Trading FX and the five fundamental puzzles
By Arek Okrasa - Market Strategist at TradeNext
Date: Monday 21 Apr 2014
Trading Fx and the 5 fundamental puzzles
-based on the most recent interview with Digital Look TV
Clearly identifying the medium and long-term trends in foreign exchange markets is key for intraday traders, hence the old market mantra: “the trend is your friend”. Taking that in to account, and with a view to the next three to six months, at the global level there are five critical ‘puzzles’ to solve regarding the directional bias of the markets’ next move.
Deflation in the Eurozone?
Starting with the Eurozone, as Alex Bueso, Digital Look’s Chief Editor pointed out, the region`s economy had until recently been slowing down sufficiently such that the risk of deflation or excessively ‘low-flation’ is now considered to be a real risk. According to Matthew Sherwood, deflation is already evident in four countries including Cyprus, where the most recent print for the consumer price index came in at a negative 1.3% in year-on-year terms, Greece (-0.9%), Slovakia (-0.1%) and Portugal (-0.1%), and it remains a “very real risk in 2014”. Should the rate of change in the consumer price level of other euro countries also dip into negative territory, then Europe’s debt problem will increase and it could eventually get out of control.
As an aside, given the strong links between financial markets and those for goods and services, it is worth pointing out that Europe is the biggest market for China’s exports. In other words, if the economic situation in European Union (EU) worsens then China will be directly affected, as will be Australia – China’s largest commodity trading partner – and we will see later on.
In order to forestall such a downturn the European Central Bank (ECB) may have no choice but to enter into some sort of quantitative easing (QE). If a QE programme is implemented - and proves successful - then risk appetite will rise. The debate in Frankfurt, however, continues to rage on, it must be pointed out.
For instance, ECB Governing Council member Ewald Novotny has gone on the record as being opposed to bond-buying to help the Eurozone`s recovery, arguing there wasn`t any threat of deflation.
Perhaps, yet on April 12th ECB President Mario Draghi explicitly stated that a further strengthening of the euro’s exchange rate would require a looser stance on monetary policy.
So will the euro weaken or strengthen over the next three months? As currencies are traded in pairs, it’s probably best if we first go over the situation in the United States.
Fed to raise rates sooner?
So to touch on Alex Bueso`s second question, is there a chance that tightening from the Federal Reserve (Fed) might come a tad sooner than forecast?
As events over the last three weeks have demonstrated, monetary policy plays an important role in determining the strength of the US dollar. From the March statement by the Federal Open Market Committee (FOMC) markets concluded that tapering was set to continue and that there was a possibility that six months following its end interest rates might rise. When this naked truth was revealed to markets eur/usd immediately dropped by 100 pips on the session and the pair continued to slip lower over the next 12 days.
The picture changed however after the release of the latest FOMC meeting minutes on April 9th. There was no mention of a hike in interest rates after the QE programme ends. Also, those minutes showed that a majority within the Fed anticipated that highly accommodative policy settings would be needed for years afterwards. On the back of this information, and during the next three days, eur/usd climbed by a 100 pips. In other words, the situation had become uncertain.
QE from the ECB may hold the key for the single currency
As always, technical analysis can help to shed some light on the most likely scenarios for the euro and the US dollar. Thus, looking at a monthly chart a ‘pennant’ formation in eur/usd is clearly visible.
I refer to the monthly chart as it reflects the long-term fundamental equilibrium between the euro and the US dollar, as a result of the interplay between the policies undertaken in each of these economic blocks.
Should the ECB decide to embark on QE just as the Fed is seeing out its promise to end its own asset purchase programme then the currency pair may turn to the downside. In fact, if interest rates also start to rise then we may even see eur/usd falling to around 1.1900 at some point over the next three years.
An alternative scenario, however, could be this: no QE from the ECB and highly accommodative monetary policy in the US. That would promptly send the pair through 1.4500.
Also from the vantage point of technical analysis, it is worth waiting for a first close – in monthly candles - above the 1.3950 mark. This would be the first indication that a continuation in the up-trend might ensue. Less conservative traders, on the other hand, can opt to take their cue from the weekly charts, as the 1.3950 level has already been taken out on that time frame.
Enter China
There is another element which may weaken the US dollar and strengthen the euro, or do exactly the opposite: the Chinese economy.
Many have probably heard talk of the “ghost towns” in China – a sign of a possible property bubble.
What many may not have heard, nor been explained, is that while China`s own state-run banks provide much of the liquidity for the country’s businesses, foreign banks have stepped up their lending to China in recent years too.
According to Heather Timmons, they have racked up over $1trn in outstanding loans to China`s public and private companies. Hong-Kong banks are the most exposed with over $446bn in loans. After that, the UK takes the lead with almost $200bn in outstanding loans, with the US right behind ($84bn). Of course, bad investments (loans) are not the only challenge which authorities in Beijing face at the moment. The slowdown in external trade puts the country in a quandary as well.
To cut a long story short, any sign of an economic recovery in China or that the People’s Bank of China will loosen monetary policy would give another boost to the Australian dollar and weaken the US currency unit. A hard landing in China usually translates into a more robust US dollar, with the ‘Aussie’ doing just the opposite. In other words, in order to trade eur/usd wisely it is also worth keeping an eye on the current situation in China.
And then there is Japan … and the Dragon
The second and the third quarters of the year may also turn out be very interesting, if the Bank of Japan (BoJ) carries out another instalment of QE. On April 8th BoJ Governor Haruhiko Kuroda waved away that possibility. Investors, however, still expect that the country’s monetary authority will come around to seeing the need for it when it meets in July. That might provide us with another good opportunity to trade. At this point two currency pairs come to mind: usd/jpy and gbp/jpy, or the so-called ‘dragon’.
Before we go on, bear in mind that usd/jpy dropped from 124 yen to 75 yen between 2008 and 2011. At the moment the currency pair is trading above 100. In other words, when the US dollar strengthens and the Japanese yen weakens the pair has around 2500 pips to go.
Looking out to the next three months, a move higher is not that obvious from looking at the charts. Nevertheless, everything may change if and when the BoJ enters into another round of QE. That is why keeping gbp/jpy on the radar looks very attractive. The British economy is picking up, so [ceteris paribus] sterling should strengthen. With the yen headed lower on the back of a decision out of Kuroda in favour of more QE, going long on the pair looks like it may be a good choice. At the moment the weekly chart shows that the pair is in a consolidation phase.
Even if the currency pair breaks the current chart pattern to the downside it should be worth keeping tabs on it. Again, once the BoJ eases its monetary policy then the direction of the dragon may become clearer. Also worth noting, some have begun to speculate that the Bank of England may increase Bank Rate sooner rather than later. Such a decision would not only strengthen the British pound, it would likely also offer greater support for the euro, as the pairs are closely correlated.
Arek Okrasa
Market Strategist at TradeNext Ltd.
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