Market environment Part 1

Market sentiment may seem like a vague concept, but when you take it apart, you see it consists of specific fundamental and technical components that interact to generate a bias for a currency, either favorable or unfavorable. The bias comes from the overall environment, and perception of the environment will color the news.

At any one time, a majority of FX traders agree on the bias even when they disagree on everything else. In terms of the components of the environment that establish market sentiment, there are big picture factors and little-picture factors.

Structural conditions. The biggest factor in the market environment that establishes sentiment is an economy’s collection of “structural” conditions. In the U.S., the most important structural issue is the current account deficit, which will be 5.4 percent of GDP this year and perhaps more — an unprecedented level in a developed country. Most analysts say this is unsustainable, a conclusion cited for the dollar’s three-year decline that started in July 2001. It was clear even then that once the current account deficit got on the radar screen, it would be very tough to get it off. At the time, the deficit was 3.5 percent of GDP, and it has deteriorated exactly as expected. That’s the whole point of a structural problem — it’s the elephant in the living room.

Another structural element is the budget deficit — but it’s a lot weaker, because the free-market character of the overall economy suggests the U.S. can earn its way out of it. Fixing the current account imbalance would require other nations to do things they show no inclination of doing, such as China and other Asian Tigers un pegging their currencies from the dollar and Japan leveling the playing field for U.S. imports.

In Japan, the big structural issues are the too-high savings rate and too low consumer spending level (twin roadblocks to ending deflation), along with a risk-averse and ailing banking sector that will not lend and allow the multiplier effect to work its magic.

In Europe, the key structural condition is the rigid labor market. When a few big European companies such as Siemens) won longer working hours without higher pay in a settlement with the unions, the euro benefited immediately. Everyone knew right away this was news that modified the key structural concern.

Cyclical data. Cyclical data, which consists of the regularly reported economic factors such as GDP, trade balances, producer and consumer prices, retail sales, etc., must be evaluated in the context of structural conditions. Except for a few big items such as GDP growth, cyclical data that is not relevant in the context of current structural conditions tends to be ignored.

For example, when it was evident Japanese GDP was growing faster than U.S. GDP in Q4 2003, it was a wake-up call because such high growth, not seen in a decade, potentially signaled the beginning of the end for Japanese deflation.

The yen got a boost from the Q4 and Q1 GDP reports as the structural bias was being revised — but then took a header when Q2 GDP was low, and low specifically because the domestic demand component of GDP was soft.

Similarly, in the U.S., the dollar took a bath in early August when the non farm payroll number (part of the monthly employment report) for July came in abnormally weak — even though payrolls are not correlated with any other important cyclical indicator — because the market had become obsessed with payrolls as a symbol of growth.

Foreign exchange rates are correlated with growth, so the U.S. recovery in recent quarters gave birth to the perfectly reasonable idea that the three year dollar downtrend might be coming to an end. However, if this proves to be the case, it would be a triumph of cyclicals overcoming a deep, unfavorable structural bias — a very tough thing to achieve.