Market rationalizations

If the capital flow report had been a much higher number, the dollar would not have fallen quite so much, but it was already in a strong downtrend to begin with, so it would only be a matter of time before data came along to push the dollar lower. Traders twist factors to fit whatever prejudice they already hold. For example, traders ignored the fact that, the same week this bad news came out, the Fed raised rates, normally a factor that supports the dollar.

But traders dismissed the rate hike as “old news” since it was already fully priced in. If the Fed had raised rates by 50 basis points instead of 25 basis points, the hike might have offset the bad trade and capital flow data.

But it was obvious the Fed wasn’t going to raise rates by more than 25, because it told us so –– rate increases would be by “measured” amounts. Of all the news items FX traders may use to rationalize their short dollar positions, the price of oil is high on the list. Say oil prices rise again.

Traders will interpret the news as worse for the dollar than for other currencies, even though European economies tend to see a bigger second round inflationary effect from higher energy prices than the U.S. (or Japan, which is the most energy-efficient of all the major countries). But you can “spin” the oil news as worse for the dollar on the grounds that higher expected inflation in Europe will pressure the European Central Bank to raise its own interest rates.

Funny, the market doesn’t care much about rates when a rate hike would seemingly support the dollar, but now it’s using a short-term interest rate to justify supporting a different currency. It is wildly inconsistent and even hypocritical, but this is the kind of slant that develops when bias toward a currency is strong. All bad news sticks to the out-of-favor currency like Velcro, while undeniably good news slides off the currency like it is Teflon.

That’s why we can’t make a list of FX factors once and for all and give each one a weight. A factor has one weight when the price is in an impulse wave –– i.e., trending strongly –– but a different weight when the price is in a corrective mode.