Market environment Part 2

Trend. The market environment also includes the long-term trend of the exchange rate. It shows the euro/U.S. dollar (EUR/USD) spot rate. The price data is inverted to reflect the dollar’s value. The downtrend started July 6, 2001, and has lasted more than three years so far, punctuated by corrections.

Notice at the end of the chart the dollar made a higher low in June, which is connected to the February low by an upward-sloping support line. Price is above the long-term linear regression line (see “Indicators in the issue,” p. 58), too. This up move in the dollar started in April — just when high U.S. first-quarter growth started to sink in. Is the most recent up move another correction that could turn into a trend reversal? The downward environmental bias is very strong, so it will take powerful cyclicals or other factors to overcome it.

Strangely enough, a powerful factor could be price moves themselves. The FX market, like other markets, watches itself. Market action is a factor in the next market move, independent of structural and cyclical concerns — a feedback process George Soros referred to as “reflexivity.”

A very high percentage of FX traders depend on technical analysis of one stripe or another, including ideas such as the exhaustion of a trend pattern. It may seem strange to include technical factors in a list of market sentiment determinants, which we normally would think of as “fundamentals,” like the current account deficit or GDP. But in practice, FX technical factors can be as weighty as the cyclicals in any given period — and a big enough technical trend change can alter perception of structural conditions, too.

In other words, we think of the technicals as reflecting fundamentals, but we have dozens of fundamentals, so sometimes a technical driven change forces us to shift our perception of which fundamentals are the important ones. Technicals don’t “influence” the fundamentals, but they influence how much relative weight we give them.

Institutional factors include the few tidbits of “dollar policy” that sometimes fall from the lips of the Treasury Secretary, but mostly the institutional component is all Fed, all the time.

In July 2004, for example, the Fed chairman asserted any soft spots in the economy were transitory and the market should expect “measured” rises in the Fed Funds rate that would normalize interest rates to a level appropriate to a full and sustainable recovery. And in mid-September, the Fed dutifully raised the Fed Funds rate for a third time.

Exchange rates are also correlated (at least sometimes) with the interest rate differential, so again it was only rational to wonder if the long dollar downtrend might be ending when the Fed began raising rates. As the Fed started making hawkish noises, for example, the high-yielding currencies softened and the dollar was purchased as traders unwound some “carry trades” (see “Getting a lift from the carry trade,” p. 32).

Political factors, including foreign affairs, are another component of the environment. One of the dollar’s corrective up moves occurred in March 2003 when the U.S. invaded Iraq. Overall, the situation in Iraq is an environmental negative, chiefly because other countries are critical of U.S. policy. For example, when the Madrid train bombing occurred on March 11, it was the dollar that fell, not the euro.

This would appear to be a strange reaction unless you understand that any act of terrorism — even if it takes place in another country — is now dollar- negative. Not surprisingly, the outcome of the presidential election is sure to impact the dollar.

News. The news is meaningful only in the context of already-existing market sentiment. One or two good numbers, for example, don’t change an overall negative bias, just as a few bad numbers won’t make much of a dent in a positive bias. A string of all-bad or all-good numbers can cumulatively do the job, though.

News comes in two flavors: regular daily news that turns the market-sentiment dial toward bullish or bearish, and “event”-type news that changes everything. Both garden-variety and event-type news influence the environment and are in turn influenced by it; it’s a complex interactive process. When you hear consumer confidence is way down, for example, you expect retail sales to fall, and since the consumer is two-thirds of the U.S. economy, you expect GDP to fall, too. As noted earlier, exchange rates are correlated with growth rates. When consumer confidence falls in the U.S., the knee-jerk reaction is to sell the dollar.

Ah, but will the selling prevail? It depends on whether the market sentiment was biased in favor of the dollar or against it before the release.

In terms of garden-variety news such as consumer confidence, let’s say the current consensus view has been generally favorable to a particular currency, and now the currency-negative news comes out. The price seesaws back and forth while traders absorb the information, but if the news is not jarring and can fit without too much effort into the prevailing consensus, the existing trend or directional bias will usually win in the end.

In fact, a dip on bad news actually constitutes a buying opportunity and the bulls will quickly put themselves back in charge — which is what happened after the end of the initial hot war period in Iraq. The war itself was long-anticipated and the market bought the dollar on the news, but the U.S.’s swift dismantling of the Hussein regime was not a strong enough factor to overcome the existing negative bias for more than a brief period.

Event news operates on a different scale altogether. It can be scheduled news, such as the employment report, or it can be an out-of-the-blue shock, such as the Sept. 11, 2001, terrorist attacks. News that rises to the “event” level is by nature wildly different from the consensus estimate, such as when payrolls come in at 32,000 when they were forecast at 225,000, which was the outcome on Friday, Aug. 6. When an event is bizarre enough (and such a low payroll level was bizarre), it becomes an event shock almost on a par with an out-of-the-blue shock.

An event shock changes everything because it doesn’t fit into an existing cyclical scenario. Payroll growth of only 32,000 compared to an average of some 124,000 over the previous three years means expectations of future payrolls numbers are going to be less trustworthy than usual and, therefore, so will data on consumer sentiment, spending, retail sales and a host of other fundamentals. Any hope the cyclical data would overcome the environmental negative bias is now out the window. In this case, the payroll event reinforced the negative bias in market sentiment.