How To Trade Forex - Learn Online Currency Trading

Simple Moving Average

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The simple moving average (SMA) is probably the best-known technical indicator. It is used to smooth price action and highlight trends.

Calculation

The SMA is the average price of an instrument over a specific time period:

n-day moving average = Sum(Pricet, Pricet-1 ...Pricet-N)/n
where,

Price t = today’s price

Price t-n = price n days ago

For example, a 20-day moving average is the average price of the most recent 20 days. The closing price is usually used in the calculation, although the high, low, opening or average price of a price bar can be substituted. To calculate, add the closing prices of the last 20 days and divide by 20.

As a market moves forward in time, the newest price is added to the average and the oldest is dropped from it. It shows a series of daily closing prices and the five day SMA values that result from progressively averaging the five most recent days’ prices.
Moving averages can be calculated for any time frame daily, intraday, weekly, monthly, etc. For a five minute bar chart, for example, a 10-bar moving average would be the average price of the 10 most recent five-minute bars. We will continue the discussion in terms of daily bars for simplicity.

International numbers

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Not only is there a slew of U.S. data to remember, there are also crucial reports released in other countries that affect currency prices. Traders need to investigate which economic data is most critical in a certain country during a given period.

For example, in addition to housing prices and retail sales, manufacturing, industrial production and trade balance data are important in the U.K. and Japan because they tend to be more manufacturing and export-oriented countries, according to Dolan.

He also says understanding things such as employee compensation, which often differs from practices in the U.S., makes interpreting non-U.S. data more meaningful.

“In Japan, private consumption data is very important, like it is here,” he says. “But there, overtime earnings and seasonal bonus data are also extremely important. Bonuses comprise a significant amount of Japanese income, and if they are declining, you can bet private spending will fall.”

In Japan, numbers depend on where the main economic liabilities are, according to Beuzelin. Exports are very important there as well.

Lately, U.K. economic data has been weakening slightly: housing prices have moderated over the last few months, and some key reports, such as the September industrial production data, have come in weaker than expected.

The U.K. central bank’s rate-setting body, the Monetary Policy Committee, has been hiking rates in an attempt to curb the inflationary pressures stemming primarily from rampant consumer demand, particularly in the housing market, according to Beuzelin.

“If we see housing prices continuing to cool, that will weigh on the pound but be good for the dollar,” he says. Although some believe certain economic reports in general are untrustworthy, there are economic reports and data relationships that prove consistently reliable, Dolan says. For example, in Japan, machine orders are closely watched. If machine orders sink but tool orders rise, there will probably be more machine orders next month.

“You have to really know the data, know what to look for and what matters and why,” he says. “Investors have been pulling out of Japan — or the media has been saying that money is leaving Japan — because the economy isn’t growing. But [the machine orders and tool orders] data proves otherwise.”

All types of FX traders — not just fundamentally-oriented players — must inevitably keep abreast of economic conditions at home and abroad if they want to avoid being broadsided by the market.

“Investors should really be betting on consumer confidence,” Dolan says.

If consumer spending is not picking up consistently in Japan, it will undermine the yen and the dollar, Beuzelin says. It addresses the issue of whether, in the long run, Japan can sustain its growth and whether wages are growing too.

“Over time, the underlying economic performance of a country determines how well a currency will perform,” Beuzelin says.

“You cannot understate the important of economic indicators as a driver of FX market activity.”

Never cut and dried

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Although economic numbers can offer great insight into the economy and the behavior of the FX market, it’s risky to put too much emphasis on an individual reading because many economic numbers fluctuate dramatically from month to month. Also, almost all of these numbers are released after the fact.

For example, although the employment report is generally regarded as the most important economic report in all markets, it is a lagging indicator and there are often tremendous changes in the payroll figures from month to month. The difference between October, when 337,000 jobs were created (nearly double what Wall Street expected), and September, when only 96,000 jobs were created, is a recent example. Accordingly, analysts and traders often average certain economic figures over several periods to smooth the readings.

Imports and exports

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In his book The Secrets of Economic Indicators, Bernard Baumohl, director of The Economic Outlook Group and former Time magazine economics reporter, lists the economic data with the most impact on the dollar as the employment report, international trade, GDP, the current account deficit and industrial production/capacity utilization. The ISM report and consumer prices are further down Baumohl’s list, although still in the top 10.

International trade summarizes import and export activity between the U.S. and other countries. In general, the foreign exchange market views any kind of increase in trade surplus as favorable to the dollar, according to Baumohl’s book.

“Trade data is extremely importantto the FX markets right now, especially if the GDP is above 5 percent,” Beuzelin says.

The current account balance data summarizes the net change in four areas: merchandise trade, services, income flows (the net income received from investing in foreign assets) and unilateral transfers (transfers of foreign aid, government grants and pension payments).

Participants in the FX markets generally pay more attention to this data than other types of traders. A deterioration in the U.S. current account balance — essentially a broad accounting of America’s trade and investment relationship with the rest of the world — will, over time, wear away the value of the dollar. If the trade balance or the difference in the value of a country’s imports and exports rises and moves toward surplus, it can hurt the dollar, according to Baumohl.

This data has more impact when the economy is weakening and is currently being closely monitored.

“U.S. growth has moderated enough that it makes [it more likely] account deficits will have an impact on the dollar,” Beuzelin says.

Industrial Production (IP) and Capacity Utilization

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• What it is: A monthly measure of the domestic industrial output, weighted according to each input category’s relative importance.

• Who puts it out: Federal Reserve Board (www.federalreserve.gov)

• When it’s released: 9:15 a.m. ET around the 15th of the month after the actual month.

• What it means: It’s an indication of different trends within various industries. In addition, it estimates the “capacity utilization” (the level of potential production capacity at which a business, such as a factory, is operating) within the economy, which, must be interpreted carefully because of the difficulty of estimating the maximum capacity in the first place.

Institute for Supply Management (ISM) index

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• What it is: A monthly survey of 300 purchasing managers,
representing 20 different industries.

• Who puts it out: Institute for Supply Management (www.ism.ws).

• When it’s released: 10 a.m. ET on the first business day of the month after the actual month.

• What it means: The index is designed to fluctuate around 50, with readings above 50 indicating a growing economy. Too-high numbers or extended periods of growth might indicate the economy is about to overheat. Using ISM index, a business cycle trough could be defined as a reading at or above 44 a few months in a row.

The markets are very sensitive to unexpected discrepancies in this number, especially if that also coincides with a turning point in the index.

Durable Goods

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• What it is: The current demand (new orders) and supply (shipments) balances in the economy.

• Who puts it out: U.S. Census Bureau (www.census.gov).

• When it’s released: 8:30 a.m. EST around the 26th of the month after the actual month.

• What it means: The durable goods number is another volatile indicator. It measures the demand for, and supply of, domestic products with an expected life length of at least one year, including both “intermediate” goods (for instance, building materials) and finished goods (cars, computer equipment, etc.). The report monitors the rate of growth within several large industry sectors, such as auto and electronics.

If demand is higher than supply it might indicate a new period of economic growth is around the corner. However, if demand stays above supply while unemployment is low, it also might indicate higher inflation ahead, as the industry will meet the demand with higher prices rather than increased production. This is most likely to occur at the end of a bull market and at the peak of the business cycle.

Retail Sales

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• What it is: The most timely, albeit volatile, report of consumer spending patterns, excluding any type of services.

• Who puts it out: U.S. Census Bureau (www.census.gov).

• When it’s released: 8:30 a.m. ET around the 13th of the month after the actual month.

• What it means: As is the case with the CPI, rising retail sales numbers might indicate demand is about to outstrip supply, which might lead to higher inflation. However, because the data doesn’t include services, but does include gas, cars and food, it is very volatile and subject to large seasonal changes and subsequent revisions.

Gross Domestic Product (GDP)

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• What it is: A quarterly measure of the production and consumption of goods and services, broken down into several sub-categories.

• Who puts it out: Bureau of Economic Analysis (www.bea.doc.gov).

• When it’s released: 8:30 a.m. ET, approximately one month after the end of each quarter.

• What it means: GDP is used to define business peaks and troughs, and together with employment data, it gives an important indication of productivity growth and economic strength.

Usually a growth rate between 2.0 and 2.5 percent is considered positive when combined with an unemployment rate of 5 to 6 percent. A higher growth rate and/or a lower unemployment rate might indicate inflationary pressure. A lower growth rate might indicate the economy is stalling. A relatively large increase of inventories might indicate a future decrease in the growth rate, as production (supply) at least temporarily has outgrown demand.

Thus, both numbers too low or too high can be interpreted negatively, depending on the current position in the business cycle. The fear of inflation, for example, generally gets more pronounced the longer a high-growth period lasts.

Consumer Price Index (CPI)

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• What it is: The difference in price from one month to the next for a fixed basket of consumer products, used as a common measure of inflation. The “Core CPI” does not include food and energy prices.

• Who puts it out: Bureau of Labor Statistics (http://stats.bls.gov).

• When it’s released: 8:30 a.m. ET around the 15th of the month for the previous month’s data (i.e., the March CPI is released around April 15).

• What it means: A rising CPI indicates increasing inflation, while a high CPI indicates already high inflation. According to standard economic theory, inflation increases when supply no longer can keep up with demand, which usually occurs at or near the peak of the business cycle and when the unemployment rate is low.

High inflation, or expectations of high inflation, usually leads to higher interest rates, as lenders of money want to be compensated for the diminishing purchasing power of their dollars. Higher interest rates, in turn, mean higher costs of doing business for all parties in the economy (both investors and companies).

Employment

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•What it is: Two surveys measuring 1) the number of people on payrolls and 2) the unemployment rate. Also measures average hourly earnings and the length of the average work week.

• Who puts it out: Bureau of Labor Statistics (www.stats.bls.gov).

• When it’s released: 8:30 a.m. ET on the first Friday of the month after actual month (i.e., November’s employment statistics are released in early December).

• What it means: The payroll report –– probably the most widely watched report in the financial markets measures the current state of the economy by way of the employment situation. It is more of a lagging indicator. Strong employment is generally considered the bedrock of a solid economy. The more people who work and the more money they make, the more money they can spend, which will increase the demand for goods and services. However, if supply can’t keep up with demand, inflation can develop, as explained in the next section.

Inflationary measures

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The third most important set of economic statistics, according to Gain’s Dolan, is inflation data, including that reflected in the Institute for Supply Management (ISM) report, inventory data, and consumer prices.

The ISM report provides one of the first glimpses inside the economy every month. It surveys purchasing managers in the manufacturing and non-manufacturing (i.e., service) industries, the latter in a separate report later in the month. Although the report sounds rather dry, it is closely monitored because the activity of manufacturing purchasing agents reflects the pickup in demand for manufactured products, which in turn is a barometer for manufacturing activity in general.

Some lagging indicators may indicate the economy is supposedly expanding or contracting when it really is not. For example, a gross domestic product (GDP) report can affect a few months of consumer confidence reports, Dolan says, as the nation spends and consumes according to what the GDP reveals.

The GDP’s effect on the FX market is determined by how strong or weak the report is. A strong report tends to spur corporate profits and firm up interest rates, making the dollar more attractive to foreign investors.

As the economy grows stronger, eventually the focus shifts to inflationary indicators such as the Consumer Price Index (CPI), Dolan says. The CPI reflects price inflation in retail goods and services by measuring the average change in retail prices over time in a basket of 200 assorted goods and services. It does not have as much of an effect as some other reports on the FX markets, but can still have an impact because of its relevance to interest rates. If rates surge on growing inflation concerns, it can hurt the U.S. dollar. High U.S. inflation erodes the value of dollar based investments held by foreigners.

A related measure is the Producer Price Index (PPI), which measures the change in prices paid by businesses for raw and semi-finished goods (as opposed to what consumers pay for finished products). A fast-rising PPI can hurt the dollar because the Fed can respond so aggressively as to jeopardize U.S. economic growth altogether.

However, a gradual rise in inflation accompanied by well-timed tightening of interest rates can lead to a steady or rising dollar.

“Inflationary indicators are not as much of a concern right now,” says Dolan.

Trading the payroll number

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On Monday, Oct. 4, before the September employment number came out, the European market began to price in a better-than-expected jobs report by buying up the dollar, as shown in the USD/CHF rate. After a sharp rally from 1.2530 to 1.2670, the market settled into a narrow sideways range between approximately 1.2610 to 1.2670 through Thursday. In the final eight hours before the employment number release, the market made several feints, first down out of the range (chasing out weak longs who had bought anticipating a strong non-farm payroll number) and then up (squeezing out weak shorts who had sold the break of the range). At the moment of the NFP release (8:30 a.m. Friday, Oct. 8), the market had returned to the midpoint of the range around 1.2630/40.

Consumption and spending

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According to Dolan, the second group of key indicators is “hard data” such as retail sales and durable goods, both of which are related to private consumption. “[Private consumption] is what ultimately will determine the direction of the dollar,” he says. “You’re not going to buy a big-ticket item such as a refrigerator when times are tough. It’s a real-time indicator.”

Lots of U.S. retail activity (read shopping) firms up interest rates, which is bullish for the dollar. However, an overly robust retail sales report can cause trouble for the dollar because many of the goods U.S. consumers buy are imported. A jump in imports increases demand for non-dollar currencies to pay for all of the imports, which can hurt the dollar.

Durable goods orders are important because they provide a look at what products will be produced in the months ahead. The actual goods are products with a life expectancy of at least three years. Ajump in orders suggests employees and factories will be busy, while a decline suggests assembly lines will slow and plants may close, which is bad for the economy. Another indicator that falls into the “real time” private consumption category is the personal income and spending report, released by the Bureau of Economic Analysis. It records the income Americans receive and how much they spend and save. A vigorous increase in income and spending is good for the dollar as high consumer demand encourages growth and places upward pressure on interest rates, but too much spending can trigger inflationary worries. “Reports that pertain to consumer spending are important to the currency markets right now,” says Beuzelin. “[This data] is very important –– if it is true the U.S. economy is moving out of its soft patch. The Fed is optimistic [about the economy] and the FX market is skeptical of that optimism, so participants pay more attention to consumer reports.”

Jobs, jobs and jobs

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Dolan lists the top report in the current environment as — not surprisingly the non-farm payroll numbers (released as part of the monthly employment report, and almost always the most closely watched U.S. economic indicator), followed by retail sales, personal income expenditures and durable goods.

“My thinking is the employment report is more significant now in terms of assessing the economy,” he says. “[Employment] is the prevailing model of growth; it’s supposed to be strong in what we thought was a growing economy. You won’t have a sustainable economy without jobs.”

The U.S. Labor Department’s monthly payroll numbers — which reflect the actual payroll statistics of non-farm jobs — is important to the U.S. dollar because a vigorous jobs report could drive interest rates higher, which can make the dollar more attractive to foreign investors. A weak report softens demand for U.S. currency because it puts downward pressure on rates, potentially making the dollar less appealing to foreign investors.

“The employment report plays a critical role in the actions of the dollar,” says Alex Beuzelin, foreign exchange market analyst at Ruesch International. “The markets view it as a good barometer of economic activity and it plays a role as to why the Fed raises and lowers rates.”

Economic reports in the forex market

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Macro analysis in the FX market is complicated for many traders because foreign exchange participants don’t necessarily digest economic data the same way as their stock counterparts, and there’s also data from multiple countries to contend with. It takes a vigilant trader to stay on top of it all.

Not all the reports have immediate importance, but some are crucial, and it is essential to know which constitute news and affect market sentiment and which are irrelevant at a given time. “How economic reports affect the FX markets depends on whether you’re trading in a declining, or weakening environment,” says Brian Dolan, vice president of research at Gain Capital. “Fundamentals have a lot of weight in a weakening environment.”

Naturally, reports that reflect the U.S. job market are more important during a weak economic environment.

When the environment strengthens and the economy is improving, inflationary reports become more of a focus.

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Bulletin boards

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Market-related bulletin boards and chat rooms aren’t hard to find. Those catering specifically to forex and currency trading are not as plentiful, however.

Additionally, message boards are only helpful if they’re active and full of participants. A board doesn’t help if a legitimate post is greeted by more silence than somebody trying to use pesos in London, or a Swiss franc in Toronto.

Unfortunately, when it comes to the Internet, you have to go through a lot of coal to find a diamond. While discussion sites focusing exclusively on the FX world can be found with a simple Web search, discovering the ones that actually have some substance requires a little more research.

One of the best boards are the forums at MoneyTec (www.moneytec.com/forums/index.php). There are more than two dozen forums, divided into several categories (e.g., Main Discussion, Trading for a Living, Trading Styles and Strategies, Tools of the Trade, etc.), and many have thousands of views and hundreds of replies.

That’s a good sign, because it indicates questions will get answered, or at least generate a discussion. There’s nothing more frustrating to a person with a legitimate comment or question than to post it and get no responses, forcing the poster to try again at another site.

Additionally, the site is easy to navigate. Threads are listed singularly, one after the other, and reading the replies can also be done in an easy, organized fashion. MoneyTec is also good because it is completely devoid of advertisements on the main forums page, although some forums are sponsored. (Some of the posts are from firms and individuals trying to sell a product, but this is the case at any message board.)

Judging from the posts we looked at, it seemed users at MoneyTec had developed a sense of community — it was obvious in many cases certain posters had become familiar with each other, as posts mentioned other members by name and some asked specific questions of specific posters.

Plus, there were very few posts that strayed from the main topic of the thread. This is often the death of message boards — interspersed with legitimate conversation are posts that add nothing to the discussion, and only serve to discredit or otherwise blur the poster or the message. This can cause new posters to avoid a site, preventing the site from growing and eventually minimizing or negating its effectiveness.

Oanda.com, (www.oanda.com) also features a bin/msgboard/ultimatebb.cgi). It has eight forums and the threads inside are lively and active. Forex News (www.forexnews.com/forum/forum.asp) has a decent forum as well — active, but poorly organized.

Another good site is the Forex Forum section of Forex Factory (www.forexfactory.com/forexforum). Forex Forum only has three main forums — General Forex Discussion, Town Square and Forex Related News. But the General Forex Discussion forum is lively, with almost 400 threads as of mid November. What’s better, many of the threads have multiple replies, and when we checked, the entire first page (18 different topics) had been replied to within the past week.

ForexForum.net (www.forexforum.net) has a fair amount of forums, but only minimal participation. Although people are reading the posts (as evidenced by the number of views), very few are taking the time to respond.

Elite Trader (www.elitetrader.com), a site originallydesigned for stock traders, has since branched out into other instruments, including forex, and the site — which claims more than 30,000 members — is consistently crowded. While forex forums — FX Trading and FX Brokers — comprise only two of the dozens of forums at Elite, both feature heavy traffic and plenty of responses. One thread in the FX Trading forum was started on Aug. 16, 2004, and was still going strong as of late November — it has more than 2,000 responses and 48,000 views. Those are the kind of eyeballs you’re looking for if you have a serious topic worthy of discussion.

Although Elite Trader isn’t specifically designed for forex trading, it’s probably the best option for forex traders looking for a place to share ideas and questions.

Macros at work in the market

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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.

The risk environment

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The final macro component we will discuss is the prevailing attitude of traders and investors toward assuming risk. There are many methods for estimating this factor, and a wise approach is to consult several inputs and create a composite barometer or index.

When public risk-tolerance is high in the stock realm, you will likely see solid interest in IPOs, highly speculative stocks, etc. The same dynamic exists in currencies. For example, the NZD, CAD and Australian dollar (AUD) are considered “risk-seeking” currencies. Given they are “reflation plays” –– a trade that is banking on economic growth developing –– and sensitive to commodity prices, they are usually more sensitive to changes in the global economy.

Such currencies will typically have an inverse relationship to investor risk tolerance. It shows the Risk Aversion Thermometer, a trader risk gauge created by RBC Capital Markets, illustrates the rise and fall of risk tolerance. It shows the NZD/USD rate embarking on a multi-month uptrend around the same time the Risk Aversion Thermometer peaked. It shows the same pattern in the USD/CAD, where the downtrend actually reflects Canadian dollar gains vs. the U.S. dollar.

The relationships described here are by no means static. However, seeking out simple associations such as these can identify favorable trade conditions, as well as avoid trades that might look good from a technical perspective, but have potential weaknesses on the macro level.

Commodity prices

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Commodities are the driving force of growing economies. China has emerged as a major player in worldwide manufacturing and has become a large consumer of commodities such as oil and grains. Surprisingly, however, China does not produce much in the way of agriculture, so commodity based economies that stand to export heavily to China, such as Australia, New Zealand and Canada, will benefit. It shows how the U.S. dollar/Canadian dollar (USD/CAD) rate is inversely related to commodity prices, meaning the CAD gets stronger relative to the USD as commodity prices rise. Below the price chart is a list of several statistical correlations between the two series over different time periods (five days, 10 days, one month, etc.). Negative cor relation figures reflect data series that move in opposite directions, with 1.00 representing a perfectly inverse relationship (one goes up while the other goes down proportionally).

Positive correlation figures reflect the opposite, with +1.00 representing two series moving in tandem.

Another notable historical relationship is the impact of rising oil prices on Japan, represented by the Nikkei stock index and the Japanese yen (JPY).

Higher oil prices have a negative impact on global economic growth as a whole, and Japan specifically because it is highly dependent on imported oil.

With oil prices rising significantly over the past year, the impact on both Japan and the global economy has been noticeable. And when global economic growth is poised to slow, in this case because of higher oil prices, Japan typically suffers.

Given a large percentage of Japan’s capital inflows are the result of equity purchases, the link between higher oil prices and a weaker yen and Nikkei is clear. If global economic growth is waning, Japan will be negatively impacted because they are a large exporter. Hence, equity inflows into Japan will decrease when growth slows or is expected to slow — and rising oil prices have been an impediment to global growth. It shows Brent crude oil and the euro/Japanese yen (EUR/JPY) rate, along with various correlation figures.

Interest rates: Attracting capital

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An interest rate differential is the spread between the prevailing interest rates in two countries. All else being equal, capital flows to countries offering higher interest rates, which benefits those currencies.

In a time with historically low interest rate yields worldwide, traders will often accept greater risk to seek out those markets offering the highest yield. In the U.S., the Federal Funds rate is at 2 percent after the Federal Reserve raised the rate .25 points at its Nov. 9 meeting, while New Zealand has an equivalent rate of 6.25 percent (the next meeting is this month, with no hike expected), making the New Zealand dollar (NZD) a more attractive currency to hold than the U.S. dollar (USD) in terms of yield.

However, the NZD’s yield does not represent a risk-free rate. If the NZD depreciated vs. the USD during the time of your investment in New Zealand, the rate differential advantage could be wiped out. Hence, gaining an extra 4.25 percent (the difference between the two rates) per annum while also enjoying the potential capital appreciation on the long NZD position itself has been a logical move for many traders.

The macro factor

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While most individual traders doubt the usefulness of fundamental or macroeconomic analysis, many of the largest players in the FX market rely heavily on it.

Although the conclusions you draw from macro or technical analysis might ultimately be similar, having a tangible rationale for entering the market, as opposed to simply obeying a line on a chart, can do a great deal to bolster confidence in your trading and deepen your understanding of how foreign exchange works.

We’ll review some of the key macro factors in the FX markets and see how they can provide insight into potential market moves. Then we’ll look at some recent trades illustrating how to combine macro research with technical patterns.

Although there are any number of fundamental factors at work in the FX market at a given time, we will address the following three: interest rate differentials, commodity prices and the level of risk aversion among traders at a given time. They are easy to understand and illustrate in the market.

When the clockstrikes five

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They show GBP/JPY rose toward the middle of the week, but they don’t indicate whether Wednesday’s unique rollover affects the pair’s price moves surrounding this event. To find out if this weekly occurrence has influenced GBP/JPY prices, we studied hourly price data from Jan. 1, 2003 to Oct. 31, 2004, or 475 trading days, and divided each day into six 4-hour periods, with the 5 p.m. rollover as the focal point: 1 a.m. to 5 a.m., 5 a.m. to 9 a.m., 9 a.m. to 1 p.m., 1 p.m. to 5 p.m., 5 p.m. to 9 p.m. and 9 p.m. to 1 a.m. the next day.

It shows the average gains or losses for each four-hour period during the entire week (30 total periods), which start and end at 1 a.m. ET on Monday morning. (The forex market is closed from Friday at 5 p.m. to Sunday at 2 p.m. Our data resumed on Sunday at 5 p.m., except between July 18 and Oct. 31, 2004, when it began on Sundays at 4 p.m.)

A distinct pattern appears in the two four hour periods surrounding each day’s 5 p.m. rollover, which is labeled “R”. GBP/JPY gained ground from 1 to 5 p.m. and fell from 5 to 9 p.m. each day except Thursday. Although GBP/JPY continued to rise immediately following Thursday’s rollover, the currency pair’s rally in the eight hours leading up to rollover was three times as large than its post rollover, eight-hour gain from 5 p.m. to 1 a.m. (0.12 percent and 0.04 percent, respectively).

On Tuesday and Friday, GBP/JPY fell throughout the day except in the four-hour period from 1 p.m. to 5 p.m. It also shows that the currency pair’s tendency to rise prior to this event and sell off afterwards has been strongest on Wednesday. The pound/yen increased 0.11 percent in the 12 hours preceding rollover — the figure’s second highest 12-hour gain — and then dropped -0.05 percent in the subsequent four hours. Despite this brief loss, it shows GBP/JPY’s most bullish period occurred from Wednesday at 5 a.m. to Thursday at 9 p.m.

It (see p. 25) compares various statistics for all 30 four-hour periods(average, median, maximum and minimum values and percentage of positive moves). It’s final six rows summarize the pound/yen’s intraday performance. It shows that each period’s average and median values are roughly in line with each other, which indicates GBP/JPY’s gains and losses are fairly reliable. As expected, all but one of the periods’ average gains also have a greater chance of gaining ground than losing it (i.e., the percentage of positive moves is greater than 50 percent).

Similarly, each of their’s average losses has a winning percentage of less than 50 percent.

It’s larger gains and losses also correspond to greater chances of moving in the desired direction. For example, Thursday’s 0.06-percent increases in the two four-hour segments from 9 a.m. to 5 p.m. have two of it’s three highest probabilities of gains (60 and 65.26 percent, respectively).

Wednesday’s shift from a 0.03-percent average gain from 1 p.m. and 5 p.m. to a -0.05-percent loss following the rollover is the second-largest drop off between time segments.

However, the currency pair’s probability of gains sank from 53.68 to 32.98 percent in that same period — it’s largest probability decline. It’s summary statistics confirm GBP/JPY tended to climb briefly prior to rollover and sink after the event. Overall, the currency pair rose 0.03 percent, on average, from 1 p.m. to the 5 p.m. rollover and then fell 0.02 percent in the following four hours.

Although this change is small, the prior period’s biggest individual loss widened from -0.51 to -0.90 percent, and its chance of gains dropped from 56.42 to 45.36 percent following the rollover — two further signs the decline is accurate.

It highlights GBP/JPY’s average four-hour gains and losses on Wednesday and Thursday and compares them to the currency pair’s overall performance. Though the pound/yen’s Wednesday performance adheres to the established pattern, its bullish behavior on Thursday stands out.

GBP/JPY posted average gains in five of it’s six periods on Thursday, which was the only day the currency pair gained ground following each rollover.

The short-term GBP/JPY carry trade

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On March 19, 2001, the Japanese government lowered its overnight interest- rate target to 0 percent and has held it at that level for 44 months, which means that traders can borrow the yen and pay no short-term interest. In contrast, Great Britain’s short-term interest rate was 5.75 percent in early March 2001, and has been at least 3.50 percent over the same period.

Therefore, the British pound/Japanese yen has provided a daily rollover payment for buyers since March 2001.

It shows the average daily GBP/JPY performance on each day of the week from March 20, 2001 to October 29, 2004 (935 trading days), and compares each price move to its benchmark move, or typical daily behavior during the same period.

Because the forex market trades 24 hours a day, our Comstock data (via FXtrek) measured each day from 5 p.m. ET to 5 p.m. the next day.

The daily price moves are quite small, but they illustrate interesting patterns. GBP/JPY tended to trade sideways on Monday, lagging its 0.01- percent benchmark. On Tuesday, the currency pair dropped an average -0.03 percent, but Wednesday’s 0.03-percent gain began a modest three-day rally, which beat its benchmark each day and totaled 0.09 percent. It shows the pound/yen posted the largest average daily gain (0.04 percent) on Thursday, and inched 0.02 percent higher on Friday.

It shows each day’s average performance and compares it to its median, benchmark, maximum and minimum values. It also lists each day’s percentage of positive moves. A comparison of the table’s average and median values suggests GBP/JPY’s lackluster performance during the first two days of the week is accurate, but its climb on Wednesday and Thursday might be slightly higher.

For example, the pound/yen’s average is flat on Monday, but its median is -0.04 percent, which suggests a few extreme positive moves skewed the average higher than it should be. Similarly, Wednesday’s and Thursday’s medians are higher than their average values, which suggest the opposite condition.

GBP/JPY’s largest average and median gains (0.04 and 0.09 percent, respectively) as well as its highest probability of gains (57.75 percent) occurred on Thursday.

Rollover fees: Understanding the fine print

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Getting a straightforward answer about daily rollover fees from your forex broker isn’t easy. Although rollover fees are based on the short term interest-rate differences of the two currencies you exchange for one another in the forex spot (cash) market, each FX dealer has its own rules, which can make the process confusing.

The spot market has a two-day settlement period, which means that if you buy one GBP/JPY standard lot (£100,000) on Tuesday, the transaction will settle on Thursday. If you hold this trade past 5 p.m. on Tuesday, your broker will roll the settlement forward to Friday and may add between $1 and $20 to your account as they calculate interest you earned.

As of Nov. 16, Great Britain’s short-term interest rate was 4.6 percent higher than Japan’s (4.75 percent and 0.15 percent, respectively, according to Forexnews.com). Therefore, the daily rollover credit on this trade is roughly $12.60, or ($100,000 * 4.6 percent)/365. (The actual rollover amount depends on your balance and the difference between GBP’s borrowing rate and JPY’s lending rate.)

Wednesday’s rollover is three times as large because it accounts for interest earned over the weekend. For example, if you enter and exit a trade on Wednesday prior to rollover, both trades settle on Friday. However, if you hold the trade “overnight” and close it after the rollover, your trade won’t settle until Monday, and you earn (or pay) three days of interest instead of one. Trades that should settle on holidays also earn (or owe) an additional day’s interest.

However, forex dealers are not obligated to pay interest. Some brokers, such as Forex Capital Markets (FXCM), only credit your account if you trade with at least 2 percent margin. Oanda calculates interest earned on currency pairs eachsecond, instead of once a day. Other brokers charge a daily rollover fee even if you’re long a higher-interest-rate currency.

Most FX dealers’ rollover time is 5 p.m. ET, but other brokers such as GFT Forex and MG Financial Group roll positions forward at 3 p.m. ET.

Rollover opportunity?

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Many traders view the carry trade as a longer-term (i.e., days, weeks or months) approach since the interest you earn is based on the trade’s length. In theory, however, it’s possible to buy a currency pair such as the British pound/Japanese Yen (GBP/JPY), whose base currency’s interest rate (4.75 percent) is much higher than the quote currency’s rate (0 percent), just before the day’s rollover, earn the rollover credit and exit the trade following this event.

Because GBP/JPY’s rollover credit is three times as large on Wednesdays to account for the weekend (see sidebar), this study focuses on the currency pair’s behavior in the days and hours surrounding this weekly occurrence. We analyzed daily GBP/JPY performance since March 2001 to find out how Wednesday’s triple rollover costs influenced this pair’s behavior. We then studied hourly GBP/JPY price data surrounding each day’s 5 p.m. rollover time since January 2003 to find out how this event affected intraday price moves.

Overall, GBP/JPY slumped on Monday and Tuesday, but rose Wednesday through Friday. On an intraday basis, GBP/JPY climbed as the 5 p.m. rollover approached and sold off in the early evening — a pattern that was magnified on Wednesday. Both tendencies suggest traders bid up prices in anticipation of the daily rollover, especially Wednesday’s three day interest-rate payoff.

The short-term British pound/Japanese yen carry trade

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Rollover fees are often overlooked, yet they can seriously affect a forex trade’s profit or loss, depending on the currency pair, your forex dealer’s rules and each trade’s length. These charges are based on the interest-rate difference between the currency you buy and the one you sell (or vice versa) when you trade a currency pair and hold it past the daily rollover time — typically 5 p.m. ET. For example, if you go long GBP/USD and hold it “overnight,” or past 5 p.m., your forex broker may give you a small credit because you bought British pounds and sold U.S. dollars at the same time, and shortterm interest rates are currently higher in Great Britain than the U.S. Similarly, if you short this currency pair, your broker may charge a small fee as the trade “rolls over” into the next day. (For more information about rollovers, see “Rollover fees: Understanding the fine print.”)

While rollovers don’t apply to intraday traders, this feature is the crux of the carry trade, or buying a currency with a higher interest rate and simultaneously selling one with a lower rate and earning the difference between both rates (see “Getting a lift from the carry trade,” Currency Trader, Oct. 2004). Like dividends, any rollover fees you earn (or owe) are separate from the currency pair’s gains or losses, but they can help enhance a trade’s profit or mitigate its loss if the daily rollover is in your favor.

Debt: The story behind the story

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If the U.S. financial authorities are not as scared as they want us to think, what are they really up to? Talking the dollar down is, strangely, one way of talking it up. In the peculiar way of markets, an official public acceptance of the dollar falling can have the perverse effect of lifting the dollar, at least for a while. To some extent, this is a function of relief that everything is out in the open, but it’s also a mark of respect and confidence in a government that hasn’t always earned praise from economists and financial experts on other matters, such as fiscal rectitude and trade protectionism.

But I suspect it’s not about the dollar at all. It’s not about the current account, either, except as a reflection of something else going on — the low U.S. savings rate, which is joined at the hip to the deficit. In short, it’s about nothing less than the sustainability of the U.S. economy.

It’s the other big fact of American financial life: The U.S. is not only a debtor nation, it is also a nation of debtors. The saving rate in the U.S. is only 1 to 2 percent of income, and has been falling for over 20 years. In fact, it has fallen the most since 2000. All value judgments aside, when a country imports capital but then spends it on consumption goods rather than capital investment, it is failing to prepare for the future. From the point of view of the Fed chairman and Treasury secretary as stewards of the economy, it’s not the sustainability of the current account deficit we should be questioning, but rather the sustainability of U.S. growth. Abundant, cheap foreign money has led us onto the path of profligacy, economically speaking.

The high capital inflows have led the U.S. into the bad habit of spending too much and saving too little. How do you induce people to save? In a free market economy, you give them inducements, like higher returns that are more desirable than a better car or another pair of shoes. Higher returns can be delivered via tax breaks, too, but tax breaks are not the Fed’s to give. Higher returns are.

But alas, all that foreign money is literally standing in the way. In September, San Francisco Fed President Yellen got this particular current account panic rolling by saying the Fed wants to normalize interest rates by nudging them higher, but the relatively high dollar is an obstacle. The Fed wants to normalize interest rates to a historically neutral level, thought to be about 3 to 3.5 percent (from the current 2 percent). But the Fed can manage rates only at the very short end of the yield curve. The relatively high dollar draws in foreign capital that allows rates at the longer end of the yield curve to be artificially low.

The last thing the Fed wants is a crisis where it has to raise interest rates to prevent a run on the currency, which is what happened in the UK in 1991. The Bank of England raised rates 3 percent in the space of a few days in an effort to control the pound falling out of the European Rate Mechanism (the occasion of Mr. Soros’ fabled billion-dollar profit). It may not be too fanciful to imagine that the Fed has been deliberately driving the dollar down to avoid exactly this outcome — not because it gives a fig about the dollar per se, but because it wants to set rates in its own time and according to its own ideas.

Consider the Fed’s mandate. Yes, it has to maintain financial market stability, but it’s far more interested in growth and employment than in the terms of trade, except as the terms of trade influence domestic production.

Here is the hidden agenda. The Fed wants to normalize rates, not for the sake of normalization, but to prevent a run on the dollar and to restore the incentive to save. After all, if the U.S. consumed less and saved more, the trade deficit would be substantially lower and no one would feel the urge to stage a run on the dollar in the first place. The U.S. would not need capital flow from foreign countries to fund the current account deficit — it would have sufficient domestic savings to buy all the government and corporate debt instruments on offer. This is not to say the Fed places a moral judgment on saving as a social virtue, but rather as the one truly sustainable mechanism to ensure further growth and employment.

The market talks about the sustainability of the current account deficit.

Financial economists talk about the sustainability of the inward capital flows. But the Fed and the Treasury view both the current account and the capital account as a by-product of real economic activity, and what they talk about is the sustainability of U.S. growth. If it takes a weaker dollar, so be it. The dollar is not the central thing. In this context, it’s only a unit of account. This is the sense in which all the hullabaloo about the sustainability of the current account is a hoax. It is sustainable today, but as the U.S. economy becomes less independently capable of prosperity, the longer it relies on foreign savings.

Now we have come full circle. The current account deficit is not really creating a dollar crisis — the Fed and the Treasury are talking it down. They must know the lower dollar will not cause much improvement in the current account, even if other efforts behind the scenes are successful in pressuring China to revalue the renmimbi. It’s silly to be selling the dollar against the euro and other European currencies when Europe accounts for only about 9 percent of trade. China alone accounts for 30 percent of the deficit, and a growing proportion of it. Asia, including Japan, accounts for over half of the deficit.

But negotiations to get Asian countries, especially China, to repeg or to float their currencies are matters of state, not of economic and financial management. China’s revaluation, which will probably occur within the next year, will provide some minor relief in the current account, but not a permanent fix. After all, China has billions of people willing to work for pennies in order to get a bicycle, a sewing machine and indoor plumbing.

The wildly uneven cost of labor can never be equilibrated by mere currency price adjustments. China will always be able to compete with U.S. companies and export to the U.S. more than it imports.

Because of the unique and unprecedented position of the U.S. in the world economy and financial system, devaluing the dollar is not going to take the current account deficit to zero or transform it into a surplus. Asian revaluation will go a long way toward reducing the horrendous size of the deficit, but even after China, South Korea and the others revalue, we will still have a trade deficit for decades to come. The terms of trade are against the U.S. — Americans simply have too high a standard of living relative to the rest of the world. Moreover, as Greenspan said in Berlin, raising the savings rate in the U.S. will go toward fixing the true current account problem, the dependence on foreigners, but it can’t do the whole job. So, even in the best of all possible worlds, we are stuck with a "structural" deficit. The next job for the market is to decide upon a deficit-to-GDP ratio it can live with. What’s the number? Something south of 5% of GDP.

The true solution to the U.S. current account deficit is to let it wax and wane with cyclical evelopments, but not to depend on offsetting foreign capital inflows. Foreign capital inflows should be the icing on the cake, not the cake. The cake should be domestic savings adequate to fund capital investment.

The only way to lift up the savings rate is to raise the rate of return. Who is in charge of rates of return? The Fed — but also the folks in Washington who pass tax bills. Privatization of Social Security, anyone?

This time it’s different

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Can we really say the U.S. is exempt from the same fate that befell other countries with unsustainable deficits? Well, yes, and this is the sense in which the Fed and the Treasury are begging the market, “Please don’t throw me in the briar patch, Br’er Fox.” None of the academic studies involves a country that has the world’s largest and freest economy, that is the sole military superpower, and that possesses the world’s largest financial markets boasting the highest liquidity, transparency and variety of instruments.

We honestly don’t know what constitutes “sustainability” regarding the U.S., and we don’t want to find out.

We don’t know whether the dollar should fall because of the current account deficit, but the attitude in Washington seems to be, "Let’s talk it down ahead of time, just in case."

Without some amelioration of the deficit today, by next year it could be 6.5 percent of GDP, 7.8 percent in 2008, or 13 percent by 2010, according to other studies cited by Summers. We know we can escape through the briar patch of devaluation, but we have no idea what we would do if the current account deficit was 13 percent of GDP and then the world’s investors decided to bail out of dollar assets. Other countries have survived such high deficits, but other countries don’t have the U.S.’s place in the world.

We have to ask whether the government talking the dollar down is just a precautionary measure. After all, you can argue the deficit is an integral part of the international monetary system today. Foreigners borrow in the dollar as well as hold it as a store of wealth.

In many instances, they use their store of wealth dollars as collateral for dollar debt. Recently the National Bureau of Economic Research sponsored a paper arguing the availability of these dollars “liberates” capital formation in poor countries from inefficient domestic financial markets. The economists say the empirical evidence (using China as a test case) bears out the idea.

This helps to explain why emerging market countries show an outflow of some $450 billion in the latest year to rich countries, which seems like an aberration, unless some of the capital is being recycled back to them in the form of collateralized debt.

Consensus opinion

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By now, everybody is talking about the dollar’s inevitable further decline, with even an august figure such as former Fed chairman Paul Volcker speaking of a 75 percent probability of a currency “crisis” sometime in the next five years. Publications ranging from The Economist, Business Week and Wall Street Journal to mass-market magazines and network TV news all solemnly declare the dollar is going to hell in a handbasket.

Traders flinch at such a consensus, because when everybody agrees and has already positioned himself short dollars, there’s nobody left to sell and push the price down.

But academics and some analysts flinch, too, because the global imbalance is not necessarily a bad thing.

Besides, devaluing the dollar won’t fix anything — the trade deficit will not improve by much. A 10 percent drop in the dollar induces less than a 10-percent (if any) improvement in the trade balance.

Growth in the U.S. generates more imports than growth in other countries. Even if all the major countries had the same growth rate, the U.S. would still import more than other countries would import, including from the U.S. Because correcting the current account imbalance is mostly a case of correcting the trade imbalance, the only way for the U.S. to export more than it imports would be to go into slower growth or even recession.

But the rest of the world relies on the U.S. for export-led growth, so if the U.S. imports less, other countries would go into relatively deeper recessions and import even less from the U.S. This is a real Catch-22.

So why do we have the Federal Reserve and the U.S. Treasury out on the conference circuit goading the foreign exchange market into a frenzy over the current account deficit? After all, the current account deficit has been growing steadily since 2000 — the dollar has gone up, down and sideways during the same period. (In fact, it has done all three in the past year.) These moves are not correlated with changes in the deficit.

The global imbalance obviously does not have a direct one-to-one relationship with the dollar. From an economic standpoint, in the typical tradedeficit situation, importers create an oversupply of the currency. In this case, the oversupply of dollars should make it less valuable. However, when demand for dollars is high for investment purposes, the power of the trade deficit to depress the dollar’s price becomes weak, and everybody knows it.

This is why, from a trader’s viewpoint, the monthly trade figures don’t contain useful information. These days, it’s the capital flow report that counts. In September, global investors were willing to increase their net holdings of dollar-denominated assets by 5.8 percent in a month when the dollar was falling by 1.3 percent. Crisis?

What crisis? We have no hard evidence anybody is unhappy about owning dollar denominated assets. In fact, the most recent Treasury capital flow report (Nov. 16) reports that net portfolio investment rose to $63.4 billion in September (from an upwardly-revised $59.9 billion in August). Net portfolio flows into the U.S. are averaging $72.2 billion per month so far this year, compared to $58.2 billion in 2003 and $47.9 billion in 2002. And the cumulative annual inflows are stunning — $649.5 billion in the first nine months of 2004: a 26 percent increase over 2003’s $514.5 billion. Considering the actual rate of return on short-dated money is zero or negative, this is quite a feat. China, for example, is sitting on $60 billion in dollar cash.

The capital inflows are more than enough to cover the current account deficit, which is running at an annual rate of about $665 billion. To speak of a funding crisis is to cry wolf, and Greenspan admits it:

“Current account imbalances, per se, need not be a problem, but cumulative deficits...raise more complex issues. Market forces should over time restore, without crises, a sustainable U.S. balance of payments. At least this is the experience of developed countries, which since 1980, have managed and eliminated large current account deficits, some in double digits, without major disruptions.”

“Sustainable” deficits is a reference to a study in 2000 by the Fed showing the outer limit of a current account deficit is about 5 percent, and after that, currency depreciation kicks in as an balancing mechanism (www.federalreserve.gov/pubs/ifdp/2000/692/default.htm). Deficits become unsustainable when they reach or surpass 5 percent of a nation’s GDP. The U.S. is beyond that point today.

The Q2 current account deficit stands at 5.7 percent of GDP, compared to the previous high of 4.5 percent in 2000 and 3.5 percent in 1986. The U.S. deficit is also about 1 percent of global GDP and more importantly, takes back, in the form of capital flows, about two-thirds of the cumulative current account surpluses of all the world’s surplus countries, according to Larry Summers, former Treasury Secretary and now President of Harvard University. The size is unique. No country has ever run such massive deficits before.

The Great Global IMBALANCE HOAX

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From November 2003 to February 2004, and again going into year-end 2004, the dollar fell more than 10 percent against the Euro. In each case, the underlying cause of the dollar’s drop was universally reported to be the “structural global imbalance,” whereby the U.S. runs a huge current account deficit that is offset by foreigners, including central banks, who buy U.S. financial assets.

It’s not so much the U.S. current account deficit itself that propels the dollar downward, but the fear that foreign investors, especially central banks, will withhold demand for U.S. securities, especially Treasuries, until the dollar finishes dropping or the real return is compellingly greater than the return on equivalent assets.

We’ve been here before. In fall 1985, the countries that later came to be known as G7 (U.S., Great Britain, Germany, France, Canada, Japan, and Italy) met secretly at the Plaza Hotel in New York and decided to drive down the price of the dollar to correct a trade imbalance of about $120 billion annually. The dollar fell 21 percent against the Deutchemark the following year, and another 18 percent the year after that. In 2000, the trade imbalance again became a big topic in the foreign exchange market. That time, the dollar rose against the euro.

What’s different this time is the Federal Reserve is doing most of the talking. The fear of inadequate foreign funding of the current account deficit has been voiced by a whole slew of Fed officials, both regional Federal Reserve Board presidents such as Janet Yellen (San Francisco) and Robert McTeer (Dallas) as well as Fed Governor Ben Bernanke.

Ahead of the G20 meeting in Berlin, Fed Chairman Alan Greenspan laid down the rules for thinking about the global imbalance (www.federalreserve.gov/BoardDocs/speeches/2004):

“The question now confronting us is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment. Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point.”

Once you get past the ornate language, you realize this is practically an invitation to sell dollars. It’s also a near-verbatim repeat of what Greenspan said in 2000, except then he was speaking in a considerably more relaxed, almost offhand way. This time, Greenspan was speaking at a major European conference and knew his words would flash around the world in seconds.

Treasury Secretary John Snow contributes to open acceptance of the dollar falling when he says, on principle, U.S. policy is for a stronger dollar, but if the market wants to take the dollar down, the U.S. believes in free markets.

Weak buck trade

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Guy Gengle, vice president of dealing at Global Forex Trading (GFT), points to the U.S.dollar/Canadian dollar (USD/CAD) as a hot trade to watch. Over the longer-term, Gengle says “I don’t think you can negate the weaker (U.S.) dollar.”

A look at a daily USD/CAD chart reveals a steady and strong downtrend in the USD, and the CAD at its highest level vs. the buck in more than a decade.

As of mid-November, the USD/CAD had pushed to a new low at the 1.18 area. Gengle sees potential for a short-term corrective bounce in the dollar, vs. Canada, which could offer short-term traders plenty of opportunity, he said. A corrective rebound could see USD/CAD bounce up toward the $1.22/1.23 zone, Gengle speculates.

Looking beyond any market correction, however, the longer-term downtrend in the U.S. dollar vs. the Canadian dollar was likely to resume, Gengle says. On the downside, he highlighted the $1.18 area as a “big level.”

Declines through that floor could open the door to further depreciation, perhaps even as low as $1.12/1.13.

Another look down under

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Sean Callow, currency strategist at Ideaglobal, offers another top cross rate pick. He points to the AUD/USD as a hot cross to watch. A daily chart reveals the Australian dollar has been screaming higher vs. the U.S. dollar in recent weeks. The cross rate soared from a low at 68.53 in early September to the 78.45 area in mid November.

First, Australia is boasting an interest rate of 5.25 percent, or the second highest in the industrialized world right now.

“That is a good solid yield for anyone to be sitting on right now,” Callow says.

Also, the country is enjoying solid fundamentals, including a strong domestic economy lately, with unemployment in October hitting its lowest level (5.3 percent) since 1978. Gross domestic product growth is expected to remain robust in the 3.5 percent area.

“The strong domestic economy underpins the relatively high interest rates, with no fears of a rate cut,” Callow says.

Another factor supporting additional gains in the AUD/USD is the rising cost of exports. Australia is a major exporter of coal, wheat, natural gas, gold and steel. The Reserve Bank of Australia estimated its commodity price has risen 16 percent year-over year, as of October.

“That directly helps Australia’s export revenue,” Callow explains. Callow also notes that speculators looking for a place to put on bearish trades on the U.S. dollar have an advantage of buying the Aussie dollar because, “you get a decent yield pickup and are not likely to face a central bank on the other side. The Reserve Bank of Australia does intervene at times, but generally it is small scale. They will not be trying to take on the market.”

Near term, Callow sees the AUD/USD testing the 80.00 mark, possibly before year-end. If that level cracks, Callow expected additional upside momentum toward the 82.00 or 83.00 area by first quarter 2005.

Hot rates

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Wondering what the most active and interesting forex rates to trade right now are?

Currency Trader asked three analysts for their top cross rates heading into the New Year and they chose AUD/JPY, AUD/USD, and USD/CAD.

According to Brian Dolan, director of research at Gain Capital, action in the AUD/JPY could prove interesting over the next several months. While AUD/JPY had, as of mid-November, pushed to its highest level (around 81.75) since March 2004, Dolan highlights a number of fundamental and technical factors that could make that trend switch gears. Generally, Dolan favors selling the Australian dollar vs. the yen.

While fundamental factors are positive for both of these currencies, Dolan believes the yen is more likely to appreciate amid “potential for revaluation of the Asian currencies,” which would allow the yen to strengthen, he says. While many Asian countries, notably China, have been able to artificially keep their currency levels relatively weak despite robust growth, “the next major shift will likely see these currencies appreciate,” Dolan says. Any strengthening of the Chinese currency would probably spill over to the yen.

A second factor likely to support a retreat in the AUD/JPY rate over the next several months is a decline in “uridashi” issuance, Dolan speculates.

Uridashi refers to non-yen fixed income instruments sold to Japanese investors. Uridashi denominated in Australian dollars have been a popular choice among Japanese investors, simply because of higher Aussie interest rates. However, “uridashi issuance peaked in 2003 and is expected to decline further this year,” Dolan notes.

As the Japanese economy continues to show signs of improvement, Japanese investors may choose to keep their investment dollars at home. If the decline in uridashi issuance continues, the demand for Aussie dollars will decrease.

Finally, Dolan highlights a potential head-and-shoulders top formation on the monthly AUD/JPY chart as a negative factor. Dolan says as long as the 82.50 resistance area (established by a trendline connecting the tops of the two shoulders) holds, he looks for an eventual retreat back to approximately 74.00/75.00 (the level of the pattern’s “neckline”) over the next six months.

The technicals

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Looking at the charts, Rogers highlights key levels for forex traders to watch on the downside. He points to the bottom coming in at $1.8393.

“We bounced off the bottom three times in the past two weeks,” he says. “If we go below that level a lot of people will start to think the uptrend is over.”

Andrew Chaveriat, technical analyst at BNP Paribas, also says the key level on the upside is $1.8770, the July high.

Gains through that key resistance point would target a retest of the $1.91 area, he says.

“I would be bullish at this point and buy these dips,” he says.

He also highlights the $1.83 area as key to watch on the downside.

“A close under there would signal a deeper retracement,” Chaveriat concludes.

U.S. dollar action

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However, given the market’s general acceptance that the tightening cycle is likely over in Britain, action in the sterling may, at least in the short-term, be driven by the direction of the U.S. dollar. “As opposed to developments in the UK, the key hinge point for the pound is the dollar,” Lynch says.

Thomson Financial’s Rogers expects the pound to test the $1.88/1.90 area before the year is over.

“I don’t think the dollar sell-off is over yet,” he explains.

While Rogers is upbeat on the outlook for the pound, he does note that recent gains in the sterling have not kept pace with euro and Swiss franc strength.

“Because rates are likely on hold, it is definitely holding the pound back from making stellar gains,” he explains.

Macro factors

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Renewed weakness in the U.S. dollar, which saw the euro push to all-time highs in the $1.30 area, have helped support sterling in recent weeks, analysts say.

Another factor that supported the pound from mid-October to early November was reserve shifting from dollar assets into the pound by the Bank of India. However, Rogers notes as of mid-November they stopped buying sterling.

The key question for forex traders is: what will the end of BOE rate hikes mean for the pound, which has been stuck in a narrowing consolidation? From an interest-rate differential standpoint, Credit Suisse First Boston’s Stephansen notes “the ECB [European Central Bank] hasn’t begun hiking yet. Since the BOE is at the end of its tightening cycle, this policy divergence could bring a correction to the sterling.”

ECB left rates steady at its early November meeting at 2.00 percent. ECB President Jean Claude Trichet highlighted improvements in economic strength in the euro zone area, but warned about the negative impact from higher oil prices. The ECB’s only mandate is to ensure price stability.

The inflationary impact from stronger energy prices could move the central bank to raise rates there.

Pound picture

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What has this meant for the British pound? The sterling soared to a 12- year high at $1.91 in February 2004, driven in part by aggressive BOE rate hikes and the positive interest rate differentials those hikes created for the currency.

However, since February, the pound-dollar rate has formed a triangular consolidation pattern on the weekly chart with the most recent swing-high resistance around $1.87 and swing-low support around $1.77. As of mid-November, the pound had edged toward the upper end of that range and is poised to test resistance at the $1.87 area.

The end of BOE rate hikes

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After a series of aggressive rate hikes over the past year, the Bank of England (BOE) held its repo rate steady at 4.75 percent at its Nov. 4 meeting. Many analysts believe this may mark the end of the tightening cycle in Britain — at least for now. The next meeting is set for Dec. 9.

“The BOE inflation report was a bit less concerned about inflation going forward,” notes Bob Lynch, currency strategist at BNP Paribas in New York. “We do think the tightening cycle is complete.”

Analysts point to signs the housing market is cooling off in Britain as one factor that could keep the BOE on the sidelines in the months ahead.

Housing prices have stopped rising and by some measures have even registered declines in recent months.

Although housing-price inflation still registered a hefty 13.8 percent year-over-year increase in September, actual housing prices declined -0.1 percent during September, according to the UK Office of the Deputy Prime Minister (ODPM). However, the key point for the BOE is “the rate of increase has decelerated substantially,” Lynch says. “We had been seeing price increases at a 20-percent per year rate.”

In terms of overall growth in Britain, Kathleen Stephansen, director of global economic research at Credit Suisse First Boston, says the economy isn’t doing too badly. While a soft patch was seen in the third quarter with a 2.2-percent growth rate, Stephansen forecasts overall GDP growth at 2.8 percent in the UK in 2005. BNP Paribas’ official forecasts for 2005 GDP growth are slightly lower at 2.5 percent. “They’ve had a very strong economy over the past few months,” says Tom Rogers, senior currency analyst at Thomson Financial. “They are growing stronger than the rest of Europe.”

In other economic news, the UK trade deficit narrowed sharply in September to 4.5 billion pounds from 5.2 billion pounds. Analysts point to an 11-percent jump in exports to non- European Union countries as the key factor behind the shrinking gap.

Broad-based improvement occurred, with impressive gains to Asia, including a 15-percent increase to China and 27-percent increase to Japan.

Dollar policy

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U.S. Treasury Secretary John Snow gave no signal of a shift in the U.S. dollar policy on Nov. 17 after it slumped to yet another low against the euro.

He maintained steadfast language in recent weeks when asked about the dollar, apparently ruling out any U.S. support for intervention to stem the slide in the currency.

Snow has denied the argument that Washington favors a weaker currency to help exports and the economy.

In addition, G20 policymakers made no mention of the dollar’s slide in a statement issued at the end of their meeting in Berlin, reinforcing the view that major nations have accepted the need for a weaker dollar to correct the U.S.’s trade gap.

The G20’s call for more Asian currency flexibility was seen putting more downward pressure on the dollar, according to news reports.

Financial markets had been speculating the G20, which includes the Group of Seven (G7) rich nations and big developing countries such as China, might create the kind of international accord the G7 struck in 1986 to manage major currencies.

CME volume update

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The Chicago Mercantile Exchange electronic trading volume in November achieved a new trading record of 3.7 million contracts. This was the second time the exchange traded more than three million contracts in a single day electronically, the last time being 3.5 million contracts traded on Aug. 6.

CME electronic foreign exchange (eFX) also set a record on Friday, Oct. 27 with 270,648 contracts traded, compared to the previous overall eFX record of 236,000 set on Oct. 28. The strong volume in CME eFX was driven by a record in EuroFX futures on CME Globex of 143,331. The exchange also set a new record in CME Eurodollar futures traded on CME Globex with 2.1 million contracts.

FOREX ON THE TIFFE

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Published reports indicate the Tokyo International Financial Futures Exchange (TIFFE) will start a forex margin trading market early in 2005. Both individuals and institutions will be able to trade on the exchange, which will begin by trading the U.S. dollar, euro, pound and Australian dollar. Traders on the exchange will have 10 times leverage (i.e., a $10,000 deposit will allow them to trade $100,000 worth of securities).

CHINESE COMPANIES GET HELP

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A trio of financial groups –– ABN Amro, Credit Suisse First Boston and ING –– are going to offer derivatives that will help Chinese companies minimize fluctuations in currencies. The firms are able to offer the products thanks to a loosening of financial rules by the Chinese Government. The derivatives will allow Chinese businesses to hedge against swings in the price of foreign currencies. Other firms are interested in offering the derivatives but are awaiting approval from China.

Credit risks

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If the partnership works, the implication is many of the parties involved will have to relax their credit risk constraints. Banks that usually only trade with other banks would not potentially be trading directly with hedge funds and CTAs.

But the CME/Reuters stance is that while Reuters will provide easier access to the wider range of trading opportunities, the CME will offer credit intermediation.

The agreement offers a method of removing credit as an obstacle to the search for new liquidity and brings a regulated product to a market with an appetite for regulation. The CME operates a capital efficient market because it functions as a central counterparty (CCP) that assumes responsibility for trade clearing.

While some banks might not want to operate in that environment, the cost of capital usage, which will increase in the future, means any efficiency will be seized on. The market model of futures exchanges, with their central counterparties, is appealing to market participants, Sears says. The idea is, if this deal develops as it could, there’s a chance the spot FX world will adopt an exchange model and the CME and Reuters will be the two major beneficiaries.

“This is a whole new opportunity for [us] to get bank customers,” Sears says.

Reuters and the CME have worked together before in the development of the Globex platform. Additionally, rumors emerged in mid-November the CME is interesting in acquiring Instinet, Reuters stock-trading business, to broaden its trading reach beyond futures.

“Acquisitions and consolidation are an important part of CME’s growth strategy, but we do not comment on any specific aspect of that strategy,” says David Prosperi, spokesperson for the CME.

Positive reaction in FX market

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The partnership basically breaks down barriers between futures and spot forex market participants. Specifically, Reuters will take a market data feed from CME and convert the currency futures prices into the spot forex rates the interbank market is accustomed to using.

Reaction in the FX markets has been positive.

“It’s a good idea because more and more traders are now watching FX futures and the spot FX prices for indications and potential price action,” says Dave Floyd, trader and owner of Aspen Trading. “It reminds me of the way we used to watch the S&P futures so closely for clues on what stocks might be about to make a move.” Despite concerns by some critics that FX is too big a market for an exchange model, “it simply isn’t,” Sears says.

“The bigger it gets the better. If there were only a handful of players, they would all know each other.

Anonymity will add to the appeal of the system,” he says.

With 17,500 stations around the world, Reuters brings the mainstream interbank FX market to the partnership, while the CME contributes a different group: The CME’s customer base is 50 percent hedge funds and commodity trading advisors (CTAs).

Reuters and the Chicago Mercantile Exchange: A match made in heaven?

2009-06-15T20:49:00.000-07:00

The Chicago Mercantile Exchange and Reuters LLC are planning to open up currency futures trading to a wider customer base. And the partnership is more than just the CME displaying its market data on Reuters terminals, as some in the industry previously thought.

The two organizations have agreed to electronically connect their foreign exchange networks: the eFX futures contracts traded on CME’s Globex electronic trading system and Reuters’ Dealing 3000 system, which trades spot forex. The agreement is scheduled to go live for beta testing in December.

The partnership should have a significant impact on CME currency volume, adding depth and liquidity, according to Richard Sears, managing director for foreign exchange in the products and services division of the CME.

“We’ve displayed [our data] in spot equivalent terms,” he says. “We now quote it the way the cash [forex] markets do. It takes futures contracts and strips the interest-rate bit out so [traders] can compare futures prices to spot prices.”

Sum of the parts

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As the world’s largest financial market, forex consists of a variety of players, ranging from individuals to institutions, operating on different time frames and using different kinds of transactions. Although swaps and forwards are not part of retail online currency trading, individual traders should understand how these activities affect the FX market as a whole.

Interest rates

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If the forward rate is higher than the current spot price, the difference is referred to as a “premium”; if it is lower it is called a “discount.”

The premiums or discounts for any given forward dates are known as “swap rates.” The amount of the premium or discount reflects the difference between the interest rates on the underlying pair of currencies.

Swaps

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FX swaps are transactions involving the immediate exchange of two currencies (and their associated interest rates) at a spot rate and, later, a future offsetting exchange at a forward rate.

(Forward transactions, by comparison, do not involve the immediate exchange of currencies at the spot rate.)

For example, a swap might consist of one party exchanging $1 million for Japanese yen at the current USD/JPY rate and reversing (at a specified future date) the transaction at an agreed-upon exchange rate.

Among other things, a swap allows a trader to extend an existing forward position to an even later date.

“The forward time frame is not locked down — it can be applied at any date in the future,” says Kurt Hoeksema, chief dealer at Global Forex Trading. “And you can ask for the future date at the time the trade is entered into. That flexibility is what is so beneficial to a long term trader.”

Forwards

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FX forward contracts are transactions in which participants agree to exchange a specified amount of different currencies at some future date, with the exchange rate being set at the time the contract is entered into. Forwards are similar to futures contracts, except they are not standardized. That is, two parties can determine the size of the trade and the delivery date — aspects of a trade that are unalterable in exchange-traded futures.

Although there is no standard transaction period for forward contracts, typical time frames are one, two or three weeks, then in monthly intervals. The flexibility of a forward transaction is largely what makes it attractive.

FX forwards remove uncertainty, and are therefore common transactions to hedge risk for future business transactions denominated in a particular currency.

Spot forex

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The spot (cash) market is by far the most important sector of the forex world for individual traders. A spot market is one in which commodities or financial instruments, including currencies, are bought and sold for immediate delivery, which usually takes place the same or next business day.

This is the market in which retail traders are participating when they trade currencies through an online forex broker.

Although virtually no individual online forex traders will engage in forward and swap transactions, understanding how these trades work will give retail currency traders a better understanding of the larger market in which they operate.

Spot, forwards and swaps

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When people refer to the “currency market” it’s sometimes unclear precisely what they mean.

Currencies are traded as futures contracts, as well as a variety of transactions in the forex market namely, spot, forward and swaps transactions.

Each type of forex transaction has its role in global banking and currency trading.

Recently the Bank for International Settlements (BIS) released its triennial survey of the foreign exchange markets (see “Forex survey finds tremendous increase in currency trading,” p. 10), and not surprisingly, it showed the spot currency market, forward transactions and swaps grew to extraordinary levels in the three years from 2001 to 2004.

According to the survey, the spot market expanded 60.5 percent to $621 billion, after contracting 32 percent in 2001; forwards grew 59 percent to $208 billion. Foreign exchange swaps turnover grew 44 percent.

With the FX market rapidly intensifying and new players getting involved every day, it is helpful for potential and current traders to understand what these different kinds of transactions are and how they interact.

New products and services November 2004

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The FXCM Speculative Sentiment Index (FXCM SSI) from FXCM, a retail currency trading broker, is now available for public distribution. FXCM SSI provides a snapshot of the market sentiment and the pen interest of small noncommercial forex market participants. The indicator is compiled using aggregate order flow information from FXCM’s non-commercial clients (more than 55,000). FXCM SSI provides data on the long and short positions held by non-commercial market participants for the major currency pairs (EUR/USD, USD/JPY, GBP/USD, and USD/CHF), as well as current market positioning on the day of publication, and indicates if a currency pair is overbought or oversold. In addition, the FXCM SSI leverages FXCM’s client base of speculative traders from North America, Europe and Asia to provide global market sentiment, without bias toward American trading activity. The FXCM SSI is made available to the general public on the Internet at 10:30 a.m. ET every Thursday. Visit www.dailyfx.com/ssi.html for more information.
Trading Technologies International Inc. (TT) and Hotspot FX Inc. announced Hotspot FX will provide access to its spot foreign exchange marketplaces via TT's X_TRADER order entry platform. All X_TRADER users will have the option to trade Hotspot FX products. The arrangement marks the first cross-market extension of X_TRADER into the cash foreign exchange markets. Hotspot FX, which is the first spot FX marketplace to connect to TT’s platform, expects to launch trading on the TT platform during the fourth quarter of 2004. For more information visit www.tradingtechnologies.com or www.hotspotfx.com.
FXpress offers the FIRST Treasury Workstation, a global solution for managing foreign exchange, commodities, and debt and investment portfolios. FIRST is a Web-based platform providing global exposure management, robust accounting functionality (including FAS 133/138 and IAS 39 compliance), integrated financial instrument coverage, and superior security and audit capability. For more information, visit www.fxpress.com.
Pristine Trading University has released two DVDs by Forex Capital Markets (FXCM). “The FXCM Forex Course — An Introduction to Forex Trading” is a 48-minute “crash course” in trading the 24-hour forex market, with an overview of major currencies and fundamental and technical analysis for forex trading. “Forex Trading Strategies — Technical and Fundamental Strategies for the Forex Market” takes an in-depth look at technical analysis, fundamental analysis, stop placement, risk management and how the general market affects exchange ranges, and gives five step-by-step trading strategies for the forex market. The DVD is 80 minutes. For more information visit www.pristine.com/seminars/online/PTU/fxcm.

Peter Panholzer: Currency system architect Part 3

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AT: This year has been pretty rough overall for currency managers, and currencies have been stagnant for a while. Let’s talk about the evolution of online forex brokers. As this market grows, what do you think of the potential profit opportunities? Will the trend moves continue to dissipate and will that make it harder for currency managers to make money? Is a sea change in the market occurring?

PP: I’ve been around long enough to know that it’s not new. But on the other hand, the market is changing with regard to the distribution of prices. We know that market prices are not normally distributed, meaning there are sharp moves that don’t fit the normal distribution pattern — these “fat tails” in a non-Gaussian (bell) curve. This tendency is increasing, in my opinion.

All system trading ultimately relies on near-normal distribution. When this deteriorates, you have less opportunity for systematic trading. Things will be more difficult for system traders, and fundamental traders who have a view about price levels might come to the forefront.

On our Web site there’s a comparison between systematic and discretionary currency managers how they under perform and outperform each other. It shows that, currently, discretionary are ahead of systematic traders. If that will persist, I don’t know. I should like to think not.

AT: If it does, how would it impact your trading?

PP: It’s not going to. But we have to be more careful with the fine-tuning of the parameter spaces and be on the button with regard to monitoring how systems perform in general and how other traders perform.

AT: It wouldn’t lead to shortening your trading horizon, decreasing your size or some other change?

PP: No. We are very happy with the current model. We don’t, generally, reduce the position size if we lose money.

AT: So when you talk about adjusting parameters depending how the market evolves, what are you talking about changing?

PP: The parameters we change are “buffers,” which adjust to market volatility. But we tend not to change them, if we can avoid it.

AT: Are the buffers essentially volatility-based filters that dictate how much a market has to move after an initial signal is triggered before the signal is acted upon?

PP: Yes.

AT: What’s an average trade length?

PP: Two days.

AT: Is forex a unique market, in that trading currencies is different than trading stocks or bonds?

PP: Currencies don’t “scale” like other assets. Stocks, bonds and other asset prices scale logarithmically (i.e., on a percentage basis). What I’m saying is, the daily volatility of, say, soybeans trading at $12 will be higher than it would with beans trading at $3. It moves in percentage terms according to the price level. That’s normal.

I checked the average daily range or volatility of the British pound when it was trading around $1 vs. when it was around $2 or $2.50 and, funnily enough, there was virtually no difference in the daily volatility. It should have been half when the pound was trading at $1 vs. where it was with the pound at $2, but it wasn’t.

This is probably because currencies are reciprocal — you could say there’s a pound/dollar rate and a dollar/pound rate. By contrast, gold bullion is measured in dollars, but you never measure dollars in gold bullion.

One thing’s for sure: Currencies do not fluctuate more when they are at higher prices — at least as much as they should.

The medium of currencies is not comparable to the bond and stock markets, in which you have indices people can buy — a portfolio of bonds or a portfolio of stocks, like buying all the stocks in the S&P 500 — that serves as a benchmark. You can’t do that in currencies.

AT: I read you only trade the three largest currency pairs (EUR/USD, USD/JPY and EUR/JPY),
but you also have a study that discusses the superior trend characteristics of less mature currencies. If some of these less mature markets have better trend characteristics even if they’re less liquid — isn’t there enough price movement to justify doing some trading in them?

PP: The risk is just too big. Everything is fine and dandy on paper, but simulations don’t show everything — you find out there was a 50-point market gap that wasn’t factored in because most people work with hourly data, at best. Even if you had one-minute data, even then you wouldn’t even necessarily spot a “liquidity black hole” (a term created by Prof. Avinash Persaud). We’ve seen liquidity holes occur in time spans less than one minute. So even if you make a one-minute chart, the gap doesn’t show up.

And this is a risk that has increased recently in my opinion — I’ve never seen so many liquidity holes, particularly in the dollar/yen rate.

AT: Are there any currency pairs you are currently not trading but are watching because they are poised to become mature enough to trade?

PP: No.

Peter Panholzer: Currency system architect Part 4

AT: Also, do you think some of the less mature currency pairs are viable for individual traders, who don’t have to worry as much about huge liquidity?

PP: Sure. You can choose between many models when you buy a car.

AT: You seem to feel the Bank of Japan is especially responsible for the liquidity holes you talk about — you’ve even referred to their “manipulative moves” on your Web site. Why is that?

PP: The Bank of Japan simply has more discretionary powers than other central banks.

AT: What basic principles would you advise forex traders adopt given today’s market?

PP: After all my 31 years of trading, I’ve come to say that the best way is to trade systematically — in an unemotional way — and that can only be done using very rigorous system construction and exploitation of data statistics.

You can do this as an individual trader, but it takes a lot of resources. You can’t buy a good trading program, in my opinion. We certainly wouldn’t sell ours. The program has to fit you like your own clothing. In that sense we have a tailor — that is, a programmer who is, ideally, himself a trader — andwe work together with him to develop and monitor the systems. This is Adam Hartley, of SnapDragon Systems in Oxford, England.

I also believe simple rules, amazingly enough, make the best systems; complex rules don’t, necessarily. A complex rule, for example, would be the application of chaos theory. Rocket scientists were given millions of dollars to research and trade using fractals and non-linear dynamics, and they failed. Sophistication is not the solution.

Sometimes the simplest system will be the most useful because it is easy to understand and execute — the Turtle system, for example, or the very similar system I used long before the Turtles. (“Turtle”was the name given to the trend following disciples of trading star Richard Dennis, who made hundreds of millions of dollars in the 1970s and 1980s.) Decades ago I used a four-week breakout system (buy at the four-week high and sell at the four-week low), and that turned out to be the Turtle system, except the Turtle system entered at four weeks and got out at two.

Obviously it was very useful in very trendy markets in the 1970s when there was inflation. That’s another thing: The 1970s were unprecedented inflationary years. If that happens again, we’ll have some tremendous advantages. What you need is movement. Right now, there’s not so much in the currency market.

AT: If a general deterioration of trend moves is inevitable — not just cyclical — doesn’t that eventually spell doom for currency trend followers? Wouldn’t you eventually have to adopt a different approach?

PP: Currently these clouds seem far away. As [Former Canadian Prime Minister] Pierre Trudeau once said to an old lady who asked him about inflation, “The universe will unfold as it must.”

AT: Do you have any feeling about currencies over the next six months or so?

PP: I think 2005 will be a banner year for currencies. I also have a strong feeling the remainder of the year will show a strong improvement in conditions. There seems to be some kind of seasonality that October, November and December tend to be good months. But of course, that could be called witchcraft (laughs). Nevertheless, the statistics are there to show the last quarter is good.

AT: Why is 2005 going to be good?

PP: Because when you come out of a long sideways move, in general, you get a big move. This is natural.

AT: Do you think the high leverage sometimes offered by forex brokers is a good thing for smaller traders to use?

PP: I think it’s irresponsible to trade with only the margin money — in the spot market or in futures. But the exchanges and brokers have an interest to let the little guy trade with as little money as possible the margin. It’s not in the interest of the trader. It’s in the interest of the broker because it creates more commission per customer dollar.

All I can say is, in currency trading leverage is a very important thing. You can use no leverage or 100 to-1 leverage. And in general, you should always use less leverage than you think you should because we always overestimate our tolerance for risk.

We don’t always understand that risk isn’t always a money risk; there’s the risk of regret. Sometimes you regret you haven’t been in the market, sometimes that you got out too early or that you’ve taken a loss when it wasn’t necessary. It’s not only the money we worry about, it’s also our regret we worry about.

Peter Panholzer: Currency system architect Part 2

2009-06-12T20:36:00.000-07:00

AT: What were your trading experiences in that period from 1973 to 1979? How long did it take you to develop your systematic approach?

PP: It took me from 1973 to 1977 that’s when my trading blossomed and I started to make oodles of money. It takes four years of tuition in any endeavor in life. If you want to learn golf, tennis, piano, a language — it always takes at least four years, doesn’t it? But before that I didn’t make money — I made it, I lost it. I survived. But that’s normal. Whatever I lost, I considered tuition.

AT: How did you initially approach the markets?

PP: I’ve been a contrarian since 1972. The figures published by Market Vane (Sibbet-Haddady) started in 1972, and ever since then I’ve been following them. But then to apply that information, that takes insight, too. So when I say it took me four years of learning, that includes learning contrarianism. All the money I made before I started system trading was through contrarian trades.

AT: What’s an example of the kind of trade you might have used in this regard?

PP: Take sugar, for example. After running up from 6 cents to more than 60 cents throughout the early 1970s, it had just collapsed back to 6 cents. Everyone considered it a bargain, of course.

Well, contrarian thinking taught me to go against “everyone.” I went short at 6 cents and everyone thought I was nuts — until I cashed in my profits at 4.5 cents. In relative terms, a move from 6 to 4.5 is huge. Nobody thought that way, but it’s a 25-percent drop, after all.

The following winter (1978) I holidayed in Mexico City, but, in true Jesse Livermore fashion, instead of visiting monuments I hung around brokerage houses and got to talk to a Mexican client who “confided” to me that his brokerage had lent him the required additional margin for his short cocoa contracts, which were then trading at 89 cents/pound. “We don’t want you to close out your position and let some gringo profit from your losses,” they had told him.

To me that sounded like a starting pistol. I immediately called my partner in Toronto and asked him to go long six contracts of cocoa in my account. It was a bumpy ride all the way up to above $2 when I took my profit.

AT: What ideas did you go through in that period that you ended up casting aside?

PP: Econometrics — what we might call one step ahead of fundamentals — didn’t work for me. For example, at our firm we had a curve that showed the average weekly movement of pork bellies in and out of warehouses. That has a seasonal pattern — it goes up around Easter, down in the summer and increases in the winter. You can average that over 20 years and get a smooth curve.

Then I compared the actual movements against the 20-year average to determine what that would mean in terms of a move in pork belly prices. That idea makes a lot of sense, but it doesn’t work. This is what led me to the numbers game.

AT: Is “the numbers game” what most people would consider technical, quantitative or statistical?

PP: Completely statistical. I do not believe in technical indicators per se, although some people use them as a tool — and there’s nothing wrong with that. Let’s say you have a hammer. If this hammer suits your hand particularly well and you can hit a nail right on, that’s a good hammer for you. For me, system trading is a good hammer.

AT: Is it fair to say that whatever you use has to be testable?

PP: Certainly. A lot of research goes into the stability of parameter spaces — which are ranges of system parameter values across which you want performance to be consistent as markets evolve.

But I think the most important thing I’ve learned in the past 25 years is that if you delegate trade execution to someone else, you’re more likely to succeed. I’m purely systematic. We now have what we call a “robot interface” with one broker. That account has no interference whatsoever. No resting orders are placed in advance, so the broker doesn’t know the robot’s “intentions.”

We prefer not to show our orders. I believe in that in principle. If a broker sees the order, there’s always the argument that brokers [execute] where the orders are bunched up, for example.

With the robot, the order sits on our computer server and the broker doesn’t see it. The moment our server sees the trade trigger, it executes at the market with the electronic broker platform.

AT: That sounds like a good idea for individual traders, too: Instead of placing limit orders, place the trade as a market order when you get a signal from your system.

PP: Yes, of course. All I can say is, in all likelihood, this is the best way to execute a system. Second guessing it is the biggest danger.

AT: What’s the TETRA program?

PP: It’s the program applied in most of the funds we manage. We started it in January 1998.

AT: Is it a trend-following approach? How does it work?

PP: It’s a hybrid system. A trend-following system normally has some kind of sliding protection something that keeps moving with the market; that’s how you follow the trend. We have a hybrid because we use both profit targets and sliding protection, in a systematic way.

We use four-hour (the primary time interval), hourly and daily data in the TETRA program. These intervals are not being changed. Some researchers, such as Richard Olsen (see “Richard Olsen: Tuned to high frequency,” Currency Trader, Oct. 2004 p. 42), have found you can use “tick time” that multiple hours of trading activity can be compressed into one hour, for example

A system consists of three things:
Entry mechanism, exit mechanism and then re-entry mechanism. If you don’t have a re-entry mechanism, you have no system.

AT: How did you determine these time intervals? How long a process was it?

PP: It was a process covering years of research and hard toil.

Peter Panholzer: Currency system architect Part 1

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Forex might be all the rage in the trading industry these days, but most individual traders have begun to take note of the world’s largest market only fairly recently.

Peter Panholzer, head of trading and chief investment officer at DynexCorp and Panholzer Advisory Corporation (PAC), which together manage $53 million in the forex market, has been trading the currency market professionally since the late 1970s. He was currency before currency was cool.
Panholzer was something of a trailblazer, having started managing money exclusively in the currency
market at a time when common wisdom dictated doing so was a mistake because of the lack of diversification. Also, he was an early practitioner of systematic trading, which was a relatively novel concept in currencies at the time.

Panholzer, 61, who became a Canadian citizen in 1977, grew up in Vienna, where he earned a master’s degree in architecture from the Technical University of Vienna. This seemingly unrelated focus of study actually served his future career choice well. “I have a mathematical background,” he says. “In Vienna, the education for architecture is not just artistic, there’s a lot of engineering involved, and therefore a lot of math. I acquired my programming skills myself in the early 1970s.”

Panholzer worked as an architect for six years in Toronto, and he co-designed some award-winning
buildings in Canada. But when contemplating going solo, some of the inequities of his profession got
under his skin. His decision to try trading was the result of his belief in “objectivism, the philosophy of
Ayn Rand (author of the books Atlas Shrugged and The Fountainhead) that effort and talent should be
rewarded,” he says. “Unfortunately, in architecture, talent and effort are not, in most cases, rewarded. A bad architect who was a good businessman would be the richest architect you could find anywhere.” Panholzer continues. “Yes, there are some excellent architects — Frank Gehry and, in Canada, Arthur Ericson come to mind — who probably have been enjoying the benefits of Ayn Rand’s philosophy in the truest sense.

There you have two great talents who, like Frank Lloyd Wright, reaped the financial rewards of their talent. But there are great architects out there who are not rewarded accordingly. That bothered me.

“In trading that’s not the case. In the markets, you get rewarded — or slapped in the face — immediately.” Although 2004 has so far been a slap in the face for DynexCorp and most other currency funds, Panholzer has mostly been rewarded over the 25 years of his trading manager career. DynexCorp’s TETRA trading program was down roughly 15 percent this year through September, but Panholzer has had only three losing years since 1994 and DynexCorp was the No. 1 currency manager in 1998 and No. 3 overall from 1994- 1999, according to the Managed Account Report’s rankings of riskadjusted returns.

Panholzer began his market career in 1973 trading silver. He started trading currencies for his own account in 1977 and with such success that he began managing money in currencies exclusively in
October 1979. He’s been doing it ever since.

In 1979 he joined the Toronto branch of ContiCommodity Services (Canada) Ltd. as an account executive. He transferred to the Lugano, Switzerland branch office in 1981. Between 1979 and 1984, he ran the Magnum Currency Program (using currency futures contracts at the Chicago Mercantile
Exchange) at Conti, which produced an average annual return of 80 percent in its first three years.
After four more years at E.F. Hutton in the mid-1980s, he struck out on his own, founding PAC in
1988, to specialize purely in foreign exchange spot trading. Since 1992 he has lived in Monaco.

DynexCorp handles institutional business, which consists mostly of banks outside the U.S., while PAC,
which has an American office and is NFA and CFTC registered, handles individual and small corporate clients. The funds are traded in strict systematic fashion using Panholzer’s TETRA trading program.

“I didn’t start trading a strict system until 1979, which at the time was a fairly new approach,” he says. “And the attitude was trading currencies exclusively was a mistake because you weren’t diversified enough.” “We essentially have three traders looking after the signals,” he continues. “There is no discretion. They all use the algorithm that delivers the orders, which is very convenient because even a person who doesn’t know how to trade can internally monitor the program.”

Panholzer’s belief in systematic trading is based on two principles familiar to most mechanical traders: testability and objectivity. But he makes a distinction between “system trading” and “technical trading systems.” “System trading is different from technical trading,” he says. “In technical trading, you’re reading tea leaves — the indicators. Interpretation of technical indicators is often subjective and not programmable. But you can program a system.”

Panholzer sometimes sounds like a typical “quant” — talking about the trading in terms of distributions and other statistical concepts — but he also has a somewhat quirky sense of humor (which he occasionally uses to deflect inquiries into more specific aspects of his trading) and, like any good money manager, a talent for changing the subject. When asked what he thinks he does differently from other currency traders, he replied, “I do everything differently from other currency traders. The only thing that connects currency traders is that they never seem to sleep.”

CURRENCY MOVERS: Canadian dollar

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After a robust 2003, the Canadian dollar pulled back vs. the U.S. dollar in the first four months of 2004 before pushing to new relative highs in September. The U.S. dollar/Canadian dollar (USD/CAD) rate on Oct. 20 broke down below the shorter-term support level (around 1.25) it had established earlier in the month.
Although there is speculation in some circles the Canadian dollar stands a good chance of continuing
to gain against the dollar — the recent price thrust and rate hikes by the Bank of Canada would seem to support that position — there are several reasons for traders to be mindful of the potential for a correction, if not a larger reversal, in the not-too-distant future.

Technical traders will watch how the 1.25 level in the USD/CAD acts as resistance after being penetrated as support. If another meaningful down move is in the wings, technicians will look for this level to turn back any upside correction, and will not want to see it exceeded significantly or for very long. A move above the Oct. 13 spike high of 1.2688 would at least temporarily invalidate the downtrend scenario, but most chart watchers will be nervous about a strong or sustained move up to 1.2575-1.2600. Testing a pattern modeled after the four-day sell-off that occurred from Oct. 20 to Oct. 25 showed a slightly bullish short-term tendency after such moves.
It shows the percentage returns (measured from closing prices) for the first 15 days after a four-day down move greater than 2.5 percent when the three most recent closes were lower than the preceding closes.

There were 14 previous patterns that met these criteria since 1998, the most recent being March 29 and 30, 2004. Except for days 8-10, the average moves were marginally higher (day 3 had a negative median return), and all days but two (days 2 and 3) had positive returns at least half the time. Also, although days 8-10 had negative average returns, their median returns were positive — which
implies an “outlier,” or exceptionally large, non-representative value has distorted the average — and the percentage of positive returns on that day were 71 percent. (However, the mild upside bias turned slightly negative in days 18-20 after the pattern, not shown).

A 120-minute chart of price action through 11:30 a.m. ET on Oct. 27, shows the USD/CAD
having established a third progressively lower short-term support level, but was trading slightly higher
on the day. In addition, Commodity Futures Trading Commission Commitment of Traders data shows small speculator long positions at one of the highest levels of the past 12 years, which is typically viewed as a contrarian signal because of the pattern for small traders to be on the wrong side of the market near turning points (see “Canada looking toppy”).

The U.S presidential election on Nov. 2 might also have a role to play. “Elections and the U.S. dollar“ shows a long-standing tendency for U.S. dollar to rally after elections.

And of course, there is little in the markets that crude oil cannot impact these days. Crude’s historic strength this year has bolstered Canada’s (an oil exporter) economic bottom line this year, and any significant sell-off will affect the CAD.

In short, traders who have most recently jumped (or re-jumped) on the Canadian dollar bull bandwagon could be in for a rough ride if any combination of these factors align in the coming weeks.

Trade example

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On Oct. 18, 2004, a currency trader who noticed the EuroFX had been in a range between roughly 1.2450 and 1.2250 for a few weeks and believed the economic releases of the next two weeks would cause the euro to break out of this range could have created the following position: a long strangle in weekly options, purchasing the Friday expiring (Oct. 29) 1.2300 puts and 1.2500 calls for a combined 98 ticks($1,225). Breakeven at expiration would be above 1.2598 or below 1.2202, not including commission and fees.

The slight upside bias to the strike prices reflects the previous day’s bullish move up to 1.2500.

The cost difference between these weekly expiring options and the monthly options that expire in the first week of November would be considerable. A trader wanting to buy the monthly November 1.2500 calls and the 1.2300 puts would have to pay a combined cost of 143 ticks ($1,787.50). Breakeven at expiration would be 1.2643 or 1.2157, not including commission and fees. If you believed the employment report was going to move the market within the next day but were unsure about the next three weeks, there would be no reason to pay for the added time value of the November options.

For short-term traders who want to trade imminent market events, weekly currency future options provide the opportunity to buy options cheaper and more accurately target specific time windows.

Trade scenarios

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Weekly options are useful in several types of trading situations. First, say you recognize the Swiss franc (SF) has been in a trading range for the first three weeks of November, and the fourth week of November does not have any major economic releases likely to move the market out of this range. In such a situation, you might want to sell a strangle in fourth-week expiring options.

A short strangle consists of selling a call option with a strike price at the high end of the most recent week’s range and selling a put with a strike price at the low end of the range with the expectation the market will remain between those price levels until expiration. Selling “naked” premium this way can be very risky, but for experienced traders who can monitor the market very closely and whose research indicates a positive probability for the expected low-volatility price action, the risk is manageable. If the
market remains within the range and the options expire worthless, you keep the premium you collected from the short options.

If you established the short strangle using comparable monthly options, you would collect more premium (because these options are further from expiration and have more time value). However, these options would notdecay as fast as the weekly options because they have more time value than the weekly options.

A long strangle could be used if you think a currency might make a significant price move during a particular week. For example, say the Canadian dollar (CD) has also been in a trading range for the first three weeks of November, but you think economic numbers published in the fourth week of November could really move the currency. You’re not bullish or bearish, but you believe these numbers are going to cause the Canadian dollar to break out of this range. In this case, you could buy a fourth-week expiring strangle, buying calls at the top end of the third week’s range and buying puts at the bottom end of the range.

The risk on a long strangle is limited to the purchase price of the options, plus commissions and fees. (However, if one of the options expires in the money, you can end up holding a long or a short futures position, which would leave you with unlimited risk.) The third trade scenario is based on the idea the Canadian dollar will break out of its range to the downside during the fourth week of November, except that you’re already long Canadian dollar futures. In this situation, you could sell fourth-week Canadian dollar call options to hedge the futures position.

Benefits

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What advantages do weekly currency options offer over regular monthly options? Options that expire every four to five weeks can be difficult to incorporate in short-term trading strategies. Weekly currency options allow you to tailor strategies — especially those that incorporate both futures and options — to a shorter time frame, rather than a monthly outlook. Traders sometimes fall into the trap of using long-term macro approaches to trade short-term price movement. If you want to capitalize on short-term
trends, it’s logical to use short-term tools.

Each trading week many economic numbers are released in the United States and overseas that affect the value of the dollar and foreign currencies. If you believe a specific currency, such as the EuroFX (EC), is going to react to a particular number, you might want to position yourself accordingly in the market. However, if you think this move is going to occur in a specific week, you may be caught in the predicament of paying for the time value of a longer-dated monthly option. With a weekly option, you can tailor your trade to the specific time window that contains the opportunity.

Each week presents a new opportunity to speculate or hedge underlying currency futures with options. One technique that can be used in a variety of trading situations is to structure positions according to the most recent weekly trading range, to take advantage of expected price action within or outside this range.

Weekly currency options

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Trying to stay on top of economic numbers and volatile markets requires knowing which markets
and tools are the most appropriate in a given situation. In the currency futures market, the weekly expiring options (“serial options”) offered by the Chicago Mercantile Exchange allow traders to more effectively take advantage of short-term trading opportunities.

Weekly currency options expire on the Friday of the designated week and can be traded one month out from the current week. For example, during the second week of November, you would be able to trade the options expiring on Friday, Dec. 10, which is the second Friday in December. Regular currency options expire the first Friday of each month and can be traded up to a year in the future.

Conclusion

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Combining a trend-following technique along with a stochastic enables you to make sure you are buying pullbacks in uptrends, selling rallies in downtrends and taking advantage of the temporary extremes during sideways trading range affairs.

These two indicators, the Donchian channels and the stochastic, work well together in this regard.

To turn this concept into a workable trading plan you need to review the history of your preferred currency markets to determine the best points to exit losing trades, take profits and ensure any unique attributes are accounted for in your approach. For example, it could turn out a 70-period channel is too long or there is a more appropriate lookback period for the stochastic oscillator.

Taking signals

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However, there is a problem with using a 14-period Donchian channel and a 14-period stochastic. Identical lookback periods do not make sense if you’re trying to determine both the long-term trend and shorter-term overbought and oversold points to signal entry points.

Trial and error led to adopting a 70- period Donchian channel as the trend filter, with the simple rule that if the two channel lines are stretching apart, the market is trending. If the channel lines are contracting, the market is in a trading range.

When the market is in a trading range, the stochastic can be used to buy oversold points and sell overbought points. When the market is trending, take only those stochastic signals in the direction of the trend.

It shows the same price action, with 70-bar Donchian channel lines added. Beginning in December 2000 the difference between the channel lines leveled off and the market entered into a trading range. In February 2001 the two lines contracted (the lower line was static while the upper line declined) and the stochastic indicator prematurely signaled a bottom in March. However, the indicator gave another crossover buy signal in June, just ahead of the July lows. There was a crossover sell signal just before the September 2001 peak.

During June 2002, price began to push the upper Donchian channel line higher while the lower channel line moved sideways. This stretch signaled that the market was moving into an uptrend. In this situation, you would look for the stochastic to pull back and give a buy signal. Because the market is
trending it is not necessary for the stochastic to fall all the way to 20 or lower; if it does, however, it is still a valid buy signal if the channel lines are stretching. For example, in October and December 2002 and April 2003, %K crossed above %D at opportune moments to enter the bull trend during pullbacks. In September 2003 and April 2004, the stochastic did, in fact, drop below 20 when generating %K/%D crossover buy signals.

Donchian channels

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Donchian channels are lines that delineate the highest high and lowest low over a specific lookback period. They are named after Richard Donchian, who tested and popularized certain breakout trend-following techniques in the 1960s.

The blue lines surrounding price in are 14-bar Donchian channels, which show the highest 14-week high and lowest 14-week low at any given point. Because the stochastic indicator measures the most recent closing price relative to the range of the last 14 weeks, high readings occur when price
hits the upper Donchian channel. Similarly, low stochastic readings ccur when price tags the lower Donchian channel. If the market starts to trend upward, as it did in April 2002, the upper Donchian channel line will move up more quickly than the lower channel line. This expansion or stretching of the two channel lines, which means the market is making repeated higher highs (look at April and November 2002, for example), is an indication of a trend.

Ranges, trends and stochastics

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The stochastic is designed to indicate when a market is overbought or oversold. A stochastic displays two lines, %K and %D. The %K line is calculated by finding the highest and lowest point in a trading period and then finding where the current close is in relation to that trading range; %D is a moving average of %K. We’ll be using the following stochastic parameters: 14 period for the basic lookback period and three days for both of the moving average smoothings (a “14,3,3” stochastic). For more information on this indicator, please see the sidebar, “Stochastic basics.”

It is a weekly chart of the Euro/U.S. dollar currency pair (EUR/USD), along with the 14-period
stochastic oscillator. It shows how during trading ranges (such as the one from June 2000 to January 2002) high stochastic readings tend to coincide with price highs while low stochastic readings tend to accompany price bottoms.

A traditional overbought (sell) signal occurs when the stochastic is above 80 and the %K line crosses below the %D line, which happened in both January and September 2001. These events coincided with market peaks. Conversely, the traditional oversold buy signal occurs when the %K line crosses above the %D line when the stochastic is below 20. The first buy signal occurred in May 2000.

There are times when the stochastic buy signal crossover may repeat before the final price low occurs. For example, a buy signal occurred in September 2000, but it turned out to be early, as the market subsequently made a lower low. In early November, the stochastic flashed a second buy signal.

This same pattern of back-to-back buy signals occurred in early April 2001. The second buy signal was two weeks ahead of the final low in the first week of July 2001. The next stochastic buy crossover occurred in early December, but the trend made one more new low and, again, another buy signal occurred in February 2002. Although our eyes are naturally drawn to the signals that work well in the trading range, the subsequent uptrending period highlights an attribute of the stochastic
oscillator that many people overlook: When a market trends, the stochastic can, in fact, confirm the trend by failing to reach the extreme levels counter to the trend. In other words, if the market is in an uptrend, the stochastic will reach the overbought level but fail to make oversold readings. An uptrend
is, in a way, a persistent overbought state.

The stochastic pushed into overbought territory in April 2002 and never declined below 20 again until August 2003. The market simply continued to zigzag in an uptrend; the upward shift in the stochastic readings (where the %K crossed back above %D when the indicator was at relatively high levels, such as occurred in November 2002) was a sign of strength.

Channeling currencies

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The adage “the trend is your friend” is perhaps more applicable to currencies than any other market. The fundamental factors driving the currency market tend to change slowly, leading to sustained trends or sideways market conditions that can last for a year or more.

Recognizing this, a logical way to try to trade currencies is to first determine the trend, and then use techniques to trade in concert with that trend — that is, find points when the market is pulling back in an uptrend so you buy at a relatively low level.

The approach outlined here combines the Donchian channel, which determines the trend, with the stochastic oscillator, which is used to time the trade entries.

Trade opportunities

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The unusual rally in the U.S. dollar after presidential elections implies going long on the sixth day after the election and exiting three months later. But two factors suggest caution: the dollar’s rise is based on only seven instances and the index hasn’t rallied following close elections. The good news is that over the past 31 years, the dollar has climbed modestly after election day, so buying the dollar in earlyNovember and holding it through the end of the month may be profitable, depending on current market conditions.

U.S. dollar index futures contract

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Although the Fed’s dollar index represents the longest set of available historical data (1973 to 2004), it is helpful to study past performance of the U.S. dollar index futures contract to see whether the trends discussed previously appear here. However, there are two problems with this comparison: The futures contract has only been trading since 1985, and the number is weighted differently than its Fed counterpart.

Despite these limitations, we analyzed both data sets over the past 18 years to see whether they have moved in line with each other. It compares the average gains and losses of both instruments and their benchmarks in eight periods surrounding election day.

Comparing reveals the U.S. dollar has lost more ground around elections over the past 18 years than since 1973. While the Fed’s index posted smaller average losses than the NYBOT’s futures contract, neither instrument consistently gained ground after election day.

However, the U.S. dollar’s futures contract moved in the same direction as the Fed’s index in each of the preelection periods; the relationship between both instruments was less clear after the election. Also, the Fed index and the DX contract followed the same pattern around presidential and mid-term congressional elections.

Presidential vs. mid-term congressional elections

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The dollar’s most interesting trends appear when mid-term congressional and presidential elections are measured as separate (and smaller) categories. There have been only eight non-presidential congressional elections since 1973, and It shows that the dollar sharply dropped in the 60 and 40 days both before and after election day. However, the index was more bullish in the three weeks before and (especially) four weeks after it.

The longer-term price moves appear less dramatic when compared to their benchmarks, or typical same-length losses during these eight years. For example, the -1.53-percent average decline in the 60 days prior to the election is roughly inline with its 1.40-percent benchmark loss in that period; the
dollar’s performance in the 60 days following mid-term congressional elections tells a similar story.

Also, the dollar’s average gains in the 15 days around these eight elections are unusual because its benchmarks lost ground in these periods. The dollar’s strongest gains occurred in the 10 days before and 15 days after congressional elections (0.65 and 0.46 percent, respectively) not only because they outperformed their benchmarks, but they were also in line with their median values.

It‘s final category shows the seven presidential elections had the opposite effect on the U.S. dollar. Here, the dollar posted its largest average gains in the longer-term (60- and 40- day) periods surrounding these elections. Also, the dollar’s presidentialelection- year benchmarks were quite bullish, which means not all the gains prior to and following this event are as noteworthy as they seem.

For example, the index’s 0.91-percent average gain in the 60 days before a presidential election was slightly below that period’s benchmark. Despite this caveat, the U.S. dollar rallied strongly starting in the third week after presidential elections, culminat ing in a 2.76-percent average gain by the 60th day following them.

They highlight the differences between the dollar’s average gains and losses around
presidential and mid-term congressional elections, respectively.

The dollar gained ground leading up to presidential elections, but actually lagged behind its benchmarks in four of the six periods. However, the index rose 1.07 percent, on average, in the 40 days preceding the event, beating its benchmark by 0.42 percent. The figure also clearly shows the dollar’s outstanding climb from the 10th day after election day. It reiterates the dollar’s fall in the 60-, 40- and 20-day periods before congressional elections.

While this downtrend reappeared between the 20th and 40th day after the event, the dollar posted gains and beat its benchmarks in the intervening seven periods (e.g., 15 days prior to and 20 days following it).

Election types

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Although the dollar moved in a distinct pattern around the past 31 elections, its behavior varied based on the type of election. It shows the dollar’s average gains and losses in the 12 periods surrounding all election days and compares it to the dollar’s performance in even-numbered years — either presidential or mid-term congressional elections — and the benchmark moves for the periods of the same length over the past 31 years.

The dollar was more bullish surrounding presidential and midterm congressional elections than during less-significant ones. In even-numbered years, the index posted either smaller average losses or larger gains in 11 of the figure’s 12 periods.

The index’s performance in the first month after the election highlights this trend. In general, the dollar traded sideways in the second week following an election, but after presidential and congressional elections, its 0.17-percent, five-day gain doubled to 0.34 percent by the 10th day. This postelection rally during even-numbered years culminated in a 0.61- percent average gain by the end of the first month — nearly three times as large as the 0.21-percent climb in the same period overall.

It breaks down average gains and losses into different election types: presidential and midterm congressional; odd-numbered (non-national election) years; midterm congressional only (1974, 1978, 1982, etc.); and presidential only. Comparing the first category’s average and median values reinforces conclusions drawn. The dollar’s median value was higher than its average in eight of the 12 periods around elections in even-numbered years. Therefore, the dollar has likely performed better before and especially following presidential and mid-term congressional elections.

The table also shows the U.S. dollar sold off leading up to and after oddyear elections. While the index gained an average 0.18 percent in the 15 days before these events and 0.24 percent by the 60th day following them, it fell or traded sideways in the table’s 10 remaining periods.

Elections and the U.S. dollar: 1973 to 2003

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To see how the Fed’s U.S. dollar index has fared around elections from August 1973 to January 2004, we measured its performance in six periods both before and after each election day. We tracked the gain or loss from the 60th and 40th days before election day to the day before it. We also measured
the dollar’s price moves from the preceding 20th, 15th, 10th and fifth day prior to each election to the day immediately before it. To gauge how the U.S. dollar performed after elections, we then studied its behavior from the day before the event to the fifth, 10th, 15th, 20th, 40th and 60th days after it.
It shows each election date over the past 31 years as well as the U.S. dollar’s individual gains and losses in the 12 periods surrounding it. For example, “Day -40 to Day -1” measures the dollar’s change from the 40th day preceding the election to the day before it; “Day -1 to Day 40” represents its gain or loss from the prior day to the 40th day following it. (Day 1 is election day.)

The table’s final rows show the dollar’s average, median and benchmark performance, or typical same-length performance since 1973. Each period’s probability of gains is also shown The dollar lost an average -0.95 percent in the 60 days before the election and nearly as much in the prior 40-day
period. These losses faded in the month preceding election day and it gained roughly 0.22 percent in the 15- and 10-day periods.

While the dollar lost an average -0.05 percent on election day (not shown), the index rose 0.10 percent by the end of the first week after it. Also, by the end of the 20th day, or a month after the election, the dollar climbed 0.21 percent. Although the dollar then fell -0.25 percent by the 40th day, it rebounded in
the third month.

Comparing the table’s average and median values reveals a more accurate picture of the dollar’s typical price moves. For example, the -0.95-percent average loss in the 60 days leading up
to the election was likely skewed lower by a few unusually large losses, such as the -7.59-percent sell-off in 1998, since its median value was flat. However, the -0.81-percent drop in the 40-day period is supported by the similar decline in the median value. Also, the aforementioned -0.25-percent average
move from Day -1 to Day 40 is countered by a 0.13-percent median increase for that period. (For more
information about discrepancies between average and median values, see “Average and Median,” p. 35.) It also shows the dollar has welcomed decisive presidential victories. The index has gained at least 1.62 percent by the 60th day after five of the table’s seven presidential elections. The years in which the dollar didn’t perform as well in this period represent close elections.

For example, the disputed 2000 election between Al Gore and George W. Bush led to a -2.32-percent decline, and Jimmy Carter’s fairly narrow victory over Gerald Ford in 1976 boosted the dollar only 0.76 percent by the end of the analysis window. Since neither John Kerry nor George W. Bush command a significant lead immediately before the 2004 election, the dollar may not rally as expected.

Elections and the U.S. dollar

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In the weeks leading up to the recent U.S. presidential election, the question on everyone’s mind (besides the outcome) has been how the event might affect the financial markets. Although most of the attention has been on the election’s impact on the stock market, analysts are also focused on the fate of the U.S. dollar, which is again approaching the eight-year lows hit earlier this year.

Discussions about how this election may influence the U.S. dollar are limited by the infrequency of presidential elections, making it difficult to draw solid conclusions. Also, fundamental analysis (e.g. the implications of economic policy) can tell you more about the dollar’s longer-term trends than its
daily (or weekly) movement surrounding an election.

To find out how elections — presidential and congressional — typically affect the U.S. dollar and whether the event could knock the dollar out of its slump and induce a rally in the next three months, we studied the moves of the Federal Reserve’s U.S. Dollar Major Currencies Index in the 60 trading
days before and after each election from 1973 to 2003.

While this period is relatively short for studying an annual event, it represents an important era in the U.S. dollar’s history. In March 1973, the United States and other major world governments decided to let their currencies trade freely against each other, a policy which scrapped nearly 30 years of fixed currency rates under the prior Bretton Woods Agreement. We also compared the behavior of the Fed’s U.S. dollar index to the New York Board of Trade’s U.S. dollar index futures contract (DX), which was
launched on Nov. 20, 1985, by the New York Cotton Exchange. While the Fed’s major-currency index acts as a proxy for the dollar’s strength, the NYBOT’s dollar index futures can be traded, so its historical performance adds perspective to this analysis.

Overall, the U.S. dollar tended to start sinking three months prior to an election and then rise modestly in the three weeks leading up to the event. This rally typically continued for a month following election day. The dollar posted its largest average gains after presidential elections compared to mid-term congressional elections.

Real numbers on investor behavior

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Relative bond yields are both a cause and effect of real transaction flows. So is the level of a currency. As FX traders, we want to know whether money is going to flow to one currency over another, and also whether existing flows will be maintained at the same levels. The world’s savers generate a certain amount of investible cash every month, and it’s very much a zero-sum game as to who is going to be the beneficiary.

One way we keep score is the U.S. Treasury International Capital System after $63.1 billion in July (revised). Other revisions reduced the January- July cumulative by $17.3 billion. It’s a bit scary that foreign purchases of U.S. Treasuries were only $14.6 billion, down from $22.4 billion in July and $40.6 billion in June. Agency bonds (mostly Fannie Mae and Freddie Mac) were $21.2 billion, corporate
bonds were $26.5 billion, and foreigners sold equities to the tune of $2.1 billion after becoming buyers of $9.8 billion in July and $1.8 billion in June. This was the fourth month in six foreigners were net sellers of U.S. equities. Meanwhile, U.S. investors were sellers of foreign equities and bought only a small amount of foreign bonds ($2.6 billion). If U.S. investors had been net buyers of foreign equities, the net inflow would have been even lower. The monthly average so far in 2004 is an inflow of $73.2 billion, compared to the monthly average of $58.2 billion in 2003 and $47.9 billion in 2002. Yearto date, 2004 has seen an inflow of $585.3 billion compared to $508.3 billion last year.

By country, Japan was a buyer of $27.4 billion (up from $12.3 billion in July), mostly in Treasuries more than half the total capital inflow for the month. China actually sold $800 million in Treasuries but bought $2.5 mil lion in Agencies, while Taiwan also sold $1.1 billion in Treasuries. Hong Kong, Singapore and South Korea were all small buyers. Counties that represent speculators rather than central banks — the Caymans and Bahamas — were still buyers, but in lesser amounts.

A smaller monthly number that still has a cushion is not cause for big alarm, but we also need to worry about the variability of the inflows. The monthly number varies from as high as $104 billion (May 2003) to as low as $6.2 billion (September 2003). We care about foreign inflows into the U.S. more than any other country because the U.S. current account deficit is the gorilla in the living room, generating a need for $50-55 billion per month just to balance the outflow of dollar cash in trade.

China made $5 billion from selling to the U.S. but didn’t turn around and reinvest in it in U.S. paper; China sold U.S. Treasuries and bought only $2.5 billion in Agencies — less than half its dollar earnings. At the September Treasury auction of 10-year notes, foreign central banks bought only 2.8 percent of the offering, after taking 38 percent and 54 percent of the two previous 10-year auctions. Foreign central banks were back in October, taking 32 percent, but their mysterious absence in September is a nagging worry.

Worrywarts fret foreigners will at some point consider they have as much U.S. paper as they want to hold. Fed and Treasury officials mention the potential exhaustion of foreign demand from time to time as a key background factor for dollar depreciation forecasts, although insisting t U.S. is not in imminent danger of a wholesale pullout. Well, no wonder.

The U.S. $23 trillion bond market is the biggest in the world by far. To some extent, the falling dollar the seed of bond market salvation. Bond traders have to offer cheaper prices/higher yields to get buyers to buy, which in turn provides dollar demand to the FX market. But as we know, a trend is a hard thing to shift once it gets going. Watch the relative bond yields for clues as to the persistence of the dollar downtrend and its possible end.

The third component

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So far we have looked at relative nominal returns. As mentioned, money will flow to the highest real return, which means the nominal yield minus the expected rate of inflation. Economists and analysts have fiddled around for years trying to depict expected inflation and incorporating inflation forecasts into their estimate of the real return. In late October the inflation rate in the U.S. was about 3 percent and the inflation rate in Europe was about 2 percent. And as noted in the yield-curve discussion, the market had confidence in the will of the European Central Bank to restrain inflation, more so than its faith in the Fed on the same point. It’s not that Greenspan is more tolerant of inflation — such an idea would set his socks on fire — it’s that he has a mandate to promote growth, too.

In the current environment, beset by oil price shocks, both central banks are curve on the prospect of slower growth, but at some point they may be shocked into raising the long end of the yield curve to reflect higher inflation expectations in the U.S. And while both yield curves could show a lift at the
long end, the U.S. curve may not rise enough at the long end to make up for every expectation.

Assuming the European curve rises by less, a function of confidence in the ECB, European bonds may still be preferable on a real-return basis. Never mind Europe’s slow growth and institutional problems — to the bond investor, the real return and the steadiness of the return are as important as the actual level of return.

Duplicating what the pros see

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Unless you are willing to spring for the cost of a Reuters or Bloomberg terminal abiding trust of the market in the European Central Bank’s iron determination to restrain inflation. As a general rule, you want to buy the currency whose central bank is able to maintain a flattish yield curve, which is an indicator of central bank “credibility.”

A steep yield curve may reflect the prospect of higher growth, but also of higher inflation, while a flattening yield curve can imply lower growth than once expected, especially if the short end is going up, as in the U.S., while the long end is coming down.

These yield curve effects can’t be seen on the yield differential chart of a single maturity, such as the 10-year notes, but they are a hidden factor in their construction. The lesson here is not that the U.S. 10-year note has a 20-point or 40-point advantage over the German Bund and that’s that; the point is how the differential is shifting and how that relates to the two yield curves.

This is why it’s not enough to buy the higher return or sell the lower return — the shape of the yield curve and relative changes in yield count, too.

Getting the information

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As we know, speculative FX trading has far bigger volumes than real deal flow (actual transactions conducted in private between investors and their banks), but second-guessing potential real deal flow makes up a big part of speculative trading.

It’s easy enough to get U.S. 10-year T-note yield data (from the Federal Reserve databank) and overlay it with the euro/U.S. dollar exchange rate. The correlation looks pretty good. As the yield on the 10-year bond was falling, the euro was rising, albeit with quite a lag. But this is only one-third of the story. We also must consider what the yield is doing in the equivalent German 10-year bond (conveniently named the Bund), and we also have totake into consideration the yield shown is the nominal yield, not the real yield. Additionally, it’s not easy to get the German Bund yield. Yields are published every day by financial newspapers such as the Financial Times, but it’s impossible to get the historical data set unless you collect it yourself or pay a data vendor.

Professional FX trader shave charts of 10-year note pairs on terminals as a matter of course. In fact, they set up such charts to show only the yield differentials, and overlay the relevant currency pairs. This is illustrated which shows the U.S. 10-year Tnote/ German Bund yield differential
along with the euro/U.S. dollar rate (courtesy of currency trader Bob Sinche at Bank of America).

The chart shows a daily time frame, but in practice you could display the information in hourly bars, 15-minute bars or any other configuration. Bond traders respond to the same information we watch in the FX market — payrolls, business and consumer confidence surveys, inflation rates, etc., in both countries — and their collective judgment of fresh data is reflected on the chart.

On this chart, the euro (solid line) fell from a peak in February to lows in April and May as the differential (dotted line) went over -.40 points against the euro (right scale). Then the yield differential against the euro started to move back toward zero into September, while the euro was mostly in an uptrend.

In September, there was a curious divergence in which the euro fell while the yield differential was still shrinking. That’s a divergence that doesn’t make sense. There should not be a bias against a currency (the euro) when its return is getting closer to the return on its competitor, the dollar. Hence, if you were watching this chart, you could have predicted the euro was being oversold and was going to rise, as it
subsequently did. The euro broke upside resistance around 1.2420 on Oct. 15 and soared over 1.2800 by Oct. 26 (see chart inset), an unusually sharp breakout.

The obscure key to successful FX trading

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In FX trading, there are a dozen big-picture factors that set the tone for the trading environment, but one of the most consistently reliable is the bond yield differential between two countries.

The logic is straightforward: When capital flows are free from taxes and regulation, the country with the highest real return will attract the most capital inflow, with some consideration for market size, liquidity and transparency.

International bond buyers are chiefly fund managers (including pension and hedge funds) and central
banks. When buyers put new money into a country’s bonds, by definition they are also demanding the country’s currency. And while fund managers and central banks don’t make seismic shifts in their portfolios’ compositions every day (or even every week), professional FX traders keep an eye on whose bonds are looking the prettiest and plan for the day when portfolio rebalancing does take place.

The actual flow of transactions is a closely held secret because of the promise of confidentiality between banker and client.

The big banks and brokers never leak the trades of their fund managers, or disclose the finance
ministry of Country A is getting rid of some U.S. Treasuries in favor of German Bunds or UK Gilts.
Sometimes the finance ministries themselves make such announcements, such as China revealing a few years ago that it was diversifying reserves into the euro, but it’s rare.

Death-defying rebalancing act

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Clearly, something must be done to restore deficits to reasonable levels. But there are several promising signs, and reasons to believe a dollar crisis may not be imminent. First, once-languishing markets like China are on a growth trajectory that could spur new demand for U.S. exports. For another, there is continuous excess capacity in post-tech-bubble markets, including IT and especially labor. Although higher energy and commodity prices remain a concern, excess capacity reduces the likelihood of runaway core inflation.

The government is also working to carefully engineer an orderly expansion, and to trim the trade imbalance by gradually reversing its accommodative interest-rate stance. Global monetary policy makers will continue to gradually raise uncommonly low interest rates but they will only have the luxury to do so at a measured pace as long as core inflation does not surprise on the upside.

As for the risk of a near-term shift in overseas competition, not even the U.S.’s most rapidly growing trading partner, China, can handle the massive export demands of a consumption- oriented market like the U.S. It will take some time before such developing markets build the necessary infrastructure to do so. Progress is quickly being made, however, as China has recently received more
direct foreign investment than any other country, including the U.S. Nonetheless, you can be sure the U.S. will take the necessary steps — e.g., bolstering research and development— to retain its position as a leading destination for foreign trade and investment.

The global rivalry for economic growth will increase, and while demand for raw materials will keep
commodity prices firm, the international competition for jobs will continue to tighten differences in the global standard of living.

Given the significant challenges the U.S. faces with respect to global competitiveness, the value of the dollar is tough to predict long term. But barring unforeseen crises, such as another terrorist attack, continued oil price increases, or a seismic stock market shock, normal cyclical forces are in place to deliver moderate U.S. economic growth that should prevent a disorderly softness of the dollar for the coming 18 months.

The global trading partners also have a stake in the precarious USD

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While a weaker USD could have the positive effect of helping U.S. exports catch up with imports, it would lessen the appeal of foreign investment in dollar-denominated assets. Even so, the U.S. remains the world’s largest market for foreign exports, the U.S. dollar is still the most widely held
reserve currency, and U.S. exports continue to be the main engine of growth for overseas markets.

Central bank intervention could be undertaken to prevent a dollar slide, as foreigners attempt to maintain their exports to the U.S. The last time an international monetary crisis of this sort occurred was in the 1980s, when the U.S. brokered the Plaza Accord to stem further increases in the dollar, which subsequently lost half its value against the yen and the mark within a two-year period. Conditions were very different then, with foreigners concerned about inflationary growth rather than the sluggish demand outlook they now face.

A weak-dollar policy would also have domestic effects, dampening growth in private U.S. consumption. Given the importance of consumer spending and today’s uncommonly high levels of personal debt, a spike in interest rates could have serious consequences, offsetting the benefits of improved trade import/export levels. The dollar’s fall, depending upon how fast and how hard, could significantly impact U.S. purchasing power, both here and abroad.

Factors driving dollar valuations

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The confidence of global and domestic market participants could be compromised by several factors. Oil prices and core inflation continue to be significant risk factors that could weaken global markets.

A shift in competitive foreign markets should also be monitored. The U.S. has long been the global leader in information technology (IT), as our culture and economy are conducive to innovation, capital formation and free market competition.

Lately, however, there has been considerable media and market focus on growing forces of foreign competition. America’s general dominance in IT and the services sector is being challenged by emerging technology suppliers such as Singapore and Taiwan, as well as outsourcing destinations
like India. BusinessWeek reported (“The Promise: Global Brain Power,” Oct. 11, 2004) U.S. investment in research and development of 2.7 percent of GDP was outpaced in 2003 by two thriving innovation hotbeds: South Korea (2.9 percent of GDP) and Israel (4.7 percent of GDP).

These and other countries are becoming major contenders in the race to supply the lucrative global computer and telecommunications networking industries.

In the currency market, traders question the long-term outlook for the dollar given the rise of the euro as a major currency, and the opening of new financial markets. For instance, in an effort to develop its capital markets, China is planning to ease restrictions on foreign investments and exchange (Bloomberg, “To Rally Stocks, China Moves to Ease Foreign Trading Rules,” Sept. 23, 2004). Relaxed capital controls and the formalization of Chinese financial market rules will be key to building global confidence in that market as it matures. However, the magnetic appeal of U.S. markets remains
strong. Unfazed by such jolts as widespread U.S. financial market improprieties in recent years, foreigners continue to entrust their capital to the world’s largest and most secure marketplace. The ongoing recovery and stability of U.S. financial and trade markets is another prerequisite for continued
strength in the USD.

Employment growth will support the dollar, while the reverse is also true. U.S. consumer spending has risen steadily even through the recession, despite such setbacks as investor fears in the wake of the terrorist attacks and following high-profile accounting scandals. With nearly 70 percent of GDP driven by consumers, their ability to spend is a critical driver of currency and broader markets. Continued disappointments in job reports, as in early October, would have a tempering effect. If capital flows are attracted elsewhere and foreigners become reluctant to invest sufficiently in the U.S. to fund
our national deficits, U.S. interest rates must rise to attract foreign funds, and the dollar must fall to make the purchase of U.S. assets and exports more attractive. If interest rates rise, the amount owed to foreign investors for their dollar denominated holdings will rise, adding to the deficit, whichmust be financed.

The dollar and the deficit

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Never before has the U.S. accumulated such staggering levels of foreign indebtedness at such a rapid pace. Over the past year, claims on the U.S. by foreigners rose by $107 trillion through August compared to U.S. investments abroad of $495 billion.

The $580 billion in net foreign capital inflows, accumulated mostly in interest-bearing liabilities, is crucial for funding the massive U.S. current account deficit. But at the same time, these unpaid claims could have calamitous repercussions.

The U.S. account deficit has continued to widen in large part because of the seemingly insatiable U.S. appetite for imports, fueled by the continued relative strength of the dollar and affordability of goods and services in foreign markets. From January through August of this year, U.S. exports of approximately $752 billion were dwarfed by imports of some $1.15 trillion in goods and services with its major trading partners, leaving a deficit of nearly $395 billion.

China plays a major role in the current deficit scenario. Less than a decade ago, the U.S. invested little in the then stagnant Chinese economy, and China’s stake in the U.S. was also relatively small. Today, China is one of the U.S.’s most important trading partners. The fastest-growing global economy, China comprises 12.1 percent of U.S. imports, compared to a mere 4.4 percent of U.S. exports to that market. Basically, U.S. consumption and investment levels continue to substantially outpace U.S. production and sales of goods and services overseas.

Our research shows the trade-weighted dollar (representing the foreign currency price, or the export value, of the U.S. dollar) has depreciated since its peak in 2002, declining by almost 20 percent from the recent February 2002 high to the end of September 2004. Meanwhile, oil prices have surged to all-time highs, troubling markets with the possibility of rising inflation.

Nonetheless, the decline in the dollar has been relatively orderly, facilitated by continued growth in productivity and gross domestic product (GDP), the recovery of U.S. financial markets, the resilience of foreign investors and, at times, the intervention of foreign central banks, which have been willing to absorb the softened dollar’s impact on trade. Central banks orchestrate monetary policy to manage
currency supplies and valuations while influencing import/export trends.

AMERICAS November 2004

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The South African economy continues to expand, as Q2 growth was 3.9 percent greater than Q1. The increase marked the 23rd consecutive quarter of growth, the longest streak since the country began collecting data in 1960. According to the the South African Reserve Bank, manufacturing contributed 1 percent to the GDP, while transportation, communication, finance, real estate and business services contributed 0.7 percent each. The GDP was also buoyed by lower interest rates, a slightly higher budget deficit and favorable international terms of trade.

ASIA & THE SOUTH PACIFIC November 2004

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Australia’s unemployment rate in September fell to 5.6percent, down 0.1 percent from May’s 5.5 percent rate, which was the country’s lowest in 23 years. The news, released just two days before the national elections, has been credited with helping secure a fourth term for incumbent Prime Minister John Howard.
While there has been talk for months of China revaluing the yuan, The State Administration of Foreign Exchange said in mid-October there will be no change to the currency. Unlike most other currencies, the yuan is “pegged” to the U.S. dollar, meaning its value does not fluctuate regardless of the market environment. The current exchange rate is around 8.28 yuan to the dollar, which U.S. manufacturers say is weak and beneficial to Chinese-made goods.
The Central Bank of Japan announced its “quantitative easing” policy will remain in effect until the country’s CPI has a year-on-year rate above zero percent. The easing policy keeps Japan’s short-term rates near zero, sparking economic growth as the money market becomes flooded with extra funds. However, the bank also said it would consider an inflation target above 1 percent so when the CPI did
return to positive territory, market expectations would be stabilized and a return to deflation would be minimized.
The Reserve Bank of India (RBI) raised its overnight interest rate — the benchmark rate in the country — by 25 basis points to 4.75 percent in late October. The RBI said high inflation concerns were the reason for the raise, although it did keep its longer-term rates on hold. That rate has held steady at 6 percent — a 30-year low — since April 2003. The RBI also cut its GDP forecast for the fiscal year ending in March 2005 to a range of 6 to 6.5 percent, down from its earlier 6.5 to 7 percent target. For fiscal year 2004, the growth rate was 8.2 percent.

Europe November 2004

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The United Kingdom saw its Q2 GDP rise 1.4 percent compared to Q1, while the country’s unemployment rate dropped 0.1 percent points from July to 4.7 percent (data is compiled every other month). The unemployment rate is a drop of 0.4 percent compared to August 2003.
German unemployment in September stood at 10.7 percent, up 0.1 percent from the previous month. The number of new unemployed workers increased by 27,000, twice what was forecast. Economists in Germany believe the jobs number indicates companies remain reluctant to hire, even though overall economic signs have been pointing up.
France’s annualized growth rate of 3 percent beat the euro-zone average by about 0.1 percent, according to the National Institute of Statistics and Economic Studies of France (INSEE). The INSEE credits “brisk household consumption, notably of manufacturers, accompanied by an accelerated recovery in investment” for the rise. The INSEE noted rising oil prices add uncertainty to future forecasts, and continued higher prices would “flatten the slope of the recovery without causing a downturn.”RICAS
European finance ministers at the September European Central Bank (ECB) meeting agreed to not adjust fiscal rules governing the euro too radically after most central bankers asked for conservative changes earlier in the month. At a press conference after the meeting, ECB president Jean- Claude Trichet said, ”Let’s improve implementation. Let’s not change the wording of the regulation.”
Trichet also told the European Parliament that Hungary’s government should not be able to increase its influence over the country’s central bank, as the country is proposing. Under the plan, two vice presidents of the Hungarian central bank would be removed from the council that sets monetary policy and interest rates.
Ottmar Issing, chief economist of the ECB, told an ECB conference new members of the European Union should not adopt the euro currency until their economy is ready for it. While Issing believes use of the euro for new members will lead to further trade and financial integration, he also thinks
countries that take on the euro too soon could lose those benefits.
A member of the Bank of England told the BBC the UKeconomy may be growing at a greater rate than numbers released last week suggested. Although economic growth slowed to its lowest rate since the first quarter of 2003, Richard Lambert said he doesn’t believe the growth rate is as slow as the numbers suggest.
In late October, Turkey revealed its new currency, which will go into circulation on Jan. 1, 2005. The new lira comes after 30 years of economic crisis, including hyperinflation for much of the 1990s, although the inflation has eased somewhat since exceeding 100 percent in the mid-1990s. The government hopes the new currency will stabilize things.
The Economy Ministry of Spain said in late October it is keeping its GDP target for 2005 at 3 percent, up from 2.8 percent in 2004. Deputy Prime Minister Pedro Solbes targeted oil prices as a reason for the increase, although he opposes any cuts in fuel tax and instead favors reduced use of oil products.

Australian dollar

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Shifting gears to the other high-yielder down under, the Australian dollar (AUD) has been range-bound since May, but was bumping up against the top of the range in mid-October. After soaring to its 2004 peak at 0.8005 in February, the AUD retreated into a clear-cut sideways range between roughly 0.6770 and 0.7370 in the May- October period.

“We may see a little more strength in the commodity currencies, like the AUD, but it is kind of a last gasp,” warns Solin. “There may be some life left in that trade, but not much. The risk is that you’ll see the latecomers come into that trade and that is it.”

Pointing to the economic outlook in Australia, Thomson Financial’s Rogers notes “people are getting a little nervous about where the Aussie economy is going to go. The fear is that China will slow down and they are Australia’s third largest trading partner.”

The overnight cash rate stands at 5.25 percent in Australia, with the late rate hike seen in December 2003. Looking across the foreign exchange markets, Rogers points out that recently “all the major currencies have made new highs in the last run lower in the U.S. dollar. But, the AUD is not even
close. There is clearly a deceleration going on. The fears of a slowing economy are real.”

Economists are currently forecasting about 3.5 percent real GDP growth for Australia through mid-2005, which would be down from the second quarter 2004 year-over-year 4.1 percent pace.
In recent market action, Rogers notes, “the Asian accounts have been selling into it rather than buying it. The AUD has been struggling to get above 0.7390.”

Rogers recommends traders look to sell the AUD on the crosses, such as the euro, the yen or the Swiss franc. Though, he adds, “selling it against the U.S. dollar would be tough because we are in a broadly declining dollar environment.”

High yielders running out of steam?

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The Reserve Bank of New Zealand (RBNZ) has been on a tear this year, hiking interest rates five
times as of mid-October. Analysts say another .25 basis point rate hike is likely in the cards at the Oct.
28 meeting. If that materializes, it would push the official cash rate there to a whopping 6.50 percent
the highest in the industrialized world.

This aggressive monetary tightening helped the New Zealand dollar (NZD) be one of the strongest currencies against the U.S. dollar in the third quarter. The NZD has rallied from its 2004 low, hit in late May at 0.5912, to near the 0.6950 area in late OctoberBut the fast pace of tightening by the RBNZ could actually backfire and weaken sentiment for the NZD looking ahead. Fears that the RBNZ overtightened, which could actually weigh on economic growth in New Zealand, could depress the currency.

“They may have to pull a Bank of Canada and cut rates in the first quarter of 2005,” says Tom Rogers, senior currency strategist at Thomson Financial. (The Bank of Canada abruptly shifted
gears in its monetary stance mid-year in 2004.)

“The RBNZ has been hiking in a slowly growing global environment and we all know that everything is interrelated,” he adds. Slower growth forecasts for the country have already been issued by the RBNZ, with GDP seen at a 2.5 percent year-over-year rate in the first quarter 2005, vs. second quarter 2004’s
strong 4.4 percent year-over-year pace. Sean Callow, currency strategist at Ideaglobal, echoes Roger’s concerns.

“They might have been too aggressive on their rate hikes,” he says. “While their economy is doing well, they need to be paying more attention to the global economy.”

In addition to concerns over sustaining economic growth amid the tight monetary policy atmosphere, the NZD is hurtling straight toward major psychological and chart resistance at the 0.7100 level, the February 2004 price peak.

“The 0.7000 area is a tough barrier,” says Callow. “Psychologically, that means a lot to the Kiwis. They are worried about their competitiveness at that level. They are very reliant on selling their products to the world and they don’t want to be burdened by a high exchange rate.”

Just this year, New Zealand passed legislation permitting the RBNZ to intervene if the exchange rate is exceptionally high or low. As the NZD approached that 0.7000 level in late October, the New Zealand Finance Minister made statements suggesting the administration was not “comfortable” with the level of the NZD. Speculation of intervention if the NZD moves above the 0.7000 level could provide the currency with a tough ceiling.

“I wouldn’t be buying it here at 0.6900,” says Callow. “At these levels, I’d be leery of coming in and chasing the market higher,” agrees David Solin, partner at FX Analytics.

Looking ahead

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Some analysts say risks exist for a correction or at least a slowdown in the bull trend. David Solin, partner at FX Analytics, notes since January 2002 “USD/CAD has come from the $1.60s to $1.24 in the space of two years.” Can the trend continue? “Not at this pace,” warns Solin. “We are getting very long in the tooth.”

Analysts agree that, at a minimum, there is room for a healthy correction in USD/CAD. Overall, the decline in USD/CAD has been very orderly in recent months and price has retreated within a well-defined downtrend channel on the daily chart. “At some point, we will need a little bit of a shakeout and a dollar rally,” says Coleman.

Traders should anticipate bearish risks such as a sharp pullback in crude oil prices, which could spark a retreat in the Canadian dollar, or an overall shift in bearish U.S. dollar sentiment. Also, there is that high number of speculative traders holding long positions. COT data is typically used in a contrarian fashion, with individual speculators representing the leastinformed and most underfinanced sector
of the trading community. As such, they are prone to rush in at highs and sell at lows. The fact that most of them are long now is an argument in favor of a correction.

Nonetheless, barring any major unexpected events, such as a terrorist attack or a radical shift in Bank of Canada monetary policy, “we are still in a ‘sell the rallies’ mode for USD/CAD,” says Coleman. Traders could look to monitor action within that downtrend channel and “lighten up as we near the bottom of the channel and take advantage of corrections to re-establish shorts.”

Solin agrees forex traders would be best served by shifting to a range-trading strategy as he expected “range-y” market conditions ahead.

Canada looking toppy

2009-06-12T20:14:00.001-07:00

Since late May, the U.S. dollar/ Canadian dollar currency pair (USD/CAD) has trended solidly lower,
falling from the $1.40 area to the $1.24 level, signaling a significant strengthening in the Canadian currency. The reason is simple: Overall, the Canadian economy has performed better in 2004 than most economists expected. Exports grew beyond initial forecasts, which supported GDP growth, while inflation levels remained low.

After posting economic underperformance vs. the U.S. dollar a year ago, some analysts now expect Canada to outperform in 2005. The Bank of Canada recently issued a revised growth forecast for 2005, putting GDP growth just under the 3.0 percent mark, which could compare favorably to forecasts for 2.5 percent GDP growth in the U.S. next year.

But beyond that, a number of other bullish factors have supported the gains in the Canadian currency, including a strong trade surplus (in part helped out by higher crude oil prices) and aggressive tightening by the Bank of Canada. However, some wonder how much stronger the CAD can get.

“Canada has a compelling fundamental story…but an awful lot of good news is already factored into the price,” notes Jamie Coleman, managing analyst at IFR/Forex Watch.

After three rate cuts early in the year, the Bank of Canada shifted gears this summer, from an easing stance to a tightening stance. The central bank hiked rates in September and October, boosting the overnight cash rate to 2.50 percent. In its latest statement, the Bank of Canada suggested additional rate hikes could be expected.

An expanding trade surplus, compared with the U.S.’s widening trade deficit, is also another factor in the bullish camp in recent months, analysts say.

“[Canada] already had a trade surplus, but [has] gotten an extra boost from rising commodity prices in general,” says Sean Callow, currency strategist at Ideaglobal.

Canada’s merchandise trade surplus stood at $CD7.4 billion in August, up from year ago levels at $CD4.9 billion. “They are an oil exporter,” explains Dave Sloan, senior economist at 4Cast Inc. “When oil is strong that is a boost to their growth.”

And oil is indeed strong. New York crude oil prices recently hit a new record level at $55 per barrel before pulling back to around $50 at the beginning of November. Adding power to the overall bull
trend in the Canadian dollar is the speculator buying.

“This is a favored speculative trade,” says Callow. “It’s a very liquid market and nobody is fiddling with it. If someone wants to sell the U.S. dollar, you can’t buy China because it’s fixed. With Japan you might have intervention, but with Canada nobody is going to stop you on the other side of the trade.”

Recent data from the Commitment of Traders (COT) report, released by the Commodity Futures Trading Commission (CFTC), backs this up.

The COT report shows the net positions of different classes of traders. Speculators were long 66,500
Canadian dollar futures contracts, the third largest total since October 1992, according to Callow.

G7 meeting fails to sink dollar

2009-06-12T20:13:00.003-07:00

The Group of Seven repeated a call for more currency flexibility at its last meeting beginning Oct. 1, but did not raise pressure on China to revalue its yuan.

This lifted some weight from the dollar, which was driven down before the meeting. Any move by China to free the yuan — now pegged to the dollar at a level many analysts see as too low — would be expected to put downward pressure on the U.S. currency.

The G7 repeated language used at a meeting last February, reaffirming exchange rates should reflect economic fundamentals and calling for currency flexibility.

In addition, during the meeting the G7 warned high oil prices pose a risk to the global economy, but the economic outlook for 2005 was still favorable.

CME, Reuters announce firms to participate in FX launch

2009-06-12T20:13:00.001-07:00

Chicago Mercantile Exchange, Inc. and Reuters announced in October the seven banks and
futures clearing firms to participate in the launch of CME FX on Reuters.

They are: ABN AMRO; Bank of America; Barclays Capital; HSBC; Royal Bank of Scotland; kandinaviska Enskilda Banken (SEB); and Societe Generale Group members, Societe Generale and Fimat International Banque SA.

Beta testing is expected to begin by the end of Q4 2004, with the launch shortly afterwards.

CME FX will provide Reuters’ global customers with access to CME’s electronic foreign exchange (eFX) markets in a spot equivalent format. The agreement, introduced in May, marks the first major linkage of sell side traders in the interbank FX market to CME eFX futures markets.

The service will be initially available in the United Kingdom and U.S, with later rollouts to other European, Asian and North American markets. Both in-house FX traders and clearing firms for nonmember Reuters customers will be able to trade CME eFX futures on Reuters flagship foreign exchange trading platform Reuters Dealing 3000.

Euro also robust

2009-06-12T20:12:00.004-07:00

Activity was also strong for euro denominated contracts, up by 100 percent.

Business in euro-denominated interest rate swaps expanded by 66 percent. In terms of market size, contracts denominated in euros remained larger than those in dollars — $461 billion vs. $347 billion.

After decreasing between April 1995 and April 2001, activity in yen-denominated interest rate swaps expanded by 119 percent, to $35 billion. According to the BIS, the growth may reflect the signs of economic recovery and the associated changes in the outlook for interest rates.

Activity in pounddenominated interest rate swaps was also up by 157 percent, to $59 billion. Turnover in foreign exchange derivatives — or currency options — was up by 109 percent, to $140 billion. A currency option provides a trader with protection against adverse movements in foreign exchange rates. The share of this segment of the OTC derivatives market remained around 12 percent. Activity was boosted by contracts involving the U.S. dollar (up by 104 percent, to $110 billion), especially the
dollar/euro and the dollar/yen pairs (up by 124 percent and 58 percent, respectively). Turnover also increased for other euro-denominated contracts, by 130 percent, to $23 billion.

Looking at the counterparty breakdown, turnover with other financial institutions rose to 43 percent of global OTC derivatives turnover, up from 29 percent in April 2004.

Dollar still rules, derivatives gain ground

2009-06-12T20:12:00.003-07:00

Between 2001 and 2004, there were no substantial changes in the composition of the FX market.

The U.S. dollar was on one side of 89 percent of all transactions, followed by the euro (37 percent), the yen (20 percent) and the pound (17 percent). It shows the U.S. dollar/euro continued to be by far the most traded currency pair in April 2004, with 28 percent of global volume, slightly less than in 2001,
followed by U.S. dollar/yen with 17 percent (20 percent in 2001) and U.S. dollar/pound with 14 percent (11 percent).

The share of trading in local currencies in emerging markets increased slightly to 5.2 percent.

In the OTC derivatives market, average daily turnover increased by 112 percent between April 2001 and April 2004, to $1.2 trillion at currentexchange rates. The OTC market section consists of “non-traditional” foreign exchange derivatives — such as cross-currency swaps and options — and all interest-rate options.

“What surprised me was the large increase in derivatives trading,” says Osman Ghandour of The Forex Edge. “It appears the forex market is attracting a higher level of speculative fever — always a dangerous sign. “However, what’s more, I think participants have become more sophisticated in trading crossrates, which also adds to the turnover,” he continues. Bank of New York’s Woolfolk also
sees speculative trading as a significant factor in the forex market.

“Currency is now traded as an asset class more so than at any time in the past, and such speculative interests have undoubtedly boosted FX turnover,” he says.

Business in interest rate contracts grew by 110 percent. The increase was driven especially by trading in dollardenominated instruments, which were up by 128 percent, according to the survey. Activity was intense for dollardenominated options, with turnover up a whopping 675 percent.

Because of this jump, trading in interest rate options represented 17 percent of total trading in interest rate products — a threefold increase over April 2001. “If you look at the breakdown of the increase, the largest component is not the spot market, but rather FX swaps, although all three components — spot,
outright forwards and swaps — all posted gains year over year,” says Dave Floyd of Aspen Trading, an FX trading and research firm.

Money managers and individual traders

2009-06-12T20:12:00.001-07:00

According to the survey, trading between banks and financial customers (such as hedge fund managers) rose, and its share of total turnover went up from 28 percent to 33 percent. The survey said the higher activity between reporting banks and financial customers may reflect a sizeable
increase in activity by hedge funds and commodity trading advisers, as well as robust growth of trading
by asset managers (money managers). Between 1998 and 2001, when the last survey was taken, activity in that market segment had been driven mainly by asset managers while the role of hedge funds had declined.

“There are two contributing factors driving the BIS-reported increase in daily turnover in the foreign exchange market,” says Michael Woolfolk, senior currency strategist with Bank of NewYork. “First, the prior tri-annual figure was reduced by the launch of the euro and subsequent elimination of high volume European cross currencies such as the Deutsche mark/French franc (DEM/FRF) and Deutsche mark/Italian lira (DEM/ITL). Given the growth trend in FX turnover during the preceding decade, this number would have been closer to $1.7 trillion without the launch of the euro.

“Second, the current tri-annual turnover figure reflects an acceleration in the velocity of foreign exchange transactions as hedge funds and other speculative trading interests play a larger role in the market,” he adds. The survey reveals trading between reporting dealer banks rose between 2001 and 2004, although its share continued to fall, from 59 percent in 2001to 53 percent in 2004.

According to theBIS, restraining factors might included the continuing consolidation in the banking industry, as well as efficiency gains derived from the use of electronic brokers in the interbank spot market.

The share of trading between banks and non-financial customers edged up slightly to 14 percent.
“[Interdealer shrinkage] is actually a testimony to individual customers,” says Glenn Stevens of FX brokerage Gain Capital. “They’re bypassing the banks and going to market makers like us. Also
the onset of electronic trading has contributed. Price discovery is a lot closer.”

Forex survey finds tremendous increase in currency trading

2009-06-12T20:08:00.000-07:00

A global reserve bank survey confirms what many in the market have suspected: The FX market has grown immensely over the past three years.

The much-anticipated Bank for International Settlements (BIS) Triennial Survey of FX Market Turnover or 2004, released Sept. 30, revealed average daily FX turnover (the value of trading volume) rose from $1.2 trillion in 2001 to $1.88 trillion in April 2004, a 57-percent increase at current exchange rates and a 38-percent increase using 2001 exchange rates.

The triennial report by the BIS, based in Basel, Switzerland, said the rise followed a surge in interest from hedge funds and asset managers.

The 2004 survey shows a large increase in activity in traditional foreign exchange markets compared to 2001. Turnover rose across instruments, but particularly in the spot and forward markets, according to the BIS.

In addition to valuation effects, factors boosting turnover include individual trader and investor interest in foreign exchange as an asset class alternative to stocks and bonds.

Wild, wild west

2009-06-09T02:38:00.001-07:00

For years, forex market regulation was scarce and fraud was rampant. While the industry has cleaned itself up to a certain extent, the FX market is still the Wild West when it comes to taxes.

As mentioned, in most cases there is no reporting of forex gains or losses on a Form 1099, so it’s up to you to gather your own information.

Remember, Form 1099 rules are minimum reporting guidelines set forth by the IRS. New products are constantly being created, and it takes years for the IRS to set guidelines for how each product should be reported. Brokerage firms tussle with the IRS each year on what they must report, as all the changes cause great stress and cost on their accounting systems. Many new and smaller forex brokerages have grown quickly to take advantage of the explosion of interest in cash forex especially after the stock markets went into a bear spin a few years ago. However, many of these firms are not strong on reporting, systems or tax compliance, so you may be on your own when tax time comes. Before you open a forex account, ask your brokerage firm what kind of reporting and support they offer you.

Currency trading is a hot commodity, but not all currency contracts are taxed like commodities. Forex is subject to IRC section 988 rules and, if you’re a trader, you can elect out of IRC 988 and gain 60/40 tax treatment.

Before you begin trading forex, find out if your brokerage firm will help you with trade accounting. If not, you may have a huge accounting headache on your hands come tax time.

Combining accounts

2009-06-09T02:37:00.000-07:00

There have been reports of brokerages that add forex totals to Section 1256 totals on the Form 1099. This is technically incorrect by law — the two transactions should be segregated but it may save you taxes and accounting headaches.

These brokerages might be able to argue you elected out of Section 988 when you opened the account, although it’s best to consult with a trader tax expert should something like this occur.

However, if you have large losses and do not wish to opt out of Section 988, this could be a problem. Again, consult a trader tax expert.

Accounting differences

2009-06-09T02:36:00.004-07:00

Not only do currency futures traders enjoy beneficial tax treatment, they also have it easier when it comes to filing their tax return. Futures brokers send traders (and the IRS) a Form 1099, which provides one total for your gains or losses.

The “mark-to-market accounting” rules of Section 1256 make accounting a snap. Brokerages simply adjust realized gains and losses with beginning- and end-of-year unrealized gains and losses.

The gains or losses listed on the Form 1099 are be reported on Form 6781, then transferred to a Schedule D.

However, forex traders do not have their profits or losses reported on a Form 1099, so they are on their own. Some brokerages offer online reporting, but these are often incomplete and are unreliable when it comes time to fill out a tax return.

So if you trade in anything other than Section 1256 contracts, you will probably need your own accounting solutions or software programs. Unfortunately, most good accounting programs are geared toward stock traders. There is a solution for forex traders, though: the “Performance Record Approach” (PRA) The IRS accepts results from the PRA, and the formula is as follows:

NP=ENA – BNA – C + W

NTA=NP – II + IE+OE
where

NP = net performance

ENA = ending net assets (at market value)

BNA = beginning net assets (at market value)

C = cash deposited

W = cash withdrawn

NTGL = net trading gain/loss

II = investment income

IE = interest expense

OE = other expenses

If you have not switched out of Section 988, the net trading gain/loss should be reported on Line 21 of Form 1040. If you do elect out, the net trading amount should be added to Form 6781 as “cash forex elected out of IRC 988.”

Cash traders using their monthly statement to account for gains or losses can easily get confused. Some traders get different statements for different currencies traded, and trying to figure out profit or loss can be a nightmare. The performance record approach is the answer.

Does electing out make sense?

2009-06-09T02:36:00.003-07:00

Forex traders with trading gains should elect out of Section 988 and into Section 1256. As mentioned earlier, the tax savings can be up to 12 percent.

However, forex traders with losses may be better off getting the ordinary loss treatment that comes with Section 988. Section 1256 losses can be carried back up to three years, but they can only be offset against Section 1256 gains. On the other hand, ordinary losses can be offset against any type of income.

Unfortunately, traders do not have the benefit of waiting until the end of the year to make a decision. IRS rules require traders to elect out of Section 988 on a “contemporaneous basis.” This means you must make your decision before you begin trading — and before you know if you have gains or losses.

The rules also say the election should be filed “internally,” which means you place it in your own records as opposed to filing it with the IRS. Many traders bend the rules and after year-end, if they have gains, claim they elected out of Section 988 earlier in the year. To learn how to elect, visit www.greencompany.com.

Because currency trading has long lagged behind futures and equity trading in popularity, the IRS has not paid close attention to taxpayers electing out of Section 988. However, with the explosion of online trading forex , the IRS is likely to catch up with these traders.

Section 988

2009-06-09T02:36:00.001-07:00

The principal intention of Section 988 is to tax foreign currency transactions that occur in the normal course of global business.

For example, if a manufacturer uses foreign currency to buy something in another country, the fluctuation in exchange rates needs to be taken into account. Section 988 states these fluctuations are treated as ordinary income or loss and reported as interest income or income expense. As a result, they are subject to the ordinary tax rates.

Forex traders are subject to foreign exchange rate fluctuations and as such are taxed under Section 988 rules.

However, currency traders can treat their forex positions as “capital assets” and, thus, elect out of Section 988. Traders who do this will have their currency positions treated as Section 1256 contracts.