Macros at work in the market

Posted by Scriptaty | 9:03 PM

For the past few years both New Zealand and Australia have benefited handsomely from rising commodity prices and exports to China.

In late August 2004 the Reserve Bank of New Zealand (RBNZ) raised rates yet again — the fifth .25 point hike in 2004 — because the prospect of an overheating economy was seen as a greater potential problem than a rapid rise in interest rates. Despite the fact China’s growth was moderating, the RBNZ believed dampening speculation in the housing sector was its first priority.

Meanwhile, Australia had paused a monetary tightening cycle while awaiting more data on housing, retail sales and inflation. The result was the sharp decrease in the AUD/NZD. While this chart certainly does not look like a “buy” from a technical perspective, there were broader reasons to believe the currency pair could be putting in a bottom.

Macroeconomic theory supports the idea the aggressive rate hikes by the RBNZ would soon filter through New Zealand’s economy, impacting growth. With a typical interest rate “lag factor” of eight to 12 months, fall 2004 was shaping up to be a potential adjustment period for the AUD/NZD rate. Although some key economic data still had not yet been released in early October, the market was beginning to bet the pace of economic growth was starting to wane — a viewpoint that was ultimately reflected in the charts.

After many weeks of relentless price declines, the daily and weekly charts confirmed a bottom could be in place as defined by the stochastic oscillator. On the second-to-last candle in , the AUD/NZD rate made a higher low and closed above the open while the stochastic indicator made a higher low. A similar pattern appeared(Another factor that led to the conclusion the AUD/NZD was due to turn up was the fact that the daily chart was completing the fifth wave of an Elliott Wave pattern.) A long trade was initiated on the next day’s open at 1.0580, with a stop at 1.0520, which was 10 pips below the most recent low.

As expected, either the rapid rise in interest rates in New Zealand or some conclusion to the tightening process would be the catalyst needed to propel AUD/NZD higher. The catalyst materialized on Oct. 27 when the RBNZ indicated its monetary tightening phase was nearing completion.

The new landscape now clearly favored Australia, as it indicated rate hikes may not be done. The currency pair quickly traded back through its 50-day exponential moving average (EMA) before touching the 200-day EMA at 1.1030. On Nov. 9, the New Zealand Finance Minister indicated he was “uncomfortable with the current value of the NZD” and the currency was likely nearing a top and would face headwinds going forward. The result was a nice push back above the 200-day EMA. (As of Nov. 10, the trade was still open, with a revised stop loss of 1.0790.)

The Euro/British pound (EUR/GBP) rate provides another example of the insights macro factors contribute to a trade. This scenario, which also resulted in a long position, is somewhat similar to the AUD/NZD example. In this case, we were looking for a contraction in the rate differential between the European Union and Britain.

Britain had been aggressively raising rates through 2004 in an effort, as Bank of England (BOE) president Eddie George stated, “to stem the tide in the rapid increase in housing prices.” The BOE was determined to nip this problem in the bud rather than let a full scale economic bubble develop and burst, thereby throwing cold water on consumer spending, which could send the economy into a recession.

It was at this time the European Central Bank (ECB) had halted rate cuts, as the economy was beginning to enjoy the benefits of relaxed monetary policy. The inevitable conclusion was rates would rise on the European continent but not in Britain. The prevailing carry trade environment (a carry trade consists of buying the currency with the higher interest rate vs. the currency with the lower interest rate in order to capture yield) was drawing to a close and a possible interest rate “catch-up” in Europe vs. UK was in store. See “The short term British pound/Japanese yen carry trade” on p. 22 for more information.

The charts, of course, were already bearing this out, but again, a tangible macro story allows one to really stay with a trade knowing what logically should unfold.

It shows the EUR/GBP rate. In this case, there was a straightforward pullback within an uptrend.

Pullbacks within clearly established trends offer a clear edge vs. trying to pick bottoms; trends tend to continue after periods of consolidation at support levels.

The EUR/GBP moved higher in the subsequent weeks. Continued comments from the Bank of England signaled rate hikes were all but done, while the ECB left the door open for further hikes.

The dollar’s continued weakness also played a role in pushing this trade higher. With Asian central banks intervening to protect their currencies from appreciating vs. the dollar, the euro bore the brunt of the dollar weakness because the ECB rarely conducts direct open market intervention in the euro.