Category Archives: USD

Fleshing out USD/CAD

I’m torn about USD/CAD.

For months, I’ve been looking to buy any weakness in the pair but the daily chart has broken a ‘wedge’ pattern to the downside.

My base case if for a rally to 1.12 around mid-year but I won’t fight the technicals.

It’s time to take a step back and evaluate.

Some of the reasons for my expectations for a rally:

1)      Interest rate differentials. The BOC has held rates at 1.00% since Sept. 2010. If any economic weakness materializes, a drop back to 0.25% is likely. The Fed, meanwhile, is already at zero and policymakers have set a high bar for QE3.

2)      Commodity prices. It’s not shaping up to be a good year for commodities, especially if gold is excluded. Europe is headed toward recession, US construction is virtually nil and China’s growth is slowing. These factors may be priced in but I still see downside, especially with the risks from banks, brokerages and fund redemptions.

3)      The threat of crisis. The longer the world remains at the edge of the abyss, the more likely it is that something pushes it over the edge. Europe, China, the US, the Middle East, Russia – each presents a multitude of risks in 2012.

4)      US growth may see USD gains. We know that the USD will outperform CAD on safe haven trades but surprising US growth will not necessarily flow into commodities. If growth is driven by tech and the automotive sector, Canada may be left out.

5)      There are risks in Canada. Housing prices in Canada have detached from reality. Several provinces are nearing budget crisis. Trade disputes are a risk. RIM is probably done.

But that is all old news. Here is some of what has me worried.

1)      Oil. The tension in Iran is once again solidifying Canada as North America’s oil supplier. It is also driving up prices. With investment returns at nearly zero everywhere, some big money might flow into Alberta oilsands.

2)      US stimulus. I often repeat: the US will never do austerity. Instead, more spending is likely on the way, with commodity-intensive infrastructure projects likely to benefit. At the same time, such projects will keep the US deficit high, removing any USD benefit.

3)      A US bank failure (but not a crisis). After what happened at MF Global, it’s clear that nothing has changed. I wouldn’t be surprised to see a blowup at a major US financial this year. The surprise is that it will be quickly contained by the government (perhaps before the news even hits the market) and that would weigh more on USD, especially once talk of regulation re-ignites.

4)      Growth. Canada historically lags US growth. If the US posts a strong first half, there will be a lag before the market appreciates that growth will spill over to Canada.

5)      Mark Carney (BOC Gov). He seems to have a good sense of the risks facing Canada and has consistently fretted about housing. If the US starts to grow, he will beat the Fed on raising rates. If the US falters moderately, he may sacrifice rate cuts in order to control housing inflation.

I’m going to let it sink in for a few days but I’m on guard to sell soon, likely on a break of 1.0050.

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Cable near three-week low

Every day we spin the wheel. Pick one of the PIIGS and pick one of the four following problems: banks, bonds, politics, ratings.

One day it’s Greece and politics, the next it’s Italy and bonds. The news is never positive; just bad or good enough to spark a short squeeze.

I’m generally a trend-following trader and after two weeks of nasty, directionless gyrations, I’m frustrated.

But there may finally be some clarity. I’m closely watching cable right now. The October rebound cleared but failed to close above the 61.8% retracement of the September fall. Now, we are testing the low end of the range and a break may be imminent.

It’s doubtful that I will trade a potential break of 1.5868. Ideally we will get a close below that level and perhaps a weekly close below 1.5820. That would give be the confidence to sell GBP/USD.

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All Bets Are Off as Japan Intervenes, MF Global Sinking

So far USD/JPY has shot to 79.48 from a low of 75.57 and the pair looks like it will push higher after the Ministry of Finance chomps through another set of sell orders  around 79.20. Officials may take aim at 80.00 but based on the comments out of Japan, a Swiss-like peg doesn’t sound likely.

What also has the market spooked is a few headlines from the Wall Street Journal suggesting that clearinghouses and regulators are preparing for an MF Global bankruptcy filing.

It looks as though Interactive Brokers will pick up some client accounts and the rest of the company will be placed into bankruptcy.

EUR/USD is down 120 pips, cable down 150 pips, AUD/USD down 165 pips, USD/CAD up 70 pips and gold down $35.

Intervention and bankruptcy are two of the trickiest trades out there. On the one hand, this channels Lehman and the crisis but MF Global isn’t a huge employer. On the other, what happens as all those bonds hit the market in liquidation. It certainly won’t help Italian spreads.

I want to trade this but I don’t need to trade this, so I’ll sort it out in the morning. If anything, I’m thinking of adding to my EUR/CHF long as traders are reminded about the power, and potential profits, of intervention.

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Taking Stock, Looking to Buy USD

Today marks one month since The New Crisis started. It’s a good time to reflect and flesh out some thoughts on markets and where we’re heading. The lone trading position we’re holding is a long AUD/CAD position. He sold half of it for a 150 pip profit earlier in the week and we’re holding the other half, expecting it to go to 1.05 (spot is at 1.0348, about 50 pips higher than our entry point).

We planned to post far more trading tips here over the past month but it has been such a fast, emotional market that there haven’t been the clear trends and signals that I’m looking for. We blogged about GBP/USD for several days but the elements never aligned for us and we stayed on the sidelines. At the moment, we are thinking about jumping in on the short side.   First, let’s talk about the past month. Thinking about that time, the events that pop into my head the most quickly are:

  1. The debt ceiling debate
  2. The S&P downgrade
  3. Q2 GDP and the revision to +0.4%
  4. The Philly Fed falling to -30.4
  5. Consumer sentiment (Reuters/U Mich) falling
  6. The volatility
  7. The run/retreat in gold

 

So what has changed?

The clear casualty has been confidence. It’s hard to believe all those events took place in only a month because they have profoundly changed the mood in markets and the mood in the United States. Talk of a second recession is ubiquitous and in some ways, that is a self-fulfilling prophesy.

My own feeling is that the US will avoid a technical recession but the outcome will be far worse. It has long been my belief that the US is about to repeat the Japanese ‘lost decade’. Very slow growth and very low inflation for a very long time.

Given the differences in US culture, income disparity, low personal savings rate and fiscal squeeze the likelihood is that the US experience will be worse than what has occurred in Japan. On the upside, the largest multinational corporations will continue to profit from growth in emerging markets and China. Aside from gold and commodities, these are the only places to invest for the coming decade.

But this isn’t an investing blog, it’s a forex trading blog.

What’s going on now is the process of forming a top. This is most obvious in commodity currencies where you have investors still trying to pile into the carry trade only to be wiped out again. This will end badly. Commodity currencies, especially NZD, are going to be hit hardest in the coming weeks as risk unravels.

Why am I so confident that the risk rally is over?

Simply put: bonds. The fixed income market was first in the financial crisis and it’s first now. The bond traders are the smartest and best on Wall Street. If people are piling into 5-year T-notes at yields less than 1%, something very bad is about to happen in other markets. In this environment, you cannot be long stocks, risk FX or in any trade that has worked for the past two years.

Everything is about to reverse. When that happens where do you want to be? The US dollar. When the panic hits everything will need to be unwound. Traders will want to get out of every trade and the one they’re in the most is short USD.

In the month ahead, we will be looking to buy USD at attractive levels against the commodity currencies as we enter The New, Yet Unnamed, Crisis. The best money is going to be made in the early days so be prepared.

 

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This Time is The Same: Trading Lessons From ‘This Time is Different’

I finished reading This Time is Different by Reinhart and Rogoff and I want to share some of my thoughts. Rather than a detailed recap or a sermon about what needs to be done from a policy-making perspective, I want to talk about the lessons traders can take away from this book.

If you’re unfamiliar with the book, it’s essentially an academic analysis of episodes of sovereign default. It’s not an enjoyable narrative but it’s consistently interesting in the way it continually slaps you in the face with the central premise of the book: warning signs of crisis are always there and that they’re always missed, ignored or dismissed because ‘this time is different’.

 

Importantly, it shows 1) How bank-led financial crisis are far more expensive and more difficult to escape than economic crisis. They note that on average in post WWII financial crises, real government debt increased an average of 86% in the three years following the onset of the crisis. 2) How agonizing and difficult it is for governments to escape indebtedness. Once debt-to-GDP ratio hits 100% it cuts heavily into growth and it becomes very difficult to escape a debt spiral. Countries don’t grow their way out of debt burdens, the authors show.

 

These are important points to consider as the US approaches the 100% debt-to-GDP threshold. An important definition the authors make about default is that it is not always an outright denial of external (foreign) debt but often occurs as domestic default, which they define as allowing persistent inflation above 20%. For the US — which holds minimal foreign-currency-denominated debt and manageable foreign-held USD debt — it would be through runaway inflation that ‘default’ would occur.

 

Critically for us, Reinhart and Rogoff note that a currency crash generally precedes a period of runaway inflation. In the US, you could argue that we have already entered the early stages of the currency collapse. The Fed is debasing the USD through quantitative easing while trade and fiscal deficits are generally ignored. It’s not hard to envision a USD crash in the next decade based on the historical examples of the book. In fact, we view it as the likely event that transforms the current path (a Japanese-style era of near-zero growth) into a depression.

 

One passage focuses not just on leaders, but also how traders tend to miss crisis signals: “The greatest barrier to success is the well-entrenched tendency of policy-makers and market participants is to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply.”

 

Bank supervision is an example that jumps out at me because it applies to traders and the current situation. The authors show that governments need to more closely monitor and supervise banks and other financial institutions. Continually, leaders reassure the public that financial institutions are sound even as they struggle and as they collapse.

 

Looking at the current Eurozone and US situation it’s easy to sit back and say ‘this time is different’. This time we have stress tests. This time the lessons of the recent financial crises are still at the forefront of leaders’ minds.

 

As a trader, you have to look at this book and not be moved by the urgency of the authors who talk about the importance of overhauling institutions and putting in safeguards but instead recognize that ‘this time will be the same.’

 

We bring up bank supervision because it’s tempting at the moment to believe banks have rid themselves of risky assets. That the stress tests were comprehensive and proof that leaders want transparency and that they know what’s on the balance sheets of all the systemically-important institutions.

 

Governments never truly want to know what’s on the balance sheet because  they’re scared of what they might find. It’s in their short-term interest to ignore the problems and hope they go away. For them, it’s easy to believe that this time is different because it’s in their interest.

 

Another point to heed is that domestic government debt is opaque and often the source of episodes of hyper-inflation. In the US, this type of domestic debt would include municipal and state obligations. These are both already strained. The other obvious areas flashing warning signs are entitlements, especially medicare and social security. Rather than deal with these problems  actively, the US government procrastinate and the passive response will be an inflationary episode. Again, we have to emphasise that a currency crisis will almost certainly precede the inflation.

 

Finally, the one question that the authors leave unanswered (due to lack of data) and we are struggling with is the effect of counter-cyclical government stimulus in a financial crisis. Their data showed Kenysian style stimulus in an economic crisis diminishes the severity of the crisis but this may not be the case in a financial crisis.

 

The only example of a counter-cyclical response that can be examined is Japan. The result has been twenty years of economic malaise, an extremely large government debt and no easy way forward. It’s an unenviable situation but it is impossible to say that an austerity and a laissez-faire attitude toward the economy would have provided a better outcome. We believe the past twenty years would have been much worse. But we can also argue that the outlook for the upcoming twenty years would be much better if Japan’s debts were at sustainable levels.

 

Counter-cyclical government spending has characterized the 2008 financial crisis and it has inarguably (in my mind) had positive effects on growth. For us, the question now is which countries can resist a second round of counter-cyclical spending in favour of austerity? We believe these will be the best currencies to be invested in over the long term.

 

First, we believe there is almost zero chance the US government slows spending. The US electorate demands action from the government and the upper classes are terrified of high unemployment. At the core, there is no genuine appetite for austerity. Stalled growth will diminish revenue and/or spending will continue to accelerate until a period of default by inflation.

 

As the US implements additional rounds of counter-cyclical stimulus spending, American leaders will attempt to influence on other countries to do the same. From their perspective, if they can persuade other countries to spend, the positive effect on global and domestic growth will be much greater.

 

So the question is: which countries have a political system and population capable of resisting US influence?

 

This is a difficult question to answer. We believe that many governments did not want to introduce stimulus spending in the first round of the financial crisis. Coming out of the G20 meetings in Toronto, however, leaders from all countries agreed to increase spending. A second such agreement is unlikely, instead, the US will push this agenda in a one-on-one fashion.

 

If you believe it will be easy for countries to resist the influence of the US, you’re wrong. The US could easily implement policies that would isolate and hurt countries who fail to cooperate. Efforts like the ‘Buy America’ provisions in the first round of US stimulus are an easy sell to the American public and international trade organizations are not robust enough or fast moving enough to stop even the most obvious flouting of international trade agreements.

 

The US can easily introduce damaging tariffs based on shaky legal definitions as was done to Canada in the softwood lumber affair. The case was before international tribunals as the US collected illegal tariffs for nearly a decade and the funds were never repaid.

 

For this reason, we feel Canada is especially vulnerable. While we believe the Canadian populace is somewhat deficit-averse, many of the lessons from an austerity push in the early 90s have already been forgotten. Less than a month after the large miss in US GDP and the downgrade by S&P, the government has already been asked if it will spend more to stimulate the economy and abandon plans to balance the budget in 2015. So far the answer has been no, but it certainly wasn’t the definitive ‘no!’ that would reassure us, especially given the record deficits the current government produced over the past three years.

 

We feel a similar fate is in store in the UK. David Cameron was elected on an austerity budget but the public still hasn’t felt the impacts of spending cuts. Events like the London riots will grow and the government will lose credibility when recession returns and the drop in revenues undermines any deficit savings from spending cuts (in the eyes of the public at least).

 

If we have any optimism for major economies, it’s in the Eurozone. This is the only area where political structures may be strong enough to resist the American influence. In this case, the US influence may be counteracted by the public and political desire to remain in the Eurozone. The banishment of a bad actor (like Greece) may go a long way to enforcing this goal. If governments can agree to hard limits on deficits it is likely to hurt European growth for the next five years but then set the stage for a lengthy period of outperformance.

 

The lone area where we have genuine enthusiasm is Latin America, particularly the southern cone. The leaders and the public are extremely deficit averse after the episodes in the 90s. The United States and the IMF have minimal influence in this area because of prior failures and the economies there are growing fast enough to maintain political stability of if growth is below potential. At the moment, retail forex trading is largely confined to USD, JPY, EUR, CHF, CAD, AUD and NZD with the second tier including the Scandies, several Asian currencies and several others. South America isn’t even on the map. For us that presents a tremendous opportunity and one we will be writing about in more detail in the future.

 

 This Time is Different: Eight Centuries of Financial Folly

By Carmen Reinhart and Kenneth Rogoff

View it at Amazon

 

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GBP/USD Breaks Out

Cable broke out on Tuesday. In yesterday’s post, we noted that we thought the bias was to the upside, despite the resistance around 1.6475. When that level broke, the pair rallied more than 100 pips. We talked about buying at 1.6500 and perhaps some of you did, but we did not have a buy order in play.

 

The reason we didn’t have a buy order is because we hoped the pair would come back and re-test 1.6475. It’s an effect called ‘buyer’s remorse’ where the pair will re-test a breakout level. This is generally where we like to pickup breakouts. Sometimes we miss the trade but it diminishes the number of false breakouts.

 

With cable trading at 1.6513 at the moment, we are getting an itchy trigger finger. What’s making us hesitant is that we have had 5 consecutive days of gains in the currency that we believe holds a heavy short interest. The weekly IMM data from the CFTC shows GBP is the only currency held short against the USD. That could mean we have been experiencing a short-covering rally. If that’s the case, it’s probably running out of gas and could reverse.

 

Ideally, we would like to see a day or two of consolidation with the pair generally holding above 1.6450. This would relieve somewhat overbought conditions and give us the confidence to aggressively buy. At the moment, we’re going to wait, watch and stay disciplined.

 

Our AUD/CAD trade was up more than 200 pips on Tuesday but has pulled back to 1.0312, which is still 60 pips above our first unit and 20 pips above the portion we added on Monday. We will stay patient but might trim some of our exposure on a close below 1.0296. We are still very confident in this trade and like how the technicals have progressed.

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Cable at Inflection Point

We are awed by the trading possibilities of the GBP/USD daily chart at the moment. We see amazing opportunities to make money long or short depending how the market breaks.

GBPUSD Aug 16

GBP/USD Daily Since Jan

Cable hit the highest since May on Tuesday but it only exceeded the prior high by one pip before slipping back below 1.6450. The area around 1.6475 has now become a critical inflection point. We see a minor bias higher because the break lower after the first two tries at 1.6474 was rejected so aggressively. What makes us hesitant to buy is the lack of follow-thru above 1.6475 on the break.

If cable does break above 1.6475 we don’t expect 1.6547 to offer much resistance. Instead, we anticipate a straightforward rally to 1.6747 and a likely test of 1.7000.

We are in no rush to jump in here. We may see a slide all the way down to 1.6325 before we get the conditions to rally. We will buy on a break above 1.6500.

Alternatively, if GBP/USD falls below 1.6300, we will sell on expectations of a move back to 1.60, or lower.

In either case, we expect to make upwards of 200 pips, so we can afford to be patient.

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July Trade Review: USD Longs (-60 pips)

USD longs versus CHF (at 80.12) and JPY (at 77.92) on July 27. Stopped out of both trades on July 29 July 29. Result: -60 pips

USDCHF trade analysis July 27
USD/CHF Hourly July 25-30
USDJPY trade analysis July 27-11
USD/JPY Hourly July 26-30

Entered with stops at 79.82 (30 pips) and 77.62 (30 pips). Greatest open loss: 30 pips. Greatest open gain: CHF +34 pips; JPY negligible

I entered this pair of trades at the same time. This was late on Wednesday, with a weekend debt ceiling deadline looming. The idea was simple: any good news about the US debt ceiling debate would lead to a pop in USD/JPY. At the same time, USD/JPY had leveled out around 0.8000 so it looked well supported.

What I should have known better: Never bet on the sanity of US politicians. They continued to bumble along until the weekend and eventually made a deal with hours to spare before the Aug. 2 deadline. Part of the reason I erred was because I believed it was necessary to have a deal before the weekend. Media reports mislead me. The lesson, I guess, it to only trade politics if you know the system inside out.

What I’m happy about: The stop was certainly in the right spot. I for 30 pips I bought myself 36 hours of negotiations. When the deal was finalized, it led to a 120 pip (JPY) and 140 pip (CHF) bounce. The rallies were about what I expected. So I took a gamble with 4×1 odds in my favour and lost on bad timing.

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Stocks Have Bottomed But AUD Hasn’t

The S&P 500 will continue to rebound after the post-FOMC rally but forex market risk trades like AUD/USD will underperform as the market adjusts to the zero-growth reality in the United States.

The FOMC decision set off a wild round of trading. In less than two hours, the S&P 500 traded in a 117 point range. Eventually stocks closed at the daily highs and pulled risk trades along for the ride.

Here are some highlights of the FOMC decision:

  • The Fed committed to keeping rates low until “at least through mid-2013”
  • Three FOMC members dissented to ‘mid-2013’ saying they preferred to keep the vague commitment to low rates “for an extended period.”
  • The Fed said growth so far this year “has been considerably slower” than expected. They noted a deterioration in the labor market. There is no longer any mention of “the recovery”. They also noted that temporary factors like the tragedy in Japan account for only some of the recent weakness.
  • Previously, the Fed said it expected the recovery “to pick up” in the coming quarters. It now expects “a somewhat slower” place of recovery. They compounded the downgrade by saying that downside risks have increased.
  • The outlook for inflation was downgraded.
  • The Committee discussed the range of policy tools available to promote a stronger economic recovery… and “is prepared to employ these tools”

The final point was key because it helps explain the rebound in risk assets. It sounds like the Fed has several ideas on how to boost the economy, if need be. The thinking is that after Jackson Hall something will be implemented. This was the course of action with QE2.

To us, a larger factor was the relative value of stocks compared to bonds. After the FOMC, ten-year Treasury yields touched a record low of 2.03%. Dividends on 22 of the 30 stocks in the Dow yield more than 10 years and the average yield is 3.26%. The market tried to bully the Fed into QE3. The Fed didn’t bite (yet at least) so the market took a second look at where it could stash its money and decided risk assets were still a good bet.

That’s the takeaway for the immediate term, but what about the next 4-6 months?

We believe the market is in the process of pricing in a long period of near-zero growth in the US — something akin to the Lost Decade in Japan.

The US government is tapped out and spending cuts will continue no matter the economic state. This will be a headwind to growth, cutting about 0.5% per year from GDP.

The Fed is tapped out as well. There is nothing the Fed can do to lending rates that will stimulate growth. Borrowing rates are next-to-nil and we they don’t have a mandate or the power to get the economy moving.

This scenario may sound negative for stocks but it’s not as bad as it sounds. 1) Companies with solid (A+) ratings can borrow at extremely low  rates. 2) The worldwide economy is growing, booming in some places. Multinationals are making a larger and larger portion of their revenues abroad.

In the forex market, this doesn’t translate into the ‘risk trade’. Slower US growth will hurt commodities more than corporate profits so commodity currencies will underperform. CAD is especially vulnerable because a) rate hikes are priced in. b) Canada is highly integrated with the US. c) raw commodity exports are a large part of the Canadian economy. d) Canadian house prices are overvalued.

The first thing to break down will be the carry trade. This has already begun and will continue as AUD/USD falls to 90-cents. The Canadian dollar will be the next to decline. Traders will increasingly look to emerging market currencies.

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July Trade Review: USD/JPY (+168 pips)

Entered USD/JPY short at 79.21 on July 4. Added July 21 at 78.49. Exited July 25 at 1.0627 (+120 pips) and July 27 (+42 pips). Result: +168 pips.

USDJPY trade analysis July 19
USD/JPY Daily July

Entered with stop at 79.56 (35 pips). Greatest open loss: zero pips Greatest open gain: ~200 pips

I entered this trade on my expectations of problems with debt ceiling talks. On July 18, we were two weeks away from Aug. 2 deadline and expectations were for a deal to get done. The trade was based on my belief that nothing gets done easily or smoothly in Washington – a trade I’ll make every day of the week.

I shared my analysis in a post entitled: Debt Ceiling Hiccups to Come Sell USD/JPY. I wrote “Every story I’ve read late on Tuesday sounds like an agreement is just a matter of hammering out some details and drafting a bill. That is NEVER the case in US politics.”

I posted via stocktwits in this post/chart

What I should have known better: If I would have held the trade until July 28, I would have made 385 pips. The time from the 24 Jul to 28 Jul was frustrating because the news kept getting worse but USD/JPY wasn’t breaking down. There was lots of talk about barriers at 78.00 and 77.75. The news was progressing exactly as I expected but the market wasn’t acting how I expected so I cleared out. I suppose that was a wise move with the first half of the trade but with the second half, I should have just moved the stop lower instead of rushing out of the trade. A bit too cautious.

What I’m happy about: Many things. First, I was never holding a loss on a trade that earned 168 pips. Second, I didn’t jump into the trade on July 18. Instead I waited for a bounce. Even though the bounce was only 15 pips but it was a good start to a very disciplined trade. Third, I added to a winning trade. Fourth, I moved my stops down all the way.

Bonus thought: Look how oversold the RSI is, I almost want to buy USD/JPY expecting a bounce in the next 2-3 days on a debt ceiling deal.

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