and basically is a way of measuring the maximum likely movement of price within a given time frame and level of confidence given the volatility implied by the market. This is so we can give price plenty of room to “breathe” without risking too much.
In this case, analysis of past price action and words of experts in the media (regarding the Bank of Japan) seemed to both indicate that Japan would be happy with the USD/JPY around 98 or above, so we would be happy taking profits at 98. Using current volatility, with 95% confidence we can expect a maximum loss of $616.
I realize that this may be a lot of jargon for non options traders, but once you learn it you get used to it and really it’s just a matter of filling out each of these boxes every time you approach the market–Then you can forget about second guessing yourself or worrying about getting stopped out. Again, I didn’t explain every little detail here because I don’t have room, but I’ll be posting more strategies that you need to trade options profitably in the future. If you want to fast track your success with trading forex options, however you’ll want to get the “Trading Forex with Options” ebook when it comes out tomorrow.
The case for emerging market currencies
Warning: parts of this article (in particular the currency options section) may be for more advanced readers/traders
While most of us have focused for good reasons (liquidity, transparency) on the major currency pairs such as EUR/USD or USD/JPY, there’s a great opportunity waiting out there for those willing to take a chance with less well-known currencies such as the Brazilian Real (BRL) or the South Korean Won (KRW). As always we need to examine the forces moving such currencies. As you will see, there are many positive aspects of emerging markets (EM) and their respective currencies.
First, let us consider the case against developed countries (reasons to be short these currencies).
- The debt of the developed countries is huge, and will hang over their economies for a very long time. The aggregate G7 debt is 10% of GDP.
- They will emerge more slowly from recession, and will tend to keep a tighter lid on interest rates, keeping monetary policy loose. In 2010, the forecast GDP growth in the US is 2.7%, in Japan, in the UK and EZ it’s 1.5%, and in Australia it’s 3.3%. By contrast, the forecast GDP growth in China is 9.8%, India and Korea 7.8%, Brazil 5%, and Singapore 6.5%
- Strong capital outflows- investors seeking return. The growing popularity of ETFs focused on Emerging Markets is a good example of this.
- Commodity consumption, leading to larger current account deficits
- Demographics – ageing, shrinking populations (especially Japan, but EZ and the US, too)
EM countries, on the other hand,
- Offer the best carry trade opportunities. For example, today the Brazilian Real is at 8.75%, the South African Rand is at 7%, and the Turkish Lira is at 6.75%
- Their economies are poised for much stronger growth. Emerging Asia is forecast to grow nearly 8% in 2010. Some think that in the next 5-10 years, 2 of the 4 largest economies will be EMs.
- Strong capital inflows (aka Foreign Direct Investment or FDI) seeking return
- Commodity production and export, leading to current account surpluses
- Demographics- younger, growing populations with greater fractions of contributing people.
Currencies benefit from high growth (because rising GDP & CPI drives central bank interest rates higher, attracting carry traders) and capital inflows (because local investment requires local currencies- forcing the local currency to be bought, which drives it up).
These are fundamental forces, and while in the long run will prevail, you must keep in mind that in the short term, sentiments sometimes counter these forces.
So obviously, the idea is to be long strong EM vs weak developed country. For example, long BRL/GBP, or long KRW/$.
What are the risks? There’s always the chance that the nascent recover will falter, be a double dip, or some other structure that puts these long term trends on hold (they are inescapable in the long run). Emerging Markets sometimes experience currency crises (lack of foreign reserves, high current account deficits), resulting in monetary controls, intervention and other tools which can temporarily hurt a currency.
So we need to ask how best to trade the EM currencies while managing risk? I have three example methodologies.
1) First, simply long the spot, with low leverage. This is what most folks do, and will benefit from the long term appreciation we expect, along with excellent carry. Pending dramatic movements are almost always signaled by market watchers like the IMF or World Bank. A devaluation should never take you by surprise. Here’s an example of the ZAR (South African Rand) appreciating over a long period of time due to fundamentals (Gold, other commodity appreciation)
2) Second- long the spot with some insurance. To protect against a devaluation or depreciation, put on what is called a collar. This is an option structure often used by import/export companies to protect against currency risk in a forward. The most basic structure is long an out-of- the- money put (protect the downside), paid for by a short out-of-the-money call. While this limits the upside, you are protected the downside, and collect the carry. Here’s a P&L example. Protected by the put, you can leverage up the spot to get high net carry, knowing your downside is limited.
3) My personal favorite, simple long-dated (1 yr+) option spreads. This is the favored methodology of such incredible money managers as Jim Leitner, Christian Siva-Jothy and others. It provides excellent risk management, strong upsides, and limited loss. Here’s an example P&L of a bullish spread (long call @ 90, short call @ 95, short put @ 80) I just did last week on the $/JPY. It created a maximum 4:1 payoff.
So in conclusion, I believe than the EMs are going to offer the best returns over the longer term, based on inescapable trends. While the risk is there, methods and tools exist to mitigate those risks.
Paul Stafford writes a weekly Currency Briefing, reviewing the fundamentals moving the major currencies. To download a sample briefing, or to subscribe, please visit www.4xtradertools.com
Paul Stafford on “The Carry Trade”
With a second increase in the RBA (AUD) central bank rate to 3.5% and the Norges bank (NOK) also recently increasing its rate by 25 bps (target rate 1.25-2.25%), the carry trade may be resurrected from the ashes of 2008. The carry trade unwound completely this year as central banks reduced their rates (eg the RBNZ dropped rates from 7.25% to 2.5%) in order to re-flate the world economy. Now I believe we are poised to see many countries’ rates move upwards over the next year, while others (funding currencies) will likely remain low.
First, a review of what the carry trade is might be helpful. Carry trade is a strategy which takes advantage of the different interest rates in different countries. The difference can be dramatic, as this table shows:
|
Currency |
Rate |
|
BRL |
8.75% |
|
ZAR |
7.00% |
|
TRY |
6.75% |
|
PLN |
3.50% |
|
AUD |
3.50% |
|
INR |
3.25% |
|
NZD |
2.50% |
|
NOK |
2.25% |
|
KRW |
2.00% |
|
GBP |
0.50% |
|
CHF |
0.25% |
|
CAD |
0.25% |
|
$ |
0.25% |
|
JPY |
0.10% |
Generally, the difference in interest rates can be traced to the differences in risk of default in each country. As you can see, the Brazilian Real, the Turkish Lira and the South African Rand top the list, while the US and Japan hold down the bottom of the risk and return list. I am sure an interesting correlation could be made between the interest rate and the Sovereign Credit Default Swap rate (exercise left to the reader).
Historically, the JPY was used to fund the carry trade, but now the dollar is also a very attractive funding currency. With few signs that the US will exit its loose monetary policies any time soon, it looks likely to remain so at least through next year. One effect of carry trade is that the funding currency is weakened as it is sold to buy the higher-yielding currency, which strengthens on higher demand. This is the effect that weighed on the JPY between 1996 and 1998, and again between 2001 and 2008. Much of hedge fund returns can be traced to the carry trade. The size of the previous carry trade phase could have been as high as $1Trillion
There are several ways in which to play the carry trade. One way is to exchange one currency for another, and then invest in risk-free securities in that currency, such as bonds, which will earn more interest than in the base currency. This is a little cumbersome.
Another method is to initiate positions in the Forex market. For example, when an investor goes long the AUD/JPY, he is short a currency whose central bank pays 0.1%, and long a currency whose central bank pays 3.5%. An FX market maker will either pay out (or as appropriate, charge) a carry interest, which is what the investor is interested in. It is not usually as simple as taking the difference between the central bank rates, as the market maker adjusts daily, takes a spread, and bases the rate on indices (such as Libor) that closely track the central banks rates .
The Forex method is more common because it is easier to utilize leverage to enhance the interest rate difference. Assuming for the moment that the simple difference is what is paid, a 1:1 position in AUD/JPY would pay 3.5%-0.1% = 3.4%/annum; not an especially interesting number. However, F/X carry trade investors can utilize a higher leverage such as 10:1, which would generate a return of 34%, a very exciting number. OK, what’s the catch? It’s simple- the risk of the exchange rate moving against the investor.
For example, the BRL might be seen as an excellent choice of currency to be long. In the period from 2003 to 2007 the BRL appreciated from 4.0BRL/$ to 1.6BRL/$, a 250% rise. Not only were investors getting an enormous interest rate differential, but saw the currency appreciate as well. However, if you initiated this trade in early ’08, the BRL dropped 50% in value, more than wiping out any interest rate differential. This risk can be mitigated in several ways.
- One way is to stick with the majors. Which the rate differentials are not as high, leverage can boost returns and the exchange rates don’t exhibit extraordinary volatility.
- A second way is to buy insurance. There are option strategies (eg collars) which limit the effects of exchange rate volatility, while allowing an investor to benefit from rate differentials. The cost of the collar is minor, depending on the leverage utilized. N.B this is also the tactic major import-exporters use to insure against F/X exposure, along with forwards.
An investor thinking of initiating a carry trade should line up all the macro ducks they can- twin surpluses (ie current acct and budget), purchasing price parity vs spot, GDP growth- etc. They should also manage risk by calculating the effects of exchange rate swings on the potential position, and potentially taking out insurance. A carry trade is truly a longer-term trade, as you need to hold the position for lengthy periods to maximize the interest return. However, this also increases your exposure to the drift in the exchange rate (as opposed to just the volatility). Also, there is a small but non-zero chance of a central bank devaluing a currency (eg Mexico or one of the Central and Eastern Europe (CEE) countries).
The carry trade may very well be one of the winning strategies in the next several years. Many of the higher yielding currencies-especially in the Emerging Markets (EM)-are set to appreciate more than the funding currencies of the majors ($, CHF, JPY).
Paul Stafford writes a weekly Currency Briefing, which covers fundamentals and sentiment measures for the major currencies. If you are interested in receiving it, please visit www.4xtradertools.com
