Trades: Start building long positions

At the Gestalt Shift, we look for imbalances and then signs that a shift is occurring so that we can catch the bigger, liquid moves in the currency market. A couple points of wisdom that form the core of our profitable trading methodology are the following: 1) The FX market is a zero-sum game, which means that the crowd has to be wrong at the beginning and end of a trend, where its wealth is transferred to the minority participants, and 2) Trends start at the quietest moments. The thing to take from point 1 is that when the crowd has extreme sentiment and positioning in one direction, there won’t be any more buying (selling) capacity to continue that trend, at which point price reverses its trajectory. The end of the last multiyear currency trend ended in extreme volatility, and in particular an extreme desire to buy dollars and Japanese Yen. That volatility has since reduced and currencies have mostly traded in ranges for the last month. This information, along with signs that currencies have not been willing to seek new lower levels upon terrible global economic news being announced daily has suggested (at least temporarily) a shift in sentiment.

USD/JPY has fallen from 110 to 90 in the 6 months following August 2008 on strong demand for Yen due to carry trade and global equity liquidation. At the height of panic last year the yen strengthened all the way to 87 yen to a dollar. However, since then the single unit has never been able to close below that level and has instead rested around the 90 level most recently. Furthermore, Commitments of Traders data from the CFTC shows a net long position of large traders of 43,597 contracts against commercial traders, a number that hasn’t been reached since 2004, when the Yen was at lower levels. We identify this to be a shift in sentiment because the currency had plenty of opportunities to venture on to the 80-85 range based on terrible data coming from the U.S., including dismal quarterly reports during U.S. corporate earnings season in January, U.S. employment losses of over 600K monthly, uncertainty of the viability of stimulus packages, talk of nationalization of “bad banks” with toxic assets, and more. Given the degree to which the Japanese economy is tied to the U.S. we would expect a strong push to lower levels. Could it be fear of intervention that’s causing the dollar/yen pair to hold at present levels? The Japanese Ministry of Finance (MoF) suggested that they may intervene around the 80 levels but had no intentions to at this time. Either way, the Japanese economy is in trouble now and the strong Yen adds to the exporters’ pain. This looks like an imbalance that either the market or the Japanese government will fix. This imbalance, along with the shift in sentiment discussed above makes building Yen shorts an attractive strategy. We recommend to start building long USD/JPY positions.

Yen Weekly Prices as of 16 Feb 09

Successful trades are not ones that work because we correctly predict the fundamentals, but because we see how much of those fundamentals have been discounted. This fact reminds us to consider such currencies as the Australian Dollar. The Australian economy has been hurt because of the drop in global demand for resources, and the carry trade unwinding of high yielding currencies brought the Australian dollar all the way down from near parity against the US dollar to the mid 0.65 level today. AUD has been over-punished because of the fact that it is a commodity currency and it was a high yielding currency. Another reason is gold. As noted in past entries, correlation breakdowns often foreshadow trend changes because they indicate a gestalt shift, or shift in perspective of the market participants. We currently see this in spot gold (XAU/USD) which built a base in the 700-750 range during Q4 2008 and has since climbed in a steady trend to 950 as of this week. Perhaps it is due to inflation hedging (since the US is building massive debt) or it is a safe haven play. It doesn’t matter-the fact that gold prices previously correlated with the rest of the currency-dollar pairs since the beginning of asset deleveraging in last August, but now quietly rises as the rest of the currencies stay in a range against the dollar means that there is a chance of a shift taking place. The Australian dollar’s normal link to gold prices may be restored as Australia is a commodity-based economy. At this time it may be a good idea to start building small long positions at different price levels in AUD/USD.