Related markets

News from related markets sometimes dominates overall sentiment toward the dollar, as we have seen with the widening interest-rate differential favoring the dollar since last fall. But this is often an excuse that forex traders use to justify taking trades they wanted to take, anyway.

The price of oil is a good example. We went through a period late last summer when the rising price of oil was considered especially bad for Japan, because Japan imports all its oil. In fact, Japan is the most energy-efficient country in the G7, producing more units of output per unit of energy input than anyone else, so to tar Japan with oil’s brush was just a rationalization for shorting the yen.

When Hurricane Katrina hit the U.S. Gulf coast, the market sold off the dollar against the Euro from 1.2188 on Aug. 31 to 1.2589 on Sept. 2. There is no true economic basis for such an overreaction. One barrel of oil is the same as any other barrel of oil, so it makes no difference whether the U.S.produces oil or buys its oil from the world market. It certainly makes sense for the price of oil to rise, but almost none for the price of the dollar to fall. The real reason for the dollar to fall was that traders had already observed a near- 61.8-percent retracement of the Euro’s up move from July to mid-August.

Many traders in the forex market keep track of Fibonacci numbers and this was an especially easy one to spot. The bounce up off the retracement line was facing a heavy headwind in the form of talk about upcoming interest-rate increases in the U.S., so traders needed a better-than-usual excuse to keep the move going. Hurricane Katrina fit the bill nicely and had the added benefit (for dollar shorts) of creating the spectacle of the world’s richest country failing to provide timely and adequate relief to its own citizens. The can-do country couldn’t. This is an instance where the giant miasma of anti-U.S. sentiment that hangs over the dollar took concrete form.

It quickly became clear, however, that the hurricane would take away only 0.5 to 1 percent of GDP in the near term— and actually add to GDP in later quarters as rebuilding began. Germany, the Eurozone’s biggest economy, will get 0.8-1.2 percent growth this year. A natural disaster that removed 0.5-1 percent of growth from German GDP would be an economic disaster, too. But in the U.S., with GDP at 3.3 percent in Q2 and headed for 4 percent or more in Q3, the temporary reduction in growth from the natural disaster is manageable.

Here is where context counts. Anyone observing the dollar fall on Sept. 1 and 2 could deduce the move was unjustified based on the fundamentals and that the “news” was being interpreted incorrectly. And the chart immediately began to exhibit a double top, which is one of the more reliable standard patterns. If the price falls below the lowest point of the “M” (see mid-August), it almost always follows through with a substantial drop. (A little move back upward, such as the one that occurred on Oct. 6, is also very common.)

To draw a tentative conclusion: Currencies are joined at the hip to the fixed-income and money markets because, after all, real capital flows are based on competing real rates of return. But real capital flows constitute only a small portion of total forex trading and we often see forex price moves that are contrary to the rational comparison of financial returns.

Other markets, such as equities, oil, and gold, are only sporadically decisive factors in forex prices, and even then can be exploited for their shock effect rather than any reasonable and plausible economic scenario.

You want to know what is right and reasonable in the fundamentals, but you shouldn’t always trade on it right away when the market is in a perverse frenzy.