Barbara Rockefeller "Big Picture" collection

Vol. 1: 2004-2005

2 Combining fundamentals and technicals in FX trading

(Currency Trader, Oct. 2004)

8 The obscure key to successful FX trading

(Currency Trader, Nov. 2004)

13 The great global imbalance hoax

(Currency Trader, Dec. 2004)

18 Trends, retracements and news in foreign exchange

(Currency Trader, Jan. 2005)

23 The technicals rule

(Currency Trader, March 2005)

28 How to know when not to trade

(Currency Trader, June 2005)

32 What professional traders know that you don't

(Currency Trader, July 2005)

35 Detecting the professionals' footprints: Lessons of the Chinese revaluation

(Currency Trader, Aug. 2005)

40 Fundamentals, technicals, and key reversals

(Currency Trader, Sept. 2005)

44 Myths and scams

(Currency Trader, Oct. 2005)

47 Fundamentals duel the technicals

(Currency Trader, Nov. 2005)
 THE BIG PICTURE

Combining
fundamentals
and technicals in FX trading

2 October 2004 • CURRENCY TRADER

 Technical analysis can help clarify market behavior, but it doesn’t do everything —
and it’s not always correct. The forex market also requires traders to understand
the interaction among the various fundamental catalysts.
T echnical traders like
to think technical
analysis is the quan-
tification of market
sentiment, which consists of a hodge-
podge of fundamental facts, consensus
interpretation of those facts, precon-
ceptions, misconceptions, prejudice
and lies.
Such traders contend it’s not really
worth untangling all these fundamen-
tal elements because price cuts
through all the buzz and clutter, pro-
viding the only truth you need to
make a trade.
However, traders should not dismiss
the study of market fundamentals,
because technical analysis alone does-
n’t always work. If you’ve used techni-
cal indicators for any time at all, you’ve
learned no indicator works 100 percent
of the time — in fact, most work less
than 50 percent of the time. That does-
n’t mean you should discard indica-
tors, but it does mean you should use
multiple tools and money management
techniques. Even then, however, you
can still get blindsided by a change in
market sentiment, which most indica-
tors will confirm only with a lag.
What is the structure of market sen-
timent and how can you use it to make
better technical trading decisions?
Equally important, when should you
pay the most attention to sentiment?
Regarding timing, it’s never more
important to supplement a trading
decision with sentiment than when a
market is consolidating. Prices are non-
trending well over half the time; some
analysts put the figure as high as 70
percent. When prices are consolidating,
we expect a breakout one way or the
CURRENCY TRADER • October 2004
BY BARBARA ROCKEFELLER
other, but it can be devilishly hard to
select the right direction when some
indicators are pointing up and others
are pointing down. If you understand
the components of market sentiment,
however, you can judge their effect on
the technicals, and often be better pre-
pared to jump on the breakout.
Market sentiment is crucial during
corrections, too. You never know when
a correction will turn into a reversal. At
the critical start and end points of a cor-
rection, it is almost always a sentiment
change based on news that triggers the
move. The market often seems to use
some factor or another, real or imag-
ined, to engineer a correction it wants.
Corrections are somehow part of the
natural order of markets, so traders
must invent excuses to exit positions,
whether the story holds water or not.
It’s handy to know whether a corrective
move is rational and valid, or just an
excuse. Analyzing the fundamentals
helps make such distinctions.
Market environment
Market sentiment may seem like a
vague concept, but when you take it
apart, you see it consists of specific fun-
damental and technical components
that interact to generate a bias for a cur-
rency, either favorable or unfavorable.
The bias comes from the overall envi-
ronment, and perception of the envi-
ronment will color the news.
At any one time, a majority of FX
traders agree on the bias even when
they disagree on everything else. In
terms of the components of the envi-
ronment that establish market senti-
ment, there are big-picture factors and
little-picture factors.
Structural conditions. The biggest
factor in the market environment that
establishes sentiment is an economy’s
collection of “structural” conditions.
In the U.S., the most important
structural issue is the current account
deficit, which will be 5.4 percent of
GDP this year and perhaps more — an
unprecedented level in a developed
country. Most analysts say this is
unsustainable, a conclusion cited for
the dollar’s three-year decline that
started in July 2001. It was clear even
then that once the current account
deficit got on the radar screen, it
would be very tough to get it off. At
the time, the deficit was 3.5 percent of
GDP, and it has deteriorated exactly as
expected. That’s the whole point of a
structural problem — it’s the elephant
in the living room.
Another structural element is the
budget deficit — but it’s a lot weaker,
because the free-market character of
the overall economy suggests the U.S.
can earn its way out of it. Fixing the
current account imbalance would
require other nations to do things they
show no inclination of doing, such as
China and other Asian Tigers unpeg-
ging their currencies from the dollar
and Japan leveling the playing field for
U.S. imports.
In Japan, the big structural issues
are the too-high savings rate and too-
low consumer spending level (twin
roadblocks to ending deflation), along
with a risk-averse and ailing banking
sector that will not lend and allow the
multiplier effect to work its magic.
In Europe, the key structural condi-
tion is the rigid labor market. When a
continued on p. 4
3
 THE BIG PICTURE continued
few big European companies (such as a header when Q2 GDP was low, and
Siemens) won longer working hours low specifically because the domestic
without higher pay in a settlement demand component of GDP was soft.
with the unions, the euro benefited Similarly, in the U.S., the dollar took
immediately. Everyone knew right a bath in early August when the non-
away this was news that modified the farm payroll number (part of the
key structural concern. monthly employment report) for July
Cyclical data. Cyclical data, which came in abnormally weak — even
consists of the regularly reported eco- though payrolls are not correlated
nomic factors such as GDP, trade bal- with any other important cyclical indi-
ances, producer and consumer prices, cator — because the market had
retail sales, etc., must be evaluated in become obsessed with payrolls as a
the context of structural conditions. symbol of growth.
Except for a few big items such as GDP Foreign exchange rates are correlat-
growth, cyclical data that is not rele- ed with growth, so the U.S. recovery in
vant in the context of current structur- recent quarters gave birth to the per-
al conditions tends to be ignored. fectly reasonable idea that the three-
For example, when it was evident year dollar downtrend might be com-
Japanese GDP was growing faster than ing to an end. However, if this proves
U.S. GDP in Q4 2003, it was a wake-up to be the case, it would be a triumph of
call because such high growth, not seen cyclicals overcoming a deep, unfavor-
in a decade, potentially signaled the able structural bias — a very tough
beginning of the end for Japanese defla- thing to achieve.
tion. The yen got a boost from the Q4 Trend. The market environment also
and Q1 GDP reports as the structural includes the long-term trend of the
bias was being revised — but then took exchange rate. Figure 1 shows the
FIGURE 1 — THE ENVIRONMENT: EURO/DOLLAR TREND (SPOT, WEEKLY)
The U.S. economic recovery in recent quarters gave birth to the idea the three-year dollar
downtrend might be coming to an end. If correct, it would be a triumph of cyclicals over-
coming a deep, structurally-based downward bias.
Euro/U.S. dollar rate (EUR/USD), weekly
0.85
0.90
0.95
1.00
1.05
1.10
1.15
1.20
1.25
Support line?
2001 2002 2003 2004
M A M J J A SO N D J F M A M J J A S O N D J FMA M J J A S O N D J FM A M J J A S O
Source: MetaStock; data - eSignal
4 October 2004 • CURRENCY TRADER
euro/U.S. dollar (EUR/USD) spot
rate. The price data is inverted to
reflect the dollar’s value. The down-
trend started July 6, 2001, and has last-
ed more than three years so far, punc-
tuated by corrections.
Notice at the end of the chart the
dollar made a higher low in June,
which is connected to the February
low by an upward-sloping support
line. Price is above the long-term linear
regression line (see “Indicators in the
issue,” p. 58), too. This up move in the
dollar started in April — just when
high U.S. first-quarter growth started
to sink in. Is the most recent up move
another correction that could turn into
a trend reversal? The downward envi-
ronmental bias is very strong, so it will
take powerful cyclicals or other factors
to overcome it.
Strangely enough, a powerful factor
could be price moves themselves. The
FX market, like other markets, watches
itself. Market action is a factor in the
next market move, independent of
structural and cyclical concerns —
a feedback process George Soros
referred to as “reflexivity.”
A very high percentage of FX
traders depend on technical analy-
sis of one stripe or another, includ-
ing ideas such as the exhaustion of
a trend pattern. It may seem
strange to include technical factors
in a list of market sentiment deter-
minants, which we normally
would think of as “fundamentals,”
like the current account deficit or
GDP. But in practice, FX technical
factors can be as weighty as the
cyclicals in any given period — and
a big enough technical trend
change can alter perception of
structural conditions, too.
In other words, we think of the
technicals as reflecting fundamen-
tals, but we have dozens of funda-
mentals, so sometimes a technical-
driven change forces us to shift our
perception of which fundamentals
are the important ones. Technicals
don’t “influence” the fundamen-
tals, but they influence how much
continued on p. 5
 THE BIG PICTURE continued
relative weight we give them.
Institutional factors include the few
tidbits of “dollar policy” that some-
times fall from the lips of the Treasury
Secretary, but mostly the institutional
component is all Fed, all the time.
In July 2004, for example, the Fed
chairman asserted any soft spots in the
economy were transitory and the mar-
ket should expect “measured” rises in
the Fed Funds rate that would normal-
A wide-range bar is hardly ever a one-time anomaly when it is associated
with an significant market event.
ize interest rates to a level appropriate to
a full and sustainable recovery. And in
mid-September, the Fed dutifully raised
the Fed Funds rate for a third time.
Exchange rates are also correlated
(at least sometimes) with the interest-
rate differential, so again it was only
rational to wonder if the long dollar
downtrend might be ending when the
Fed began raising rates. As the Fed
started making hawkish noises, for
example, the high-yielding currencies
softened and the dollar was purchased
as traders unwound some “carry
trades” (see “Getting a lift from the
carry trade,” p. 32).
Political factors, including foreign
affairs, are another component of the
environment. One of the dollar’s cor-
rective up moves occurred in March
2003 when the U.S. invaded Iraq.
Overall, the situation in Iraq is an envi-
ronmental negative, chiefly because
other countries are critical of U.S. poli-
cy. For example, when the Madrid
train bombing occurred on March 11, it
was the dollar that fell, not the euro.
This would appear to be a strange
reaction unless you understand that
any act of terrorism — even if it takes
place in another country — is now dol-
lar-negative. Not surprisingly, the out-
come of the presidential election is
sure to impact the dollar.
News. The news is meaningful only
in the context of already-existing mar-
ket sentiment. One or two good num-
bers, for example, don’t change an
5 CURRENCY TRADER • October 2004
overall negative bias, just as a few bad
numbers won’t make much of a dent in
a positive bias. A string of all-bad or
all-good numbers can cumulatively do
the job, though.
News comes in two flavors: regular
daily news that turns the market-senti-
ment dial toward bullish or bearish,
and “event”-type news that changes
everything. Both garden-variety and
event-type news influence the envi-
ronment and are in turn influenced by
it; it’s a complex interactive process.
When you hear consumer confidence
is way down, for example, you expect
retail sales to fall, and since the con-
sumer is two-thirds of the U.S. econo-
my, you expect GDP to fall, too. As
noted earlier, exchange rates are corre-
lated with growth rates. When con-
sumer confidence falls in the U.S., the
knee-jerk reaction is to sell the dollar.
Ah, but will the selling prevail?
It depends on whether the market
sentiment was biased in favor of the
dollar or against it before the release.
In terms of garden-variety news such
as consumer confidence, let’s say the
current consensus view has been gen-
erally favorable to a particular curren-
cy, and now the currency-negative
news comes out. The price seesaws
back and forth while traders absorb
the information, but if the news is not
jarring and can fit without too much
effort into the prevailing consensus,
the existing trend or directional bias
will usually win in the end.
In fact, a dip on bad news actually
constitutes a buying opportunity and
the bulls will quickly put themselves
back in charge — which is what hap-
pened after the end of the initial hot-
war period in Iraq. The war itself was
long-anticipated and the market
bought the dollar on the news, but the
U.S.’s swift dismantling of the Hussein
regime was not a strong enough factor
to overcome the existing negative bias
for more than a brief period.
Event news operates on a different
scale altogether. It can be scheduled
news, such as the employment report,
or it can be an out-of-the-blue shock,
such as the Sept. 11, 2001, terrorist
attacks. News that rises to the “event”
level is by nature wildly different from
the consensus estimate, such as when
payrolls come in at 32,000 when they
were forecast at 225,000, which was the
outcome on Friday, Aug. 6. When an
event is bizarre enough (and such a low
payroll level was bizarre), it becomes an
event shock almost on a par with an
out-of-the-blue shock.
An event shock changes everything
because it doesn’t fit into an existing
cyclical scenario. Payroll growth of only
32,000 compared to an average of some
124,000 over the previous three years
means expectations of future payrolls
numbers are going to be less trustwor-
thy than usual and, therefore, so will
data on consumer sentiment, spending,
retail sales and a host of other funda-
mentals. Any hope the cyclical data
would overcome the environmental
negative bias is now out the window. In
this case, the payroll event reinforced
the negative bias in market sentiment.
Anatomy of an event shock
Figure 2 shows the September 2004
euro futures (ECU04) contract. This
chart shows the price action in terms of
the euro, so “up” on the chart means
the euro price is rising vs. the dollar.
At the time of the payroll shock the
market was giving due consideration
to the possibility of the dollar starting
an up move. The dollar started moving
up (and the euro down) in mid-July.
Remember, the euro down move
occurred in the context of a longer-term
up move corralled in a wide trading
range that was congested and choppy
at the same time.
Two days ahead of payroll and four
days ahead of an expected Fed rate hike break on the news. This is the essence abnormally wide-range bar that broke
— both supposedly regular news stories of a consolidation, which often reflects the top of the average true range chan-
— the euro failed to match a previous indecisiveness. There is still a prepon- nel and carried the RSI above 50. A
low (horizontal line). It came within a derance of lower euro lows, which is wide-range bar is one that is a certain
whisker, but was still 23 points (more an important characteristic of a down- percentage (e.g., 50 or 100) larger than
than 20 percent) away from the previ- trend, but it is offset by the failure to the average bar over the previous n
ous low in a technical environment match or exceed the previous low, number of days (e.g., 15). In this case,
where the average high-low range was which suggests the down move is the bar was 200 points when the recent
109 points. The inability to match an old over. So, what action should you take? 15-day average was 109 points. A wide-
low reveals the dollar-negative bias was Bottom line: There’s no technical or range bar is hardly ever a one-time anomaly
still alive and kicking. fundamental basis for a decision until when it is associated with an event.
If the non-farm payroll number had the news actually comes out. It could go The expected rate increase from the
been within spitting distance of the either way. Price is not providing a clear Fed materialized and the euro put in a
consensus, those 23 points might have reading of market sentiment. A good close at the low for one day — a nor-
vanished and the down-sloping stan- payroll number would reinforce the mal, news-triggered outcome, but not
dard error channel might have been case for the rate hike, and together these an event. A few days later (and one
vindicated. In fact, the euro uptrend factors might feed the dollar-reversal week after the employment report)
would probably have reversed to a scenario. A bad payrolls number might came the coup de grace — the trade
downtrend once the old low was taken not stay the hand of the Fed, but it kills deficit hit a record high, reminding
out, because a whole slew of indicators the dollar up move. everyone why they had acquired a
would have turned negative, too. This And that’s what happened. The pay- dollar-negative bias in the first place
would have shown the upcoming rate roll number turned out to be so bad it three years ago.
hike was the decisive factor, after all, in became an event — as evidenced by the continued on p. 7
its own right and also as a
symbol of robust growth. You
can think of the potential FIGURE 2 — EURO DOWN MOVE DERAILED BY EVENT SHOCK
reversal of the negative bias as The price action in the days leading to (and even the day of) the Aug. 6 employment
requiring two favorable fac- report did not conclusively indicate which direction the market would break on the news.
tors, one cyclical and one There was no technical or fundamental basis for the decision until the news actually
came out.
institutional.
But the day before the big RSI September 2004 euro futures 65
news, the market made a one- (ECU 04), daily 60
day bet against the dollar. (It 55
50
might have been a bet the pay- 45
rolls news would be bad.) 40
Price closed above the open,
breaking the standard error Event shock 1 Event shock 2 1.250
channel and carrying the rela- 1.245
tive strength index (RSI) close 1.240
to its midpoint. 1.235
1.230
At this point, however, a 1.225
robust payrolls report could 1.220
still have made the euro bulls 1.215
who bought on the close regret One-day bet
1.210
their bet. In fact, the day of the 1.205
1.200
announcement, the price
1.195
opened lower than the previ- 1.190
ous close (and traded lower) 1.185
before turning to the upside. 1.180
In short, you could not have Lowest low not matched 1.175
known from the price action 1.170
1.165
in the few days leading up to
14 21 28 6 12 19 26 2 9 16
the employment report (and
July August
even on the day of its release)
Source: MetaStock; data - eSignal
which way the price might

October 2004 • CURRENCY TRADER 6

 THE BIG PICTURE continued
Except for a few big items such as GDP growth, cyclical data that is not relevant
in the context of current structural conditions tends to be ignored.
Trade numbers have a curious track
record in forex analysis. They are a key
variable in fundamental cyclical analy-
sis, and yet they hardly ever produce an
“announcement effect.” This time,
though, the reaction was tremendous
and constituted a second event. The
euro hit a nearly one-month high and
closed at its high for the day. Now all
doubt was removed. The dollar
bears/euro bulls won. The new consen-
sus was the bias is back — big time —
and the euro would target new highs.
The wide-range-bar effect is some-
what reliable, but you absolutely must
know the bias embedded in market
sentiment ahead of time and how the
cyclical data fits into it. Of the 39 wide-
range down bars over the past four
years, the euro was trading lower 15
days later only 40 percent of the time.
Of the 57 wide-range bar up moves
over the past four years, the euro was
higher 15 days after the big-bar day 60
percent of the time.
Here’s where things get a little tricky.
If you know a news announcement will
be an event shock if the data deviates
wildly from the consensus estimate,
you can forecast a wide-range day and,
thus, take the trade in the direction of
the bias on the same day as the
announcement with a better than 50-50
chance of being right, not only on the
same day but also 15 days later. (And
traders know this, which is why profit-
taking in the euro after the wide-range
days on the chart was so modest.)
Lessons
The euro scenario in Figure 2 offers a
number of lessons about processing and
acting on fundamental information.
1. Cyclical news, when it consti-
tutes an event shock, trumps the
institutional environment. The Fed
did, in fact, raise rates after the
employment report event and the mar-
ket yawned. If anything, the discon-
24
nect between the data and the Fed’s
actions will arouse talk of the Fed
being “off the curve.” (Note that dis-
satisfaction with the Fed is itself an
environmental negative.)
2. The period right after an event
shock is characterized by the market
ignoring news counter to the direc-
tion of the shock and exaggerating
the importance of news in the direc-
tion of the shock. In a negative-bias
environment, the market will stick like
Velcro to bad news. Moderately bad
news is blown out of proportion, truly
bad news dramatically accelerates the
move, and there is almost no good
news with enough weight to reverse or
even dent the move once an event has
reinforced the bias. This works in
reverse, too. When the environment
generates a favorable bias, bad news is
not heeded. Remember the “Teflon
dollar” in the late 1990s? Bad cyclical
news didn’t stick.
Currently, it would take the capture
of Osama bin Laden, a major and sus-
tainable drop in the price of oil, or
something else from left field to gener-
ate even a wobble, let alone a reversal.
Event shocks generally last a minimum
of one week, often three to six weeks,
and in the case of an economic variable
with implications for other economic
data, sometimes many months.
3. Know ahead of time which news
is capable of becoming an event and
triggering a breakout move. A good
trader is prepared. Fashion changes
regarding what news stories/environ-
mental factors have the potential to
goose a currency — you owe it to
yourself to know what they are.
As mentioned, the trade deficit hard-
ly ever does it, at least not on its own.
Payrolls have been at the top of the list
for about a year, deservedly or not. The
Institute of Supply Management report
(formerly the Purchasing Managers
Index) was not important for years, but
now it’s right up there near the top of
the heap, while industrial production
and capacity utilization data, which
was big in the late 1970s and early
1980s, is routinely ignored. Oil price
moves are events in mid-August and
probably for a long time to come, while
inflation data has the potential to be an
event. The stock market has a very
inconsistent correlation coefficient with
the dollar, but sometimes the FX mar-
ket chooses it as a factor.
At any one time, only a handful of
factors are potential events and you
can neglect the rest. If you are risk-
averse, avoid having positions when
the news contains a potential event. If
you are risk-seeking, learn to evaluate
the tolerance limits of the news so you
can instantly judge when news is going
to become an event.
4. The bar itself is chock-full of
information. The one-day bet against
the dollar the day before the news was
a warning the market was itching for an
excuse to sell dollars. Because no one
can forecast the payrolls series with any
degree of accuracy and nobody had
inside information, this was the big-pic-
ture, long-term bias at work.
5. A wide-range bar with a close at the
high is rarely just a meaningless spike
when associated with an event. There
are meaningless spikes in FX prices, but
this was not one of them. And a double-
whammy set of big-bar days with closes
at the high was pretty conclusive.
When the market is likely to trans-
form news into an event, watch the bar
as it unfolds. A price bar is as close as
you can get to a direct response to
news — immediate market sentiment.
You should almost always enter on an
event, even though you won’t get in at
the very beginning.
CURRENCY TRADER • October 2004
 THE BIG PICTURE

The obscure key

to successful FX trading
Watch what the pros watch: Explore the relationship
between currencies, bond yields and interest rates.

BY BARBARA ROCKEFELLER

I n FX trading, there are a dozen

big-picture factors that set the
tone for the trading environ-
ment, but one of the most con-
sistently reliable is the bond yield dif-
ferential between two countries.
The logic is straightforward: When
capital flows are free from taxes and
regulation, the country with the high-
est real return will attract the most
capital inflow, with some considera-
tion for market size, liquidity and
transparency.
International bond buyers are
chiefly fund managers (including pen-
sion and hedge funds) and central brokers never leak the trades of their banks), but second-guessing potential
banks. When buyers put new money fund managers, or disclose the finance real deal flow makes up a big part of
into a country’s bonds, by definition ministry of Country A is getting rid of speculative trading.
they are also demanding the country’s some U.S. Treasuries in favor of It’s easy enough to get U.S. 10-year
currency. And while fund managers German Bunds or UK Gilts. T-note yield data (from the Federal
and central banks don’t make seismic Sometimes the finance ministries Reserve databank) and overlay it with
shifts in their portfolios’ compositions themselves make such announce- the euro/U.S. dollar exchange rate, as
every day (or even every week), pro- ments, such as China revealing a few shown in Figure 1. The correlation
fessional FX traders keep an eye on years ago that it was diversifying looks pretty good. As the yield on the
whose bonds are looking the prettiest reserves into the euro, but it’s rare. 10-year bond was falling, the euro was
and plan for the day when portfolio rising, albeit with quite a lag.
rebalancing does take place. Getting the information But this is only one-third of the
The actual flow of transactions is a As we know, speculative FX trading story. We also must consider what the
closely held secret because of the has far bigger volumes than real deal yield is doing in the equivalent
promise of confidentiality between flow (actual transactions conducted in German 10-year bond (conveniently
banker and client. The big banks and private between investors and their named the Bund), and we also have to

8 November 2004 • CURRENCY TRADER

 FIGURE 1 — U.S. 10-YEAR NOTE YIELD (INVERTED SCALE) AND EURO/U.S.
DOLLAR RATE
take into consideration the Although there was a degree of lag, the yield on the 10-year note was falling as the euro
yield shown is the nominal was rising.
yield, not the real yield.
Additionally, it’s not easy 1.31 95.0
1.30 U.S. 10-year note
to get the German Bund 1.29 yield 95.5
1.28
yield. Yields are published 1.27 96.0
1.26
every day by financial 1.25 Euro/U.S. dollar
1.24 96.5
newspapers such as the 1.23 97.0
1.22
Financial Times, but it’s 1.21
1.20 97.5
impossible to get the histor- 1.19
1.18 98.0
Rate

Yield
ical data set unless you col- 1.17
lect it yourself or pay a data 1.16 98.5
1.15
vendor. 1.14 99.0
1.13
Professional FX traders 1.12 99.5
1.11
have charts of 10-year note 1.10 100.0
1.09
pairs on terminals as a mat- 1.08 101.0
ter of course. In fact, they 1.07
1.06 101.5
set up such charts to show 1.05
1.03 102.0
only the yield differentials, 1.02
1.01
and overlay the relevant 1.00
currency pairs. This is illus- 2003 2004
trated in Figure 2, which Source: eSignal and Reuters DataLink
shows the U.S. 10-year T-
note/German Bund yield differential (courtesy of currency trader Bob The chart shows a daily time frame,
along with the euro/U.S. dollar rate Sinche at Bank of America). continued on p. 10

FIGURE 2 — 10-YEAR T-NOTE/BUND YIELD DIFFERENTIAL WITH THE EURO/U.S. DOLLAR

In September the euro (solid line) fell while the yield differential (dotted line)
EUR/USD, daily 1.285
continued to shrink. There should not be a bias against the euro when its return
is approaching that of its competitor, the dollar. This implied the euro was being
1.275
oversold and was going to rise, which it did. The inset chart shows the euro’s
move above 1.28 later in October.
1.265

1.255
1.2800 0.20

25 Nov.
0.10
1.2600
0.00 Yield difference

1.2400 -0.10
Euro price

-0.20
1.2200
-0.30

1.2000 -0.40

1.1800
15 2 16 1 15 1 15 3 17 1 15 1 15 2 16 1 15 1 15
Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct.
Source: Bloomberg

CURRENCY TRADER • November 2004 9

 THE BIG PICTURE continued

but in practice you could display the minal, it’s the devil to get the same get an insight into the likelihood of a
information in hourly bars, 15-minute information and display it usefully. trend persisting. In this case, the dif-
bars or any other configuration. Bond However, you can construct a rough- ferential favoring the dollar was losing
traders respond to the same informa- and-ready alternative by subtracting points, but the dollar wasn’t falling
tion we watch in the FX market — pay- the CBOT bond futures contract from commensurately. The bond market
rolls, business and consumer confi- the Eurex Bund futures contract to get was setting up the dollar for a fall.
dence surveys, inflation rates, etc., in the price differential, then making an Using futures prices to derive the
both countries — and their collective index out of that (see Figure 3). Again, yield differential, by the way, compli-
judgment of fresh data is reflected on the euro slip-slides sideways all sum- cates matters somewhat, because the
the chart. mer while the index is falling, indicat- primary difference between the cash
On this chart, the euro (solid line) ing the price difference (and therefore price and the futures price is the cost of
fell from a peak in February to lows in the yield differential) is narrowing. financing the futures position.
April and May as the differential (dot- You can get the CBOT and Eurex Financing a three-month futures posi-
tion entails using a three-month
financing cost, so the three-month dif-
When capital flows are free from taxes and ferential is already built into bond
futures prices as well as currency
regulation, the country with the highest real return futures price.
Now consider that in between the
will attract the most capital inflow. three-month financing cost and the
yield on the 10-year note is all the rest of
the yield curve, and yield curves
ted line) went over -.40 points against data from many data vendors, change shape. Over the summer of 2004
the euro (right scale). Then the yield although you’ll have to pay two and into the fall, the yield curve in the
differential against the euro started to exchange fees for what really is one U.S. was flattening due to growing
move back toward zero into piece of data. Alternately, you can get expectations the “soft patch” would
September, while the euro was mostly the live data free with a time delay persist and the Fed would be slow
in an uptrend. from Internet sources such as about raising interest rates. Meanwhile,
In September, there was a curious www.futuresource.com. the European yield curve was already
divergence in which the euro fell while It’s a laborious process, but it may fairly flat, having a higher starting
the yield differential was still shrink- be worth the cost and effort when you point at the short end and reflecting the
ing. That’s a divergence that
doesn’t make sense. There
FIGURE 3 — BUND MINUS T-BOND FUTURES WITH EURO FX CONTINUOUS FUTURES
should not be a bias against
a currency (the euro) when The Euro FX (blue) slides sideways all summer while the Bund-bond index (black) falls,
its return is getting closer to which means the yield differential is narrowing.
the return on its competitor,
3.0 1.30
the dollar. Hence, if you
were watching this chart, 3.5 1.25
you could have predicted
Bund-bond differential

1.20
the euro was being oversold 4.0
and was going to rise, as it 1.15
4.5
subsequently did. The euro 1.10
Euro FX

broke upside resistance 5.0

1.05
around 1.2420 on Oct. 15
and soared over 1.2800 by 5.5 1.00
Oct. 26 (see chart inset), an 0.95
6.0
unusually sharp breakout.
0.90
6.5
Duplicating what the 0.85
pros see
0.80
Unless you are willing to
1997 1998 1999 2000 2001 2002 2003 2004
spring for the cost of a
Source: Reuters DataLink
Reuters or Bloomberg ter-

10 November 2004 • CURRENCY TRADER

abiding trust of the market in the
European Central Bank’s iron determi-
nation 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 indica-
tor 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 sin-
gle 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.
The third component
So far we have looked at relative nom-
inal 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 man-
date to promote growth, too.
In the current environment, beset by
oil price shocks, both central banks are
CURRENCY TRADER • November 2004
busy denying a long-term secondary
inflation effect while hedging their bets
by speaking solemnly of the risk. This
gives U.S. bond traders a problem:
They are choosing to flatten the yield
To some extent, the falling dollar contains 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.
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 impor-
tant as the actual level of return.
Real numbers on investor
behavior
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
report, which comes out every month
for the month two months back (e.g.,
the August report came out in
October). It showed the net capital
inflow in August was only $59 billion
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 purchas-
es 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, corpo-
rate bonds were $26.5 billion, and for-
eigners 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 for-
eigners were net sellers of U.S. equi-
ties. 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. Year-
to-date, 2004 has seen an inflow of
$585.3 billion compared to $508.3 bil-
lion 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 mil-
lion in Treasuries but bought $2.5 mil-
continued on p. 12
11
 THE BIG PICTURE continued
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 cen-
tral 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
12
dollar earnings. At the September
Treasury auction of 10-year notes, for-
eign central banks bought only 2.8 per-
cent of the offering, after taking 38 per-
cent and 54 percent of the two previ-
ous 10-year auctions. Foreign central
banks were back in October, taking 32
When buyers put new money into a country’s
bonds, by definition they are also demanding
the country’s currency.
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 deprecia-
tion forecasts, although insisting the
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
contains the seed of bond market sal-
vation. 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 rela-
tive bond yields for clues as to the per-
sistence of the dollar downtrend and
its possible end.
November 2004 • CURRENCY TRADER
 THE BIG PICTURE

The Great Global

IMBALANCE HOAX
Is the U.S. account deficit a real

problem, or is the Federal Reserve

concerned about something else when

it publicly talks down the dollar?

13 December 2004 • CURRENCY TRADER

BY BARBARA ROCKEFELLER
F rom 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 dol-
lar’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 foreign-
ers, 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 for-
eign 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 annu-
ally. The dollar fell 21 percent against
the Deutchemark the following year,
and another 18 percent the year after
CURRENCY TRADER • December 2004
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’s comments at the
G20 meeting in Berlin were practically an invitation
to sell dollars.
Fed Chairman Alan Greenspan laid
down the rules for thinking about the
global imbalance (www.federalre-
serve.gov/BoardDocs/speech-
es/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 lan-
guage, 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 con-
tributes to open acceptance of the dol-
lar 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 mar-
kets.
Consensus opinion
By now, everybody is talking about the
dollar’s inevitable further decline,
with even an august figure such as for-
mer Fed chairman Paul Volcker speak-
ing of a 75 percent probability of a cur-
rency “crisis” sometime in the next
five years. Publications ranging from
The Economist, Business Week and Wall
continued on p. 15
14
 THE BIG PICTURE continued
FIGURE 1 — TWO CURRENT ACCOUNT PANICS: EURO/DOLLAR, 2003-2004
In late 2003 and currently, the dollar has plunged vs. the euro.
euro (EUR), daily
Oct. Nov. Dec. 2004 Feb. Mar. Apr. May June July Aug. Sept. Ocr. Nov.
Source: eSignal
Street Journal to mass-market maga-
zines 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 imbal-
ance 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-per-
cent (if any) improvement in the trade
balance.
Growth in the U.S. generates more
imports than growth in other coun-
tries. 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
15
1.33
1.32
1.31
1.30
1.29
1.28
1.27
1.26
1.25
1.24
1.23
1.22
1.21
1.20
1.19
1.18
1.17
1.16
1.15
1.14
1.13
1.12
would go into relatively deeper reces-
sions 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 for-
eign exchange market into a frenzy
over the current account deficit? After
all, the current account deficit has been
growing steadily since 2000 — the dol-
lar 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, as illustrated by Figure 1.
The global imbalance obviously
does not have a direct one-to-one rela-
tionship with the dollar. From an eco-
nomic standpoint, in the typical trade-
deficit 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 invest-
ment 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 view-
point, 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 hold-
ings 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, com-
pared 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 cumula-
tive 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 coun-
tries, 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.feder-
alreserve.gov/pubs/ifdp/2000/692/
default.htm). Deficits become unsus-
tainable 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
December 2004 • CURRENCY TRADER
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.
This time it’s different
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 instru-
ments.
We honestly don’t know what con-
stitutes “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 coun-
tries 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 govern-
CURRENCY TRADER • December 2004
ment 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 dol-
lar 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 domes-
tic financial markets. The economists
say the empirical evidence (using
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.
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.
Debt: The story behind the
story
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 per-
verse 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 govern-
ment that hasn’t always earned praise
from economists and financial experts
on other matters, such as fiscal recti-
tude 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 coun-
try imports capital but then spends it
on consumption goods rather than
capital investment, it is failing to pre-
pare 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 question-
ing, 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 lit-
erally standing in the way. In
September, San Francisco Fed Presi-
dent Yellen got this particular current
continued on p. 17
16
 THE BIG PICTURE continued
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 cri-
sis 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 occa-
sion of Mr. Soros’ fabled billion-dollar
profit). It may not be too fanciful to
imagine that the Fed has been deliber-
ately 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 stabil-
ity, 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 mecha-
nism to ensure further growth and
employment.
17
The market talks about the sustain-
ability 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
The U.S. is not only a debtor nation; it is also
a nation of debtors.
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. econ-
omy 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 cre-
ating 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 cur-
rent account, even if other efforts
behind the scenes are successful in
pressuring China to revalue the ren-
mimbi. 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 coun-
tries, 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 bil-
lions 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 curren-
cy 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 unprece-
dented 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 prob-
lem, 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 developments, 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? 
December 2004 • CURRENCY TRADER
 THE BIG PICTURE
Trends, retracements and
news in foreign exchange
BY BARBARA ROCKEFELLER
I
n December, the foreign
exchange market behaved in a
peculiar way. The euro/dollar
was trending strongly upward
on dollar-negative news, but the trend
then wobbled and gave back some of
its gains on news that traders chose to
interpret as not dollar-negative, even
though it really was just as dollar-neg-
ative as the earlier news. Why did that
happen? The answer lies in traders
18
twisting the meaning of the news to
match the price action they expected to
see on the chart. Traders wanted a
retracement of the upmove, so they
manufactured it out of the smallest
evidence. A manufactured retracement
is very common in foreign exchange.
To recognize a manufactured retrace-
ment, you need to understand how
professional traders view FX market
trendedness.
Most professionals trade in all time-
frames, but even if they trade in only
one, they consult charts on all.
A trader at a bank or brokerage firm
is usually in and out of the same cur-
rency at least five, and as many as 50,
times a day, with a one- to two-hour
holding period. The goal is to make a
few bucks on the spread between buy-
ing and selling with customers and
counterparts. To do that consistently a
trader must get the price direction
right, not necessarily focusing on
heavy-duty economics. Ask a trader
whether a particular factor is impor-
January 2005 • CURRENCY TRADER
tant, and he or she will answer in
terms of how many points he or she
One of the most fascinating aspects of the forex
expects it to move the currency.
A smaller group of professionals,
market is how commentators twist and bend news
including traders at hedge funds, are
“position traders,” meaning they delve and data to fit what they think the price should do.
into the big-picture economics and put
on trades with holding periods of retracements, two of which are difficult to say this chart shows a sin-
many months. This can be the most marked. A position trader who bought gle downtrend from mid-May to mid-
profitable form of trading, because of the euro at the low of about 86 cents in December 2004. The retracements look
the potential to capture virtually all of January 2002 and was still holding it like uptrends in their own right, and in
a trend with almost no transaction today would have a gain of 46.50 fact they are identified as “trends” by
cost. (Actually, if transaction costs are cents, or a percentage return of 54 per- the crossovers of multiple moving
very low, more profit is made by enter- cent on the face amount. Assume averages (7, 10, 15 and 20 days). By
ing and exiting the same trend several leverage of 10 times, and the return is that reckoning, there are nine trends
times and picking up a little
extra gain on the retrace- FIGURE 1 — TRENDS AND RETRACEMENTS
ments –– and every trend, no
matter how well-behaved, The lines overlaid on the price series are one interpretation of the euro's trends. The
contains retracements.) move from 2002 forward could be considered a single trend with several large retrace-
People who don’t work for ments.
big institutions are the non-
professionals, but they num- Euro (EUR), monthly
ber in the hundreds of thou- 1.35
sands and are all over the
1.30
world. The timeframes they
trade mirror the professional 1.25
timeframes, but they tend to
concentrate in the shorter 1.20
end, because low capitaliza-
1.15
tion generally means shorter-
term trades with fewer 1.10
chances for the market to
jump up and bite the trader 1.05
with a nasty loss. People who 1.00
have been in the market a
long time see the change in 0.95
price behavior resulting from
the influx of the new non- 0.90
professional FX traders. 0.85
Trendedness is reduced and
choppy moves are choppier. 0.80
FX prices don’t trend all
1998 1999 2000 2001 2002 2003 2004
the time, and opinions differ Source: eSignal
over exactly how much they
do. Figure 1 is a monthly
chart of the euro over its lifetime. The 540 percent, or 180 percent per annum. on this chart. This demonstrates that a
green lines on the price series repre- To do that, of course, you would have trend is in the eye of the beholder, and
sent one perspective of the euro’s to have ridden out the retracements, in the techniques you use to identify it.
trends, although other lines may be which are the secondary moves oppo- A different technique might zero in on
equally valid. Notice the move from site to the trend. any of the smaller retracements and
2002 to the end of the chart can be con- Now consider trendedness in the classify them as trends, too.
sidered a single trend with several big Japanese yen in Figure 2 (see p. 20). It’s continued on p. 20

CURRENCY TRADER • January 2005 19

 THE BIG PICTURE continued

After the Federal Reserve raised a warning flag contains at least two moves in the
countertrend direction.
Nobody has ever published empiri-
about foreigners potentially losing their appetite for cal evidence proving that FX moves
follow an Elliott Wave sequence, and
U.S. securities because of the huge current account there is plenty of evidence that other
patterns are more common. But that
deficit, the monthly capital flow report became the hasn’t stopped traders from expecting
and sometimes getting them –– the
most important piece of data in the world. self-fulfilling prophecy.
In fact, one of the most fascinating
aspects of the forex market is how
Every trader picks his own time- sionals do. That’s why we have indica- commentators twist and bend news
frame and therefore his own definition tors that show a currency is over- and data to fit what they think the
of a trend. The trend concept is useful bought or oversold. A simple observa- price should do, based on an unproven
chiefly to maintain perspective and tion of a loss of momentum works theory.
sanity. It doesn’t necessarily dictate the pretty well, too. But in FX, a new
next trade. You may be able to see the appreciation of how retracements Technicals and fundamentals
euro or yen is in a long-term uptrend, develop (or should develop) is becom- The persistence of trendedness is
but also perceive the trend is momen- ing widespread. On the whole, it is because of traders grabbing hold of
tarily tired and the next best trade is to based on the Elliott Wave theory one or two key ideas and hanging on
bet on a minor correction; i.e., go short. which states that a trend proceeds by like a terrier with a bone until a bigger
You can use technicals to make a impulse waves punctuated by correc- idea comes along. The big themes
countertrend trade, and most profes- tive waves, and the corrective wave don’t change much over the years,
either, so the longer you trade
the FX market, the easier it is to
FIGURE 2 — TREND IN THE EYE OF THE BEHOLDER understand why traders
respond the way they do to cer-
Unlike the euro example in Figure 1, the "retracements" in the yen could be defined as
tain types of news and econom-
trends in their own right, and they are identified as such by the crossovers of multiple
ic developments. If you can
moving averages.
forecast the news and economic
115.5 data, you can get a head start on
Japanese yen (JPY), monthly
115.0 what the majority of traders are
114.5 going to do. Anticipating trader
114.0
113.5 reaction to news allows you to
113.0 forecast the direction of a trend
112.5
112.0 and bet on it early –– when the
111.5 juiciest profits are to be made.
111.0
110.5 It might sound silly to say
110.0 “forecast the news” when obvi-
109.5
109.0 ously no one has a crystal ball,
108.5 but in practice we usually know
108.0 the probable range of any par-
107.5
107.0 ticular piece of news and can
106.5 guess how traders will act along
106.0
105.0 the spectrum of possible out-
105.0 comes. For example, after the
104.5
104.0 Federal Reserve raised a warn-
103.5 ing flag about foreigners poten-
103.0
102.5 tially losing their appetite for
102.0 U.S. securities because of the
101.5 huge current account deficit, the
March April May Judy July August Sept. Oct. Nov. Dec. monthly capital flow report
Source: eSignal
became the most important

20 January 2005 • CURRENCY TRADER

 FIGURE 3 — EURO RETRACEMENT
piece of data in the world.
Ahead of the October data The euro has been trending upward powerfully since the current account problem pushed
release on Dec. 15, the previ- itself to the forefront of the news in September 2004. It retraced sharply the first week of
ous month saw an inflow of December, but most analysts believe the euro will break the upside resistance line (red)
as it has done twice before.
$65 billion and the monthly
average for the year-to-date 50
was $72 billion. Also, the
November trade deficit had
just come in at $55.5 billion. 0
Never mind the trade report
was for a different month -50
than the capital flow report.
Euro (EUR), daily 1.38
In the rough arithmetic of
1.37
trading, it didn’t take a rocket 1.36
scientist to figure out the cap- 1.35
ital inflow had to be higher 1.34
than the trade deficit to avoid 1.33
1.32
being hugely dollar-negative.
1.31
Then the news came out –– 1.30
incoming foreign investment 1.29
fell to only $48.1 billion. The 1.28
dollar tumbled vs. the euro by 1.27
1.26
36 points in 15 minutes and by
1.25
56 points over the next three 1.24
hours, in a straight line. If you 1.23
had known the number was 1.22
going to be bad, the trade 1.21
1.20
would have been a no-brainer. 7 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27
Actually, many people had September October November December
guessed the number was Source: eSignal
going to be bad. One clever
analysis noted that inflows into corpo- Chairman Alan Greenspan, had been deficit. Because there is nothing the
rate bonds the month before (the $67 harping on the issue for more than two U.S. can do (at least nothing that
billion month) was abnormally high. months, practically inviting traders to would provide an instant fix), these
Corporate issuance (selling of corporate sell the dollar –– a big-picture environ- bad numbers have risen to the top of
bonds) in the relevant reporting month mental factor that had set the tone for the list of important factors.
had been abnormally low. Therefore, it an anti-dollar bias. Also, the sheer size
was likely the net inflow would fall of the number was frightening. The Market rationalizations
If the capital flow report had been a
much higher number, the dollar would
Of all the upcoming news items FX traders may use not have fallen quite so much, but it
was already in a strong downtrend to
to rationalize their short dollar positions, the price of begin with, so it would only be a mat-
ter of time before data came along to
oil is high on the list. push the dollar lower. Traders twist
factors to fit whatever prejudice they
already hold. For example, traders
short by the amount of reduced corpo- trade deficit was a record $55.5 billion, ignored the fact that, the same week
rate bonds sold to foreigners, which is higher than expected and the fifth con- this bad news came out, the Fed raised
pretty much what occurred. secutive month over $50 billion. rates, normally a factor that supports
But even if you do not have access to Worse, the deficit with China –– the the dollar.
fancy analysis like this, you could have sorest of sore spots — was $16.8 bil- But traders dismissed the rate hike
made the same guess. Numerous lion, up 27 percent over the year before as “old news” since it was already
Federal Reserve officials, including and more than 30 percent of the total continued on p. 22

CURRENCY TRADER • January 2005 21

 THE BIG PICTURE continued
fully priced in. If the Fed had raised
rates by 50 basis points instead of 25
basis points, the hike might have offset
the bad trade and capital flow data.
But it was obvious the Fed wasn’t
going to raise rates by more than 25,
because it told us so –– rate increases
would be by “measured” amounts.
Of all the news items FX traders
may use to rationalize their short dol-
lar positions, the price of oil is high on
the list. Say oil prices rise again.
Traders will interpret the news as
worse for the dollar than for other cur-
rencies, even though European
economies tend to see a bigger second-
round inflationary effect from higher
energy prices than the U.S. (or Japan,
which is the most energy-efficient of
all the major countries). But you can
“spin” the oil news as worse for the
dollar on the grounds that higher
expected inflation in Europe will pres-
sure the European Central Bank to
raise its own interest rates.
Funny, the market doesn’t care much
about rates when a rate hike would
seemingly support the dollar, but now
it’s using a short-term interest rate to
justify supporting a different currency.
It is wildly inconsistent and even hyp-
ocritical, but this is the kind of slant
that develops when bias toward a cur-
rency is strong. All bad news sticks to
the out-of-favor currency like Velcro,
while undeniably good news slides off
the currency like it is Teflon.
That’s why we can’t make a list of
FX factors once and for all and give
each one a weight. A factor has one
weight when the price is in an impulse
wave –– i.e., trending strongly –– but a
different weight when the price is in a
corrective mode.
Anatomy of a retracement
The euro has been trending upward
powerfully since the first week of
September 2004 (see Figure 3, p. 21),
when the current account problem
pushed itself to the forefront of the
news (see “The Great Global
Imbalance Hoax,” Currency Trader,
December 2004). The trend picked up
steam in October and November,
22
punctuated by a couple of minor
retracements (defined here as a series
of lower lows and lower closes that
persists for longer than three periods
in an uptrend).
In the first week of December, the
euro retraced quite a lot. In fact, daily
lows twice penetrated the lower
boundary of the linear regression
trend channel. Nobody actually
thought a trend reversal could be in
When bias toward a currency is strong, all bad news
sticks to the out-of-favor currency like Velcro, while
undeniably good news slides off the currency like it
is Teflon.
the works, but when prices fall by a
large amount like this, traders who
went long near the highs are suffering
and don’t want to see their losses get
bigger. A wave of stop-loss selling
takes place, complicated in this
instance by pre-holiday and year-end
profit-taking by position traders who
had gotten in much earlier.
Most analysts believe the euro will
break the upside resistance line (red),
as it has done twice before.
Meanwhile, the euro is in the grip of
the technicals, which dictate the
retracement should take a particular
form — the Elliott Wave sequence.
Traders twisted the meaning of fresh
data during the retracement week to
match that expectation. Specifically, the
current account deficit was not as bad
as expected, so the euro fell. In any
objective analysis, this is a perverse
move based on a faulty interpretation.
In fact, it depends on looking at the
data in seasonally adjusted terms; in
unadjusted terms, the current deficit
was worse. The deficit is still 6.1 percent
of GDP, the critical number that under-
lies the dollar downtrend in the first
place, and the most recent data indi-
cates a third consecutive quarter of
worsening deficits.
Economists scratch their heads at
this willful misreading of the news,
but technical traders just try to figure
out where the retracement will end so
they can re-enter. There are two possi-
bilities on the chart. We can wait for
the price to break upside resistance, or
we can watch the indicator in the
upper window, a momentum oscilla-
tor, to signal the euro is oversold. Once
the indicator pops up from the over-
sold line, the trader has a bigger profit
potential than if he or she was waiting
for resistance to break.
Traders will line up the true weight
of the news with the corresponding
price change. If news continues to be
badly dollar-negative in any objective
evaluation but the euro fails to rise, the
price is still in the grip of the technical
traders who think their retracement
hasn’t ended. If the news is only mild-
ly dollar-negative but the euro rises
anyway, it may be time to consider a
new position even if neither of the two
technical indicators on the chart give
the signal –– some other technical indi-
cator can always be found to justify the
position the news suggests.
The market makes the news
It might seem odd the news doesn’t
dominate the price action in foreign
exchange. You’d think hard data
would always have the same effect on
price moves –– but it doesn’t. The
same data is powerful during a trend
and feeble when a trend is either not
present or in the process of retracing. It
pays to know what the professionals
are thinking, and you can be sure that
a good part of what they are thinking
is informed by the chart itself. 
January 2005 • CURRENCY TRADER
 THE BIG PICTURE
The technicals rule
T
he market has been hav-
ing trouble deciding
whether the current
account deficit is more
powerfully dollar-negative than the
rising interest rate environment is dol-
lar-positive.
The European-led current account
gang believes the structural deficit is a
far weightier issue than interest-rate
differentials. In contrast, Japanese and
other Asian traders are more con-
cerned with higher rates, especially
because Japan is in a technical reces-
sion and any monetary policy tighten-
ing there is postponed.
So while traders slug it out over the
23
fundamentals, the technical factors
rule, or seem to.
First there were a few big trading
houses (such as UBS) saying just
before year-end that the dollar would
soon start to correct from the steep
downtrend of the fourth quarter. Lo
and behold, the retracement of the dol-
Greenspan expressed a wish for the dollar to rise,
and the market was willing to oblige.
lar downtrend started on the first trad-
ing day of the year.
To cap that off, the Euro/U.S. dollar
(EUR/USD) retracement ended only
When the fundamentals
are foggy, technical factors can
drive the market.
BY BARBARA ROCKEFELLER
20 points (.0020) from the precise “the-
oretical” Fibonacci 50-percent retrace-
ment level. (Technically, 50 percent is
not a Fibonacci number, but never
mind.) A 50-percent retracement of the
move from the May 2004 low of 1.1760
to the December high of 1.3667 is
0.0954 points, which translates to a tar-
get of 1.2713 (see Figure 1). The dollar
retracement stopped in early February
at 1.2733 — which was the low on both
Feb. 7 and 8 — or 0.15 percent from the
50-percent retracement level. That’s
downright spooky, and almost certain-
ly evidence of the grip technical ideas
have on the FX market.
Unsolvable mysteries
What’s ruling the market — the cur-
rent account deficit or interest rate dif-
ferentials? This question is unanswer-
able in practice — or in theory, for that
matter. Currencies can fall despite an
interest-rate advantage, and currencies
can rise despite a current-account dis-
advantage. These are both big “envi-
ronmental” background factors that
become immediate, tradable factors on
March 2005 • CURRENCY TRADER
 FIGURE 1 – EURO RETRACEMENT
the whim of the trading community. The Euro/U.S. dollar retracement stopped in early February just 20 pips shy of
“Whim” sounds like a disparaging a precise 50-percent retracement of the May-December rally.
term, but it’s not meant to be. When
Federal Reserve Chairman Alan Euro (EUR), 1.3055, 1.3055, 1.3055, 1.3055 1.37
Greenspan told a conference in 1.36
London (the same day the G7 meeting 1.35
started in February) the current 1.34
account might soon improve because 1.33
of “market forces” and new budget 1.32
1.31
constraints, the market was willing to
38.2% 1.30
buy dollars. (G7 is the "Group of 7"
1.29
countries, including the U.S., UK,
1.28
Japan, Germany, France, Italy, and 50.0%
1.27
Canada, which meet twice a year to 1.26
talk about the global economy and 1.25
international financial system. 1.24
Recently Russia has been invited so 1.23
G7 is sometimes called G8.) But 1.22
Greenspan didn’t go into detail about 1.21
those “market forces” except to say 1.20
exporters to the U.S. had to be feeling 1.19
a profit pinch, which is a weak argu- 1.18
ment. As for the connection between 1.17
the current account deficit and the May June July Aug. Sept. Oct. Nov. Dec. 2005 Feb. Mar.
budget deficit, it doesn’t really exist, Source: eSignal
as a study by the Fed itself had just
shown the month before. FIGURE 2 – THE OIL FACTOR
The only reason for Greenspan
to make these remarks was to Some analysts contend $8-12 of the recent price of oil is a premium for the inherent
goose the dollar upward. risks in the major producing countries. However, oil has been on a serious uptrend
Greenspan expressed a wish for for several years and there is no reason to expect these risks will disappear soon,
or the price of oil will stabilize or fall.
the dollar to rise, and the market
was willing to oblige. It’s impor- Light Crude Oil (CL), 47.60, 48.50, 47.52, 48.35
tant to note the dollar was already
rising when he made the com- 55
ments; he was talking “with the
wind,” as the Japanese say. It’s not
clear if Greenspan’s remarks could 50
have stopped the dollar from slid-
ing further had it already been
falling. 45

Productivity, the buck, and

crude 40
Later in February Greenspan told
Congress future monetary policy
depends on three things: the trend 35
in labor productivity, the level of
the dollar, and the price of oil.
All three are really proxies for 30
future inflation. Rising productivi-
ty inhibits inflation, so when it
decelerates, as it is now (produc- 25
tivity is up 4.1 percent at an annu-
al rate as of Q4 2004, compared to
2003 M J J A S O N D 2004 M A M J J A S O N D 2005
continued on p. 25 Source: eSignal

CURRENCY TRADER • March 2005 24

 THE BIG PICTURE continued

4.4 percent in both 2003 and 2002), even briefly lower). This has narrowed Figure 2 shows what it looks like, cour-
Greenspan worries about inflation. the spread between the two-year note tesy of the St. Louis Fed. The index has
A falling dollar automatically raises and the 10-year note to only 70 points been on a steady upward path. Should
the prices of imported goods (at least or so, which is a historical aberration we deduce the Fed is scared, at least a
from countries whose currencies float
against the dollar), which is inflation-
ary. FIGURE 3 – SHOP TILL YOU DROP
The price of oil, of course, is a coin- The personal expenditures index has been on a steady upward path, which
toss. Oil experts say $8-12 of the recent might make the Fed nervous about inflation. But right now, the bond market
price of approximately $48 is a premi- doesn’t show that concern.
um for the risks inherent in the major Personal Consumption Expenditures: Chain-type Price Index
oil-producing countries, from Nigeria (Index 2000=100)
and Venezuela to Saudi Arabia and
Iraq. It’s unrealistic to expect those 110
risks to subside, although on the 108
demand side, the coming of spring is
an ameliorating factor. But the impor- 106
tant point is oil has been in a serious
104
uptrend for several years now and
there’s no reason to think it will stabi- 102
lize or fall (see Figure 2).
100
The bond market conundrum
98
As it has been since last summer, the 2000 2001 2002 2003 2004 2005
big issue of the day is still the mysteri- 2005 Federal Reserve Bank of St. Louis (research.stlouisfed.org)
ous refusal of the bond market to take
the yield on the 10-year bond higher in Source: U.S. Department of Commerce, Bureau of Economic Analysis
lockstep with short-term interest rates.
Since June 2004 the Fed has raised — what Greenspan calls a “conun- little, about inflation? Well, that’s its
the Fed funds rate six times, from 2 drum.” job. But if so, why does the bond mar-
percent to 3.5 percent, while the yield We know Greenspan likes the per- ket not share that concern?
on the 10-year bond has fallen from sonal consumption expenditure price Commentators say the Fed has done
4.70 percent to about 4.2 percent (and index, which is really a GDP deflator. its job too well, and the bond market
believes the Bank will succeed in hold-
ing inflation down, so there is no need
Kaufman speaks about dollar for long-term rates to rise. Others
In an interview with The New York Times, economist Henry Kaufman ("Dr. Doom") point out that when supply is relative-
had some important things to say about the dollar. ly fixed and demand rises, prices rise
— which in the case of bonds means
He thinks China and Japan will not diversify away from the dollar because it’s self- the yield falls. Because foreigners as
defeating — if the dollar drops a lot, their "export drive" to the U.S. suffers. well as domestic buyers have not
Meanwhile, the falling dollar has very little effect on exports because the U.S. can’t shown any loss of appetite for U.S.
compete with low labor-cost countries. It would take a huge dollar drop to get the paper, the drop in the 10-year yields is
desired effect, and that’s not going to happen. no surprise.
"Today, there is an enormous international disequilibrium,” Kaufman said. “For the In fact, it’s a desirable outcome,
near term, it is in the best interest of all the participants to maintain it." because last November Greenspan
fretted about foreigners losing their
This is the Golden Goose theory I wrote about in last month's article. As for a fore- appetite. This concern came in the
cast, Kaufman sees "relative stability with occasionally a little bit of give in the value aftermath of a comment from San
of the dollar." In other words, flat to down — but not up. Francisco Fed president Janet Yellen
that so much foreign demand for U.S.
—Barbara Rockefeller
paper was hindering the Fed’s desire
Click here for The New York Times article: “The Alpha Currency? It's Still the Dollar,” to get longer rates up, too. FX traders
by William J. Holstein, Feb. 27, 2005. took each comment to mean the Fed
wanted the dollar to fall, although sub-

25 March 2005 • CURRENCY TRADER

 FIGURE 4 – DOUBLE-TOP SCENARIO
sequent reports from the U.S. One of several possible outcomes in the Euro is a double-top, which would mark the dollar
Treasury did not validate any rising/Euro falling if the interest-rate differential between them were to get big enough.
such loss of appetite.
In November — the month Euro (EUR), 1.3055, 1.3055, 1.3055, 1.3055
1.38
in which the dollar lost almost 1.37
5 cents against the Euro — for-
1.36
eigners bought a net $89.3 bil-
1.35
lion in U.S. securities of all
1.34
types; in December, they
1.33
bought an additional $61.3 bil-
lion. Net portfolio flows into 1.32
the U.S. averaged $68.5 billion 1.31
per month in 2004, compared 1.30
to $57.0 billion in 2003 and 1.29
$47.9 billion in 2002. For the 1.28
year 2004, the inflow of portfo- 1.27
lio investment into the U.S. was 1.26
a total of $821.8 billion, or a 20 1.25
percent increase from $683.6 1.24
billion in 2003 and a 43 percent 1.23
rise over $574.6 billion in 2002. 1.22
The 2004 inflow of $821.8
1.21
billion is plenty to “cover” the
current account deficit, which Sept. Oct. Nov. Dec. 2005 Feb. Mar. Apr. May June
was running at an annual rate Source: eSignal
of $658.8 billion as of the end
of Q3. Bund, as is the case today. Therefore, ance sheets and used the proceeds of
In fact, the only worrisome thing we probably don’t have to worry mortgage refinancing to pay down
about the Treasury flow report was the much about capital flows in the com- high-cost credit card debt, at some
outflow of capital from the U.S., pre- ing months, which should be dollar- point rising rates at the long end of the
sumably from U.S. citizens who favorable. But now we run into two yield curve will reduce the number of
expected better returns abroad kinks in the forecast, the first from the refinancings. Surely the Fed considers
(including a currency effect). U.S. Fed and the second from the technical- this dynamic in its plans, and some
investors bought a net $15.4 billion in ly-driven FX market. economists think that instead of get-
foreign equities in December, almost
double the amount in November ($8.5
billion), and the most since 2000. They The dollar could move sideways if many traders
also went long foreign bonds. To a cer-
tain extent, this reveals U.S. investors think the interest-rate buffer is only a finger
are free to choose foreign securities but
at least some foreign investors in the in the dike; for them to accept a lasting dollar
U.S. are here involuntarily because
management rules dictate a certain
percentage of money must be invested
improvement, the current account does, indeed,
according to market size.
have to fall.
Kinks in the road
It’s only logical to assume if foreign Much of what drives the U.S. econo- ting a bigger rate increase in coming
investors are willing to place a large my is the consumer, and a lot of what months (which would be signaled by
amount of their capital in the U.S. in a has been driving consumers over the the FOMC dropping the “measured
low-rate environment, they will allo- past few years is the ability to refinance move” phrasing), we will get a pause
cate even more to the U.S. when the their main asset — their home — to get in rate hikes. In fact, some members of
yield curve finally catches up and the more money for consumption. the bond fraternity may be counting
10-year bond delivers more than 50-70 While it is no doubt true many on it.
points over the equivalent German households have cleaned up their bal- continued on p. 27

CURRENCY TRADER • March 2005 26

 THE BIG PICTURE continued
A pause is bad for the dollar,
because now the market has built in
Fed rate hikes every period. If the dol-
lar is falling and the Fed stops raising
rates, it’s a dollar negative, so the dol-
lar will fall more. If the dollar is rising
and the Fed pauses in raising rates, the
dollar will stop rising and could even
fall. If the dollar is rising and the Fed
pauses in hiking rates, the dollar stops
rising.
What does Mr. Greenspan
want?
The Fed chairman is resolutely anti-
inflation and his credentials are as
high as anyone’s have ever been.
In a technically-driven market, traders interpret
the news whatever way is most convenient
for their positions.
While the high-falutin talk about “nor-
malizing” rates is quite convincing,
Greenspan is also a pragmatist, and his
job is to prevent inflation from getting
a toehold rather than satisfying some
academic market model. The Fed can’t
do anything about productivity or the
price of oil, but it can do something
about the dollar. Greenspan can’t pos-
sibly want the dollar to fall, which
makes his “loss of appetite” remarks
last fall all the more curious.
However, it looks like traders are
buying the 50-percent trading rule,
and the Euro will now return to the
level of last December (above 1.3600),
and perhaps beyond. But this is prob-
ably not what the Fed wants. It’s likely
we’ll hear more inflation warnings
from the Fed, which will be aimed at
controlling inflation but also at
prompting the bond market to raise
the yield on the 10-year note to get it
more in line with the recent rate hikes
in the Fed funds rate. The U.S. is
already attracting enough capital, but
a more substantial differential ensures
a bigger buffer against a dollar crash.
(It needs to be a hefty buffer, too,
27
because European traders still believe
the structural deficit is some kind of
absolute no other factor can override.
This is not true. There are very few
absolutes in economics and almost
none in trading.)
Will this approach work? Yes, prob-
ably. There is likely some interest-rate
level that will halt the Euro’s rise. It’s
possible to imagine a double-top, for
example, that would mark the dollar
rising/Euro falling when the interest
rate differential gets big enough (see
Figure 4). This is only one of several
possible outcomes, and it assumes the
Fed gets its way. Alternately, there
could be sideways movement if a large
number of traders think the interest-
rate buffer is only a finger in the dike;
for them to accept a lasting dollar
improvement, the current account
does, indeed, have to fall.
In a technically-driven market,
traders interpret the news whatever
way is most convenient for their posi-
tions. When they are feeling a nega-
tive-dollar bias, news that is truly dol-
lar negative, such as foreign central
banks diversifying out of dollars, is
exaggerated. In practice, diversifica-
tion is a minor factor — only a few bil-
lion dollars against a market that
trades more than $1.3 trillion per day.
But the public relations effect is huge,
and the technicals set up a random fac-
tor such as that to have a big effect.
And the winner is…
This month, bet on the technicals, even
though the current trend being formed
is contrary to what the institutional
picture seems to be — a Fed deter-
mined not to have the dollar fall, or not
having it fall too much.
We used to have to watch the
unforecastable payrolls report, with an
obscure meaning for the economic out-
look we all got wrong, anyway. The
jobless recovery was supposed to
deliver a recession, but the canny Fed
kept rates low and fueled a consumer
boom via home refinancings instead.
Now we have to watch the unfor-
castable Greenspan, who makes
ambiguous comments in the name of
central bank transparency and dances
every noun around the room six times
before he gets to the end of the sentence.
This is just another example of the
perversity of the FX market. Of the
thousand variables that can effect
exchange rates, it chooses the strangest
and most difficult — payrolls. As far as
the upcoming month goes, it’s the silly
season. We often get a sea-change in
February-March, including vast confu-
sion over whether the yen always rises
because of repatriation of foreign prof-
its (answer: sometimes it does, but not
reliably enough to trade on). This time,
it looks like the technicals are ruling, at
least until a compelling event related
to the current account or interest rates
comes along.
Related reading
Other Currency Trader articles
by Barbara Rockefeller:
“Combining fundamentals and
technicals in FX trading,”
October 2004.
“The obscure key to successful
FX trading,”
November 2004.
“The great global imbalance
hoax,” December 2004.
“Trends, retracements and news
in foreign exchange,”
January 2005.
“The Golden Goose Rule,”
February 2005.
March 2005 • CURRENCY TRADER
 THE BIG PICTURE

How to know
when not to trade
Different indicators can help you determine the kind of market environment
you’re in and whether you should be trading at all.

BY BARBARA ROCKEFELLER
I n all securities markets, prices
are trending, mean-reverting,
or flat (going sideways). When
prices are trending, just about
any trend-following technique will
work, even the hoary old moving aver-
age. When prices are mean-reverting,
you need to determine when an excur-
sion away from the mean has peaked,
and then “fade the trend.” There are a
number of techniques to estimate
when a price is overbought or over-
sold and will likely revert to the mean.
But how do you know when a price
is going sideways and you
should do nothing? The price
FIGURE 1 — EURO UPTREND WITH LINEAR REGRESSION LINE goes up just enough to trigger
Although the trend was obviously up during this period, there were numerous a buy trade using a trend-fol-
countertrend corrections. lowing technique, only to turn
around and give you a sell
Euro (EUR), monthly signal. This is the dreaded
1.35 whipsaw loss, which can
1.30
accumulate enough to drive
you out of the trading busi-
1.25 ness altogether — especially if
you are unlucky enough to
1.20
detect a sideways period right
1.15 at the beginning of your trad-
ing career.
1.10
This discussion of trended-
1.05 ness and mean-reversion in
the Euro and Japanese yen
1.00 will zero in on a case of side-
0.95 ways prices and how a partic-
ular technical indicator can
0.90 help prevent ruinous whip-
saw losses.
0.85

0.80 FX tends to trend

Foreign exchange prices tend
2000 2001 2002 2003 2004 2005 to be highly trending, which
Source: Reuters is why many newcomers to

28 June 2005 • CURRENCY TRADER

the market have big gains in their early The steeper the slope of the linear to identify when a move away from
days. You probably know someone regression or moving average, the the trendline has gone “too far,” which
who says he bought the Euro when it stronger the trend. In fact, once a is relative. A key tool to identify “too
was around 85 cents in October 2000 strong trend is in motion, just about far,” or an overbought or oversold con-
and held the long position until year- any moving average will capture it. dition, is the relative strength index
end 2004, when it was trading at (RSI), which divides the average of up
$1.3390. Warren Buffett is one of the Fading the trend moves over n number of days (usually
folks who got into this trade (about Some analysts prefer not to think in nine to 26 days) by the average of
midway through it), reinforcing the terms of trends. They think only in down moves over the same number of
idea that it’s respectable to trade forex terms of “swings,” which could be days, and converts the outcome arith-
when you have identified a big-picture described as mini-trends. For example, metically to an index that ranges from
trend.
For the rest of us mere mor- FIGURE 2 — CHOPPY DOWNTRENDS
tals, though, it’s very hard to
This downtrend is much choppier than the uptrend shown in Figure 1. The upswings are
identify a big-picture trend. significant enough to be considered mini-trends in their own right.
We get caught up in the hurly-
burly of daily and weekly Japanese yen (JPY), weekly 122
121
movements, and even in the
120
best-behaved uptrend those
119
moves are sometimes count- 118
er-trend. And even if we 117
could identify a big-picture 116
trend and had the self-confi- 115
dence to stick to it, most of us 114
don’t have the capital to sit 113
out those counter-trend peri- 112
ods. In fact, Buffett-style 111
110
trend-following is quite rare
109
and pretty much confined to
108
well-capitalized managers 107
who are not using much 106
leverage, if they use any at all. 105
Figure 1 is a monthly chart 104
of the Euro from October 2000 103
to spring 2005. In hindsight, 102
the uptrend is clear, but it’s 101
also clear the Euro moved 2004 2005
downward, at least nine Source: Reuters
times. If you came to believe
in the big-picture trend, to
trade it was not necessarily a sure win- the trend in Figure 2 is so choppy you zero to 100. When the index is rising,
ner — you could have gotten in just as could legitimately consider each move up moves are bigger than down moves
one of those down moves was starting. a “trend” in its own right. over the lookback period. When down
Any number of charting techniques There is no rule that says a trend has moves start getting bigger than up
can be used to identify a strong trend. to last for years. You can define a trend moves, the index falls.
At the simplest level, a series of higher any way that suits you. In convention- In Figure 3, the yen down move in
highs and higher lows can be said to al terms, the primary trend (as identi- April varied quite far from the linear
constitute an uptrend. The chart in fied by the linear regression line) is regression trendline (blue line), and
Figure 1 shows a linear regression line. clearly downward, but excursions the 14-day RSI in the top window
Another useful concept is the moving away from the line are fast, violent, reflected that — the yen was becoming
average, which tracks the move and and sometimes prolonged. “oversold” as the index dipped below
smoothes confusing little jigs and jags. The way to trade a choppy trend is continued on p. 30

CURRENCY TRADER • June 2005 29

 THE BIG PICTURE continued

FIGURE 3 — OVERBOUGHT AND OVERSOLD –— THE RSI

there was an underlying
The relative strength index (RSI) is an oscillator designed to indicate when price is rela-
tively “overbought” or “oversold” on a relative basis. The RSI moved below and back upward bias, but to trade
above 30 in early April, issuing a standard buy signal. directly on the 20-day moving
average would have resulted
70 in overtrading and losses —
RSI
60 notice how many times the
50 prices crossed the moving
40 average. If this is a trend, it’s
30
not a tradable one using a
trend-following technique.
100.00 Although you could have
Japanese yen (JPY), daily 99.50 used a swing-trading tool
99.00 such as the RSI and not done
98.50
98.00 too badly during this period,
97.50 gains were not large and the
97.00 risk was very high. There are
96.50
96.00 no fewer than 53 changes in
95.50 direction between the end of
95.00 May low (where the horizon-
94.50
94.00
tal line begins) and the upside
93.50 breakout point over the top-
93.00 most horizontal line in
92.50
92.00
October. Even if you came out
December 2005 February March April May June ahead, your nerves were shot.
Source: Reuters In Figure 4’s top window is
a nifty indicator invented by
30. As soon as the index started to with the conventionally-defined big- Welles Wilder called the average direc-
climb from this oversold level, the cor- picture downtrend. Notice the two tional movement index (ADX). The
rect trading decision was to buy it. moving averages cross back a lot faster purpose of the ADX was to measure
Notice the 10-day/20-day moving this time — only seven days after the the strength of a trend, but it just as
average crossover didn’t occur until peak. easily indicates the absence of a trend
two weeks later, reflecting the perpetu- when its readings are very low — in
al problem with moving averages — Trader’s nightmare — this case, readings under 15.
they lag. Also, the currency didn’t the sideways market The ADX is a real pain to calculate,
push above the down trendline (con- In a sideways period when both trend- and fortunately most charting software
necting the price peaks) for another following and swing-trading tech- packages do it for you. The principle is

In the absence of directional movement, how do you estimate the probability

of any bet being a winning bet? In poker, you have to know when to fold ‘em,
and in trading, sometimes the optimum thing is to do nothing.
four days, highlighting the fact this niques generate mostly losses, the best to calculate an “up directional move-
traditional technique also fell short — strategy is to stay out of the market ment index,” called +DI, which is a
the move is almost over. altogether and wait for some kind of moving average of closes on days
Then the RSI peaked around 65 — consistent move to develop. when the high is higher than yester-
not reaching the overbought level of 70 The Euro went through such a peri- day’s high. The default number of days
— and started to drop. This is where od in summer 2004 (Figure 4). After in the moving average is 14, but you
you would exit the long trade with a making a low in May around 1.1750, can vary this. It’s labeled +DI because
profit and possibly also reverse back to the Euro made a high in July at 1.2460. it’s a positive number, capturing the
the short position, which is consistent The 20-day moving average shows amount of the bar that is above the

30 June 2005 • CURRENCY TRADER

trading range of the day before. This is if in a trending period the average You would have done well to stay
consistent with the idea that a series of high-low range is 100 points and then out of the market over this entire peri-
higher highs is an uptrend; +DI simply contracts to 30 to 50 points, trended- od whether you were using trend-fol-
measures the force of the uptrend. ness is decelerating. Conversely, when lowing or swing-trading techniques.
You also calculate a second direc- the average daily high-low range is ris- You might have eked out a small prof-
tional movement index, the down ver- ing from 35 to 50 points to 100 points, it, but in the absence of a clear direc-
sion, or -DI, which is a moving average trendedness is accelerating. tion, you were taking an unnecessary
of days on which the low was lower In Figure 4, the 21-day ADX risk because you were trading all the
than the day before. Again, a series of approaches the 15 level in July, but time without a clear expectation of a
lower lows is a downtrend, and -DI then falls back. The indicator stays flat positive result — something statisti-
measures the force of the trend. for the rest of the period and doesn’t cians refer to as “positive expectancy.”
Obviously, every day’s bar can be rise above 15 until the breakout in You should never place a bet unless
only one or the other. When there’s an October that takes the price over the you have a better than 50-50 probabili-
inside day — a bar with a lower high July high. (You might also notice the ty you will win.
and a higher low than the day
before — there is no direction-
FIGURE 4 — LOW, FLAT ADX
al movement. An outside day,
which has a higher high and The ADX measures trend strength. When the indicator is moving sideways below 15, it
lower low than the preceding implies the market is trendless — which is a good time to be out of the market.
day, also has zero directional ADX 18
movement. 17
16
Figure 4 shows the ADX in 15
the top portion of the chart. 14
When it is rising, upward 13
12
directional movement is over- 11
whelming downward direc- 10
tional movement, and vice Euro (EUR), daily 1.265
versa. Because ADX is a true 1.260
1.255
index, it varies between zero 1.250
and 100. 1.245
1.240
Research by Chuck LeBeau 1.235
of www.traderclub.com 1.230
1.225
shows that when the ADX 1.220
rises above 15 from a flat spot 1.215
1.210
(a “basing pattern”), a trend is 1.205
being built. The ADX usually 1.200
1.195
rises to no more than about 70, 1.190
whereupon the slope of the 1.185
1.180
index starts flattening out or 1.175
falling and you consider the 2004 May June July Aug. Sept. Oct. Nov.
trend has stopped accelerat- Source: Reuters
ing. (This doesn’t necessarily
mean you automatically exit,
but it does mean you should raise your flat spot features a head-and-shoul- In the absence of directional move-
stop closer to the last close, since decel- ders pattern that was not a true head- ment, how do you estimate the proba-
eration of the trend may foreshadow a and-shoulders — the lowest low at the bility of any bet being a winning bet?
reversal of the trend.) end of the pattern in August is not In poker, you have to know when to
When the ADX is flat, you have no lower than the lowest low in the entire fold ‘em, and in trading, sometimes
directional movement, either up or pattern, and therefore the pattern is the optimum thing is to do nothing. A
down. Higher highs are being washed not confirmed. If it had been con- flat ADX under 15 represents one of
out by lower lows in the moving aver- firmed, we would have expected the those times. 
age period. It’s no coincidence a flat Euro to fall outside the bottom of the
ADX is seen when the average high- horizontal range, since the head-and-
low range is contracting. For example, shoulders pattern is a bearish pattern.)

CURRENCY TRADER • June 2005 31

 THE BIG PICTURE

What professional traders know

that you don’t
Most professionals don’t have amazing powers or secret knowledge,
but they do know how do things such as taking losses and avoiding getting
“married” to a particular market outlook.

BY BARBARA ROCKEFELLER

T he professionals’ “secret”
is not a trading rule like
“buy the opening break-
out if yesterday’s close
was at the high.” Each trader has his
own trading rules, and each set of rules
is equally valid — there is more than
one right (profitable) way to trade a
market.
You can find trading rules for each
style of trading, generally organized
according to how long you plan to
hold positions. Trading rules can be
roughly categorized as belonging to
the day-trading style (holding period
of minutes), swing trading style (hold-
ing period of a few hours to a few
days), and position trading (holding
period of several days to several
months).
The secret is that professionals
know the difference between a
good loss and a bad loss.
FIGURE 1 — EURO BUYING OPPORTUNITY?

The Euro has broken out above a down trendline, and the stochastic oscillator is rising The good loss
sharply. Should you buy the Euro? How can any loss be “good,”
you ask? A good loss is the
Stochastic Oscillator (46.02) 90
80 result of taking the right posi-
70 tion given the information
60 available at the time. You
50
40 weighed the information —
30 fundamental, technical, or
20
10 both — and believed you had
a realistic expectation of a
Euro (EUR), daily profit. You took the position,
1.31 but the fates intervened and
1.30
threw a fresh piece of informa-
1.29
1.28
tion into the market, or a new
1.27 participant with different
1.26 ideas. Your position turned
1.25 into a loser, and your risk-
1.24 management rules forced you
1.23 to exit with a loss. Next case.
1.22
Notice how many assump-
1.21
1.20
tions about the trading busi-
1.19 ness are embedded in the pre-
18 25 2 9 16 23 31 6 13 20 27 4 ceding sentences. First, you
May June July gathered a lot of information
Data source: Reuters; Charts: MetaStock
to make the trading decision.

32 July 2005 • CURRENCY TRADER

 FIGURE 2 — FALSE BREAKOUT

The Euro failed to sustain the upward momentum. The chart offered clues the breakout
It doesn’t matter whether the was going to fail, but if you had a preconceived notion the Euro was oversold and should
rise — and you couldn’t let go of the idea — you might have stuck with a losing trade.
decision was largely or even
entirely informed by technical Stochastic Oscillator (30.63) 90
indicators. Technical indica- 80
70
tors distill market sentiment, 60
and are as valid a decision tool 50
as any other. In fact, most 40
30
forex market observers believe 20
about 90 percent of all forex 10
traders use technical analysis
in some form. Euro (EUR), daily
Second, if you had a realis- 1.31
1.30
tic expectation of profit, you 1.29
had an idea of the probable 1.28
scope of the upcoming move 1.27
— in other words, a profit tar- 1.26
1.25
get. This is an important dif-
1.24
ference between professionals 1.23
and amateurs: Professionals 1.22
know where they plan to exit a 1.21
trade, whereas most amateurs 1.20
1.19
do not. Moreover, amateurs
4 11 18 25 2 9 16 23 31 6 13 20 27 4
kick themselves for exiting a April May June July
trade too early, no matter how Data source: Reuters; Charts: MetaStock
stupendous their gain. If the
price continued to move fur- practice, they are sometimes lucky to The bad loss
ther, they mourn the lost opportunity. get 1.5:1. If a “good” loss is one where you made
Professionals make note of this, but Professionals with losing trades the right decision but lost anyway, a
they don’t get emotional about it. already know how big the loss will be “bad” loss is one where you made a
To evaluate a trade, however, you — say $350 in the case here — and bad decision and took a loss, or made
need more than the profit expectation. therefore it hurts less when they have the right trading decision but applied
You also need to know the potential to take it. The loss is not a surprise and the wrong risk-management rules. A
loss. Let’s say you can realistically it’s also not a disaster. bad trading decision, by definition, is
expect to make $1,000 on the trade. Are Professional traders are always one in which you didn’t start out with
a positive expectancy of a gain.
When you get the price direction
Professionals know where they plan to exit a trade; wrong, it’s almost always the result of
ignoring important factors or chart
most amateurs do not. indicators because you are looking for
what you want to see instead of what is
you willing to lose $3,000 to make ready to move on to the next case. really there. This is a critical difference
$1,000? No. You would soon be out of Losses are a natural part of trading. between professionals and amateurs.
the trading business if your trades had Everyone takes losses. Anyone who Professionals clearly see what they are
that risk-reward profile. can’t take losses either doesn’t have looking at and are able to restrain their
If you want to keep losses smaller enough capital to be trading in the first prejudices and preconceptions about
than gains, your stop-loss exit point place, or lacks the psychological make- what “should” be there.
has to be a smaller distance away from up to be a trader. Professionals can For example, look at the chart in
the entry point than the expected prof- ride out losses both financially and Figure 1. The Euro has broken out
it-taking level. If you expect to make psychologically; they are confident above a down trendline, and the sto-
$1,000, your stop has to deliver a loss about their trading abilities even as chastic oscillator is rising sharply. The
of less than $1,000. Traders would love they contemplate taking a loss, and rising stochastic means the Euro had
to get a 3:1 or higher reward-risk ratio, even after they take it. been oversold and is now in the
meaning a $3 gain for every $1 loss. In continued on p. 34

CURRENCY TRADER • July 2005 33

 THE BIG PICTURE continued
process of correcting upward. On the
last bar, the close is below the close the
day before and below the open — two
important warnings — but the upside
breakout is compelling. You buy the
Euro. (Actually, some professionals
bought the Euro, too, but they didn’t
buy them for a sustained holding peri-
od.) What happened next?
Figure 2 shows the Euro failed to sus-
tain the upward move. The correction
fizzled. The next day after the warning
bar, the Euro put in a higher high than
the day before, but not higher than the
previous two days. It’s an old rule that
you want a three-day high (and prefer-
Amateurs would rather be right than make money,
while professionals are willing to admit they are
wrong, and make money anyway.
ably a three-day higher close, too) before
you buy into a new move. This is a rule
you could use if you are a swing-trader
or a position trader. There is no doubt
that some day-traders made money
going long the Euro on the day after the
warning day — the Euro did venture
higher — but they had to be nimble to
exit with a gain. It was not a well-judged
trade for anyone other than a day-trader.
For a real position trader, it was not even
tempting. The position trader would
have required a close (or two or three)
over the 10-day or 20-day moving aver-
ages, too. Instead, the price surpassed
the 10-day moving average only once,
and never surpassed the 20-day moving
average.
This move was, therefore, a false
breakout, and a pretty minor one, at
that. The chart gave plenty of clues
that the breakout was going to fail, but
if you were enamored of the idea the
Euro was oversold and should rise, it
was easy to talk yourself into buying
it, and then taking a loss when the
breakout failed.
Let’s say you saw the warning signs
but decided to change your usual
timeframe. You thought you could eas-
ily switch timeframe concepts to day-
trading when your usual style is
34
swing-trading. Unless you sit down
and carefully recalculate potential
gains and losses for the new time-
frame, you will not have realistic
expectations for the trade.
Changing timeframes is not some-
thing you can do intuitively or on-the-
fly. You need to apply a little arith-
metic to arrive at new parameters.
Otherwise, you are just guessing,
which is always the wrong tactic in
trading. Trading is a business that
requires business tools. (We may think
that in the end almost every trading
decision is little more than an educated
guess, anyway, but there is a vast dif-
ference between an unfounded guess
and an educated guess.)
The outcome of guessing is to apply
the wrong risk-management rules. You
could buy the Euro the day after the
warning day and make a profit, but
you would have had to adjust your
gain/loss expectations considerably.
Let’s say you are used to swing-
trading over a three-day period. The
daily average range is 120 points and
your aim is to capture 75 percent of
that (90 points) per trade. You are will-
ing to lose 45 points per trade for a
gain/loss ratio of 2:1. These metrics
are part of your trading plan. (The
other part is your technique for identi-
fying the direction and strength of the
upcoming move.) Now you shift to a
day-trading mode, where you intend
to get in and out in three hours. What
is the maximum, minimum, and aver-
age gain you can expect? If you don’t
know, you can’t set a reasonable stop
or a reasonable profit target.
In this instance, the hourly average
range shrinks to only 20 points. Let’s
say you plan to hold for three hours,
meaning the maximum gain you could
expect would be 60 points. To aim for
75 percent of that move would be to
target a 45-point profit, and if you keep
your stop at half that, you would exit
on a drop of 23 points below your
entry. As it happens, you would have
made the 45 points if you had entered
at the Chicago open. But how many
traders can change gears like this?
Professional traders can change
gears like this. If the market is offering
a messy situation, they develop a new
strategy to take advantage of it — in
this instance, changing the timeframe
of the trade. If the world is going to
hell in a handbasket, they don’t judge
it — they find the currency most
affected, and trade it short.
The flexibility of the professional
trader extends to the asset being trad-
ed, too. If their usual currency starts
trading dead flat, they can shift to a
different one. When the Canadian dol-
lar gets stuck in a sideways range, they
turn attention to, as an example, the
Swiss franc. Are all the major-traded
currencies moribund? What’s happen-
ing in the exotics (the lesser-traded
currencies such as the Swedish krona
and Mexican peso)?
The big-picture perspective
That brings us to the final point: pro-
fessionals believe there is always
something to trade. Amateurs may
complain the market isn’t trending like
it used to, or it’s too choppy.
Professionals don’t have the luxury of
complaining about the market. It’s
their job to make money no matter
what the market is doing. Amateurs
would rather be right than make
money, while professionals are willing
to admit they are wrong, and make
money anyway.
The lesson is that to trade like a pro-
fessional, you have to work a little
harder (seeing the warning signs in the
bar configuration), be ruthless in aban-
doning preconceived ideas about what
“should” happen (taking the loss), and
adapt your trading style (switching
timeframes). Then you can have confi-
dence that the market is a playground
in which you can make money, and not
a battlefield on which you will suffer
more losses than gains.
July 2005 • CURRENCY TRADER
 THE BIG PICTURE

Detecting the
professionals’ footprints:
Lessons of the Chinese revaluation
On paper, the Chinese renminbi revaluation is a historic event. But the market’s initial reaction
was fairly muted (if intriguing). Find out how things could play out in the forex
market in the new world of Chinese forex participation.
BY BARBARA ROCKEFELLER

H ow can you know what the professionals are

doing in the spot market? At first glance, the
answer is, “You can’t.” Transactions executed
by banks for their clients (or their own
accounts) are confidential, and we don’t even learn the size of
trades; volume is not reported in spot forex as it is in equities.
Professional traders at banks and brokers like Citibank,
Deutsche Bank, UBS, and other huge institutions have the
inside track on where the “real money” is going. They can
then follow it or, in some instances (if they see it coming),
front-run it.
What is real money? Real money clients are major multi-

35 August 2005 • CURRENCY TRADER

national corporations, global investment houses, central
banks, and other official institutions. These clients are con-
sidered “real money” because they have true underlying
business reasons to buy or sell currencies.
For example, let’s say you are the manager of a global
mutual fund that requires you to have 30 percent of your
funds invested in Japanese stocks. New investor money
comes in, and now you have to buy shares in every stock
listed in the Nikkei 225 Stock Index.
To do that, you must buy Japanese yen. Now let’s say the
Nikkei is reconfigured to add a few new stocks and drop a
few old ones. You need to sell the stocks being kicked off the
list and buy the ones being added to it, and the ones being
added are usually more expensive, contributing to a bigger
demand for yen. If you are the yen trader at a major bank
and you are keeping track of the reconfiguration of the
Nikkei Stock Index, you know that your fund managers
will be buying yen and you can stock up ahead of time.
Then there is the “hot money.” Hot-money traders don’t
have an underlying business reason to be doing the trades;
When a big move is certain to come on an announcement,
even governments can find it too tempting to resist making a few fast bucks.
their trades are purely speculative. It’s called hot money
because it’s fickle and often short-term in nature. This is
traded by speculators such has hedge funds, commodity
trading advisors, high-net worth individuals — or the guy
sitting just a few desks away who is trading for the bank’s
own portfolio, as are his cohorts at the other major banks
and brokers. Traders who trade the bank’s own money are
called “prop” traders, for “proprietary.” Not all prop
traders are in-and-out artists, but some are.
Nobody knows the ratio of real money to hot money.
Most traders say hot money is a bigger proportion of total
trading than real money, but real money is the better bet to
follow — if your client is making the trade, others in the
same business are probably making the same trade, and
thus you are going to get a price trend (or at least a longer-
lasting price move). In fact, the real money will provide
market “support” in some cases. In the extreme case of cen-
tral bank intervention, the real money is very real and the
support level is well-advertised.
That’s the first clue to finding the professionals’ foot-
prints — support and resistance, which can be a specific
CURRENCY TRADER • August 2005
price right down the fourth decimal place, or a general area
10 to 20 points on either side.
Real-money traders often have a timing choice, and they
will be consistent buyers at what they consider a low, or
consistent sellers at what they consider a high. Speculators
also estimate support and resistance levels, which are
always mentioned in the endless stream of market com-
mentaries available in print and on the Internet. Market
News, Reuters, Bloomberg, and the sites of banks, brokers,
and advisors chew over support and resistance levels every
few hours, since support and resistance are (usually) mov-
ing targets.
Support, resistance, and footprints
Sometimes, however, support and resistance are fixed —
almost always a “historic” high or low that was notewor-
thy for having been the highest or lowest in a long time. For
example, on June 24 the Euro/U.S. dollar rate (EUR/USD)
passed down through the round number 1.2000 to a low of
1.1983, the lowest low since the week of Sept. 3, 2004 (10
months).
The market had been watching the round number for a
while, wondering if it constituted some form of magic sup-
port, as round numbers sometimes do. The breakout below
1.2000 (see Figure 1) implied further Euro losses. Sure
enough, on July 5 the Euro hit a fresh low of 1.1867, but on
July 8 it managed to make a low of only 1.1874 — a mere
seven-point difference, but it was not a lower low, which
didn’t escape anyone’s notice. Moreover, the bar configura-
tion of those few days was not favorable to a further Euro
drop: On the date of the lowest low, the close was higher
than the open and the previous day’s close, which proved
to be the configuration for most of the next five days.
This was a signal to professionals that a bottom was
forming around the support area of 1.1867-1.1874, and if
you can’t sell it for a gain, you should buy. You might say
the stage was set for the Euro to rise and the dollar to fall,
but at the same time resistance was well-established at the
previous highs around 1.2225.
The next move in this little saga was the mysterious rise
continued on p. 37
36
 THE BIG PICTURE continued
in the Euro on July 20. Between 1 and 3 p.m. ET — when
European traders have already gone home and the U.S.
market is almost finished for the day — the Euro flew
upward from 1.2042 to 1.2156 by 3 p.m., an enormous move
at any time, and downright astonishing for the time of day.
Everyone was caught by surprise and scratching their
heads in wonderment — yes, there was commentary from
Federal Reserve Chairman Alan Greenspan’s semi-annual
testimony to Congress, but he didn’t actually say anything
new and certainly nothing dollar-negative. What really
happened? One story had it that orders to sell dollars and
China’s goal is not to revalue; it’s to
build a sustainable forex regime.
buy Swiss francs and Euros were coming out of
Switzerland, and perhaps from an official institution. We
still didn’t know why the orders had been placed, but the
size of the move as well as the timing pointed to a real-
money source rather than a mere speculator.
The next morning the real news broke — China was
revaluing the renminbi against the dollar by 2.1 percent and
instituting a managed float based on a new and undisclosed
basket of currencies. When the Chinese revaluation report
came out, the Euro rose against the dollar immediately,
from 1.2139 to 1.2255. The dollar/yen rate tumbled from
112.31 to 110.34 within the first hour. For a short while, at
least, it looked like resistance was broken and the Euro was
off to the races.
In the nearly two years the Chinese revaluation was on
the radar screen, two forex forecasts had become the con-
sensus. First, the yen would strengthen in line (or more)
with the renminbi, since China is now Japan’s leading trade
partner. Second, it was curtains for the dollar, meaning the
Euro would rise. The dollar should fall because the relief in
the U.S. trade deficit would be small unless China revalued
by 30 to 40 percent, which was politically impossible, and
because a shift to pricing the renminbi against a basket of
currencies instead of just the dollar would reduce the need
for the People’s Bank of China to buy U.S. Treasuries. A
drop in demand for Treasuries would cause the price to fall
and the yield to rise, which sounds good until you realize
higher yields could burst the housing bubble (or “froth,” as
Greenspan describes it). With the U.S. consumer reducing
(or at least not increasing) spending, the U.S. economy
would stumble, growth would fall, and the Fed would be
thinking about cutting rates some three to six months after
the event.
Sure enough, the day after the Chinese revaluation, the
37
yield on the 10-year T-note soared to 4.276 percent on the
assumption foreign demand for Treasuries would fall. No
one knows if this is the correct interpretation of events.
There’s no evidence of lower demand, and even if official
demand falls, private demand may be a perfectly adequate
substitute. Remember, much of the foreign capital inflow
into U.S. government paper comes from the UK and
Caribbean havens, where the banks are “fronting” for the
real customers. They may be Middle East oil sheiks — or
newly rich Chinese businessmen.
Were the dramatic moves in the Swiss franc and Euro
ahead of the announcement evidence the Chinese revalua-
tion was leaked ahead of time? And if it was leaked, why
did the Euro rise, and not the yen? After all, the yen made
an even bigger move after the release.
We will never know if the puzzling Euro rise was the
result of a pre-announcement leak, and if so, who was
behind it. Perhaps the Chinese themselves bought some
Euros, or Chinese officials with private accounts. Because
the Chinese were emulating the Monetary Authority of
Singapore’s methodology, maybe it was the MAS. Since
Hong Kong and the U.S. were alerted ahead of time, they
might have been the source of the buying, too.
For all we know, other central banks (and therefore their
government officials) were told as well, not to mention the
IMF and the Bank for International Settlements, which were
certainly part of the pre-revaluation decision process. When
a big move is certain to come on an announcement, it’s too
tempting to resist making a few fast bucks, even if you’re a
government. One possible reason why the yen didn’t move
is because Japanese Ministry of Finance has been threaten-
ing for some time that it would intervene if it saw the yen
move inappropriately.
An event like this comes along very rarely, but when it
does, you want to be able to jump on the bandwagon,
because there’s usually “real money” behind it. The ear-
marks of such a move is that it is large, unexplained and in
the opposite direction of the existing trend. In the case of the
trading ahead of the Chinese revaluation, the time of day
contributed to the mystery.
How will it play out?
From experience, a big real-money move like this will con-
tinue in the same direction, breaking the previous trend and
invalidating the old support levels. But this time the Euro
high over previous resistance was only an anomaly, and it
doesn’t show up on Figure 1 because the chart was taken as
a 5 a.m. ET snapshot of the currency market, excluding daily
highs and lows. If it was a real-money move, it fizzled; by
the next day, the price was back in the old range. The cur-
rencies failed to hang on to gains and the Swiss franc, Euro,
and yen all fell back in the first few days after the announce-
ment. This is quite confusing. Where’s the follow-through?
August 2005 • CURRENCY TRADER
 The answer lies in what might be called “analytical grid- the Chinese. Nobody wanted the tariff outcome, and the
lock.” The Chinese revaluation is a unique event in interna- Chinese president was scheduled to visit the U.S. in
tional financial history. Never before has a developing September. It would have been a diplomatic nightmare to
country of such size and economic power shifted policy receive him while a massive tariff was on the agenda, but
from a dollar peg to a managed float, and never has the the administration would have to admit that in the U.S. sys-
stake been so big. And the “experts” are of two minds about tem, Congress has the right to take its own initiatives
what it means. regardless of what the administration may want for diplo-
The old consensus that the dollar must fall was put under matic purposes, putting the ball in China’s court. Therefore,
the microscope and proved to be unconvincing. Or perhaps it was sensible to expect action over the summer, and yet
some pro-dollar real money came into the picture. It’s pos- few people felt they could forecast the timing because of
Chinese complaints they
resented being bullied and
FIGURE 1 — SPOT EURO SUPPORT AND RESISTANCE
would operate on their own
After breaking below the “round number” of 1.2000 in late June, the Euro formed a sup- time table.
port level by making lows at 1.1867 and 1.1874. And yet a 2.1 percent reval-
uation is hardly sufficient to
Euro (EUR), daily
keep the Congressional critics
from presenting their ruinous
tariff bill on another occasion.
A Chinese central bank official
told the press that obviously 2
percent is not sufficient to
solve the trade imbalance
with the U.S., but it “will buy
time for industry reforms.”
Time, of course, is a relative
concept. The Chinese may be
measuring in years while the
U.S. Congress is measuring in
months. So the big question is
how much will future changes
be? Technically the renminbi
can vary 0.3 percent per day
from a central rate, so over the
course of 10 days, it could rise
by 3 percent. No one actually
expects this degree of change.
Data Source: eSignal, Chart: Equis Metastock One China expert says we
may expect a 7-percent total
sible to review a few of the issues, but it may not be possi- revaluation by year end and a total of 15 percent by the end
ble to come up with a decisive forecast at the end of it. In the of 2006.
end, we will know the winner of the analysis contest by There are two issues here. The first is that 7 percent is not
which gets broken first, support or resistance. a lot and even 15 percent over 18 months isn’t a big change.
First, the revaluation was prompted by the loud talk of Merchandise trade with China will hardly be dented by lev-
the U.S. and the somewhat softer talk of the Europeans and els like this.
Japanese. Treasury Secretary John Snow made the first In the same line of reasoning, China will be earning
demand at a G7 meeting in the Middle East in September almost as many dollars as it was before, and since the new
2003, so the subject has been on the table for a very long basket of currencies must contain a high ratio of dollars, it
time. The crisis point came when the U.S. Senate passed a will still be buying U.S. Treasuries and other official paper
first-step resolution to consider a bill imposing a 27.5-per- for its reserves in roughly the same amounts.
cent tariff on all Chinese exports to the U.S. In other words, the revaluation changed almost nothing.
To head off that outcome, the U.S. sent a special envoy to China was the biggest buyer of U.S. government securities
China for at least three week-long high-level meetings with continued on p. 39

CURRENCY TRADER • August 2005 38

 THE BIG PICTURE continued
in the 12 months ending May 2005, when its accumulated
Treasuries totaled $243.5 billion, the second biggest official
holder after Japan. Asian central banks and private
investors owned more than half of the $2.03 trillion of
Treasuries held by foreigners, out of the roughly $4.03 tril-
lion in marketable U.S. securities outstanding. Whether the
revaluation is 2.1 percent or 15 percent, China is still a major
player in the capital flow picture. They have the same stake
in preserving the value of their asset, which we call the
Golden Goose argument (see “The Golden Goose Rule,”
Currency Trader, February 2005).
The dollar is still going to be a big piece of the reserve pie
in China. First, we don’t assume the Chinese would have
left reserve diversification until after the revaluation. But
even if they did, the undisclosed basket of currencies that
will be the basis of the new floating renminbi must consist
largely (probably about 50 percent) of dollars or dollar-
pegged currencies such as the Hong Kong dollar. The need
for serious diversification on a transaction basis is low. The
only reason to diversify much or to talk about diversifica-
tion would be political — to “punish” the U.S. for some
other action in the military or diplomatic sphere.
It took a lot of wind out of speculative sails to acknowl-
edge these points. Not much has changed. The U.S. will still
be running massive trade deficits with China, and China
will still be holding massive amounts of U.S. paper.
One other thing is becoming clear: By depriving specula-
tors of a fat, one-time gain, China is only inspiring them —
and probably a new group of speculators, to boot. Hot money
capital inflows can only rise. Because the Chinese are very
smart about how markets work, you have to wonder if this is
not their intention. They complain about the inflationary
effect of inflows, but for some interim period, inflows must be
what they want. Developing economies always want capital
inflow, and China has had it in spades over the past three
years. This is not really different from the powerhouse U.S.
economy funded by European capital inflows in the 1800s.
If hot-money inflows into China grow bigger as the rate
is seen to be managed at too tame a level, the Chinese can
39
continue to sterilize them by buying up the dollars and then
investing them in Treasuries, as before; the yield on the 10-
year bond can remain constrained. The current thinking is
that rates would be about 1 percent higher were it not for
foreign (including Chinese) demand for U.S. paper. The
housing market is safe from precipitous rate increases.
But hot capital flowing into China can spill over to
Taiwan, S. Korea, and elsewhere, in a speculative effort to
get them to unpeg, too. This means outright dollar sales, so
the net effect is dollar-negative. In fact, according to this
view, the dollar must fall because the 2.1-percent revalua-
tion is too skimpy. It needs to be more like 30 to 40 percent
to stop the interest-rate/dollar game and establish stable
relationships.
Therefore, the Chinese choice of a token 2.1 percent reval-
uation is not a stabilizing influence on the global imbalance,
but potentially a destabilizing one — and discord within
the Chinese government about the extent and timing of
additional moves is a frightening prospect.
Do the Chinese really have a plan, and what is it? The
Chinese announcement contained magnificent statements
to the effect that China seeks “to enable the market to fully
play its role in resource allocation,” but China’s goal is not
to revalue, it’s to build a sustainable forex regime. It is in
this sense that what’s in China’s best interest is not neces-
sarily what’s in the interests of the rest of the world.
Because the Chinese central bank reserves to itself the
right to adjust the renminbi band whenever and however it
chooses, we now have the tiresome task of following the
pace and extent of upcoming renminbi price changes and
how they affect trade and capital flows, if any.
Clearly the benchmark Euro/dollar exchange rate can’t
stay stuck forever in the range shown in Figure 1, but until
we have a better view of the Chinese thinking on the sub-
ject — and actions speak louder than words — the main
currencies are hostage to indecisiveness and range-trading.
Keep your eyes peeled for the breakout of either the sup-
port or resistance line.
August 2005 • CURRENCY TRADER
 THE BIG PICTURE

Fundamentals, technicals,
and key reversals
Technical patterns don’t exist in vacuums. They must be interpreted within the framework
of the prevailing market conditions and news.

BY BARBARA ROCKEFELLER

I n the endless quest to understand the interaction

between technical and fundamental factors in forex,
we sometimes get a price bar that makes us sit up
and take notice.
Such is the key reversal bar, which is more than just a
price spike. It’s defined as a bar with an open below the
previous day’s close, followed by a close higher than the
previous day’s high (for an upward reversal). For a down-
FIGURE 1 — KEY REVERSAL BARS
A key reversal bar (for an upside reversal) has an open below the previous
day’s close, followed by a close higher than the previous day’s high (left).
For a downside reversal, it’s a bar with an open above yesterday’s close
followed by close lower than the previous day’s low (right).
ward reversal, it’s a bar with an open above yesterday’s
close followed by close lower than the previous day’s low.
The examples in Figure 1 show the full-blown form of the
key reversal bar when it is also an “outside day,” meaning
the low is lower than the previous day’s low, not just the
previous day’s close (in a downtrend). However, a bar does-
n’t have to be an outside day to be a key reversal day. It suf-
fices to have an open under the previous day’s close and a
close higher than the previous day’s
high.
Figure 2 shows a key reversal bar in
the September 2005 Japanese yen
futures (JYU05). Although the bar
doesn’t make a lower low, its low is
below the previous close. Anyone fol-
lowing the news would not have been
surprised by this bar, which broke the
down trendline and ended the day
nearly at the high, because this was the
day the People’s Bank of China
announced a managed float and reval-
uation of the renminbi (yuan) vs. the
dollar.
For months commentators had been
forecasting a Japanese yen jump
upward on the event, and when it
materialized on July 21, yen buyers
immediately rushed in to fulfill the
forecast. (To a trader, it doesn’t matter
whether there are sound economic and
financial reasons for the yen to rise on
the Chinese action. What matters is
that for at least one day, the price
action will be what the market has

40 September 2005 • CURRENCY TRADER

 FIGURE 2 — KEY REVERSAL BAR

The key reversal bar shown here bar didn’t have a lower low than the previous bar, but its
low was below the previous close. This bar coincided with the People’s Bank of China
announcement regarding the renminbi (yuan) revaluation vs. the dollar.

talked itself into believing.)

The key reversal day is not
a reliable standalone trend-
change indicator. It is a better
indicator of a trend change
when it is followed the next
day by a bar that delivers a
close near the high, even if an
absolute new high is not made
on the second day. For exam-
ple, if the high-low range of
the bar is 100 points, you’d
want the close to be no more
than 25-35 points down from
the high.
But in Figure 2, the closing
price the day after the key
reversal bar was closer to the
low than the high, and thus
failed to confirm its trend-
reversal potential. The yen
proceeded to make lower Source: Data courtesy of Reuters, Charts by Metastock
lows over the next four days
(although note that on the last
two lower-low days, the close
FIGURE 3 — KEY REVERSAL BAR AND THE HISTORIC HIGH
was higher than the previous
day and near the highs of The key reversal bar shown here didn’t have a lower low than the previous bar, but its low
those days). was below the previous close. This bar coincided with the People’s Bank of China
A key reversal day is also a announcement regarding the renminbi (yuan) revaluation vs. the dollar.
better predictor of a new trend
if the pullback from the new
high is weak, meaning it does-
n’t match the previous low. In
Figure 3 there is a weak pull-
back from the new high and,
of the 18 days since the key
reversal day, 13 closes were
above the resistance-line
breakout (bottom horizontal
line) and only five were below
it. In addition, the price made
three highs above the key
resistance day’s high (top hor-
izontal line), and five closes
above the key reversal day’s
close.
Finally, we can draw a stan-
dard error channel from the
lowest low just before the key
reversal breakout. The hori-
zontal line from the breakout
continued on p. 42 Source: Data courtesy of Reuters, Charts by Metastock

CURRENCY TRADER • September 2005 41

 THE BIG PICTURE continued

above resistance on the key reversal day hits the bottom of vides a seasonal inflow of money into Japan, as Japanese
the channel at .8991. The bottom of the channel forms sup- holders of foreign bonds collect their interest payments
port in its own right, and the intersection of the breakout around mid-month. Is it true the yen usually rises in
line with the channel gives it
additional strength. This may FIGURE 4 — FUNDAMENTAL SUPPORT FOR THE KEY REVERSAL
be considered a variation on
the old market lore that “old Japanese Prime Minister Koizumi’s announcement dissolving the lower house of the Diet
resistance becomes new sup- if it refused to pass reform bills privatizing the Postal Service (which also encompasses
Japan’s largest savings banks and life insurance company) triggered five full days of high-
port.” If the level were broken,
er highs and higher closes. Privatization of the savings and insurance businesses would
we would have to abandon
liberate both sectors from the heavy hand of the state and help put Japan back on the
our faith in the trend reversal road to fiscal prudence.
heralded by the key reversal
day.
We missed getting a second
bar with a confirming config-
uration, but we got three other
pattern confirmations — the
weak pullback, higher highs,
and a series of higher lows.

The fundamental side

Now we have to ask whether
the original impetus of the key
reversal day, the Chinese float,
stood up to scrutiny. The
answer is no, it didn’t. For one
thing, the Chinese central
bank said — and repeated —
that it was not going to reval-
ue again; the paltry 2.1-per-
cent revaluation against the
dollar was going to be the
only “big” move, and the rest
would have to come from the Source: Data courtesy of Reuters, Charts by Metastock
daily allowable moves. This is
why the yen faded downward right after the big day. But August? Yes, but not consistently. The yen has risen in 10 of
other yen-favorable factors were in the news, and the mar- the past 16 years. But it has risen every year in the past
ket was willing to use them as substitutes for the lost influ- seven years, which is pretty impressive. The point is that
ence of the renminbi revaluation. when it doesn’t rise, it falls only a little, but in years when
The lesson is that a breakout such as a key reversal day it does rise, it rises a lot — and that’s what people remem-
can be based on a false or weak premise, but the move is not ber.

China’s increasing integration into the world economy favors the yen
more than any other currency.
necessarily condemned to failure for that reason. The key Next, second-quarter GDP came in below forecasts, but it
reversal day itself suffices to raise questions about the pre- contained the critical component of high private-capital
vious downtrend, encouraging traders to be willing to look spending, long the engine of Japanese growth. At the same
around for other reasons to keep the new move going. time, the central bank is now predicting deflation will be
And Japan delivered enough favorable news in the days whipped by the end of the fiscal year (March 2006), allow-
and weeks following the key reversal day to support the ing interest rates to be lifted. In the background, the finan-
yen. First, traders perceive that August traditionally pro- cial sector seems to be cured of its overhang of bad loans,

42 September 2005 • CURRENCY TRADER

 FIGURE 5 — THE NIKKEI STOCK INDEX AND THE JAPANESE YEN, WEEKLY to the market, and the return
China's ever-greater integration into the world economy favors the yen more than any has become a flood. Ten days
other currency. Although the Nikkei-yen correlation is not perfect, it is strong. And every after Koizumi called for new
foreign investor who buys Japanese stocks must first buy yen. elections, the government
reported that in the most
recent five weeks, foreign
investors had bought the
Yen largest amount of Japanese
stocks in 17 months, a net
¥21.15 billion ($17.6 billion).
Figure 5 shows the correlation
of the Nikkei stock index with
the yen. It’s not a perfect one-
for-one relationship, but every
foreign investor who buys
Japanese shares has first to
buy yen.
Finally, we circle back
around to the China connec-
Nikkei tion. Chinese Premier Hu
Jintao will visit the U.S. in
September, and may use the
occasion to announce another
currency revaluation (as
wished by certain members of
the U.S. Senate) or some other
Source: Data courtesy of Reuters, Charts by Metastock act indicating acceptance of
free-market principles, such
after 10 years of sweat and tears. as liberalizing merger-and-
Third, Prime Minister Junichiro Koizumi kept his promise acquisition (M&A) terms for Chinese firms. This may be
to dissolve the lower house of the Diet if it refused to pass directed toward the U.S., since it was the asymmetry in
reform bills privatizing the Postal Service. The announce- M&A conditions that annoyed the U.S. business communi-
ment triggered five full days of higher highs and higher clos- ty in the case of the Chinese oil company CNOOC bidding
es (Figure 4). Calling new elections turned out to be a stroke for America’s Unocal, but Japan will be a beneficiary, too.
of political genius, because Koizumi’s approval ratings Because China is now Japan’s biggest trade partner and
rocketed higher on his courage in defying the old political the top destination for new direct investment capital, any
hierarchies. liberalization of trade and investment terms inside China
Koizumi’s new popularity is also symbolic of the benefits Japan. In early summer we witnessed the strange
Japanese people’s willingness to accept deep structural occurrence of anti-Japan rallies and vandalism against
change. The Postal Service in Japan encompasses not only Japanese property in China — acts which were thought to
mail delivery, but also the world’s largest savings bank and be instigated by the Chinese government, which then
the country’s biggest life insurance entity. Both the savings cracked down on them. Murky politics are behind these
and insurance businesses will be privatized (and become developments, which may yet come back to damage the
taxable), albeit over a lengthy period of time, liberating both Japan-China relationship. Meanwhile, China’s ever-greater
sectors from the heavy hand of the state and putting Japan integration into the world economy favors the yen more
back, it is hoped, on the road to fiscal prudence. As we than any other currency. In fact, some advisors say the
know from experience in the U.S., free markets create safest way to play the China card is to invest in Japan.
opportunities. A key reversal day does not always signal a trend change,
Then there is the acknowledgement by foreign investors but when fundamental conditions favor the new direction,
that Japan had been “underweight” in their portfolios since as was the case with the yen, it is something we should
the 90s. Japan is the world’s second-largest economy but respect. 
generally it didn’t hold second place in the country rank-
ings of investment managers. After the Nikkei 225 stock
index bottomed in 2003, foreign investors started returning

CURRENCY TRADER • September 2005 43

 THE BIG PICTURE

Myths and scams

Traders like to believe they’re making rational, informed decisions, but the dollar’s recent history
shows how today’s market “truths” can turn out to be tomorrow’s mass delusions.

BY BARBARA ROCKEFELLER

FIGURE 1 — EURO/DOLLAR RATE, WEEKLY

Perceptions that central banks would reduce their dollar holdings helped push
the Euro to new highs vs. the dollar at the end of 2004.

A year ago, rumors

abounded regarding
central bank reserve
diversification out of
the U.S. dollar and into the Euro. It
was one of the major factors propelling
the dollar downward in the fourth
quarter to a record low of 1.3667
against the Euro on Dec. 30, 2004
(Figure 1).
The problem is, it wasn’t true. In late
September, the IMF reported the dol-
lar’s share of reserve holdings was sta-
ble as of year-end 2004 at 65.9 percent
of total world reserves, which total
about $3.7 trillion. This was up from
the year before, not down (Table 1).
While some emerging market coun-
tries such as South Korea say they are
reducing their share of dollars, others
are sticking to the buck. Japan, for Source: TradeStation
example, is the world’s largest holder
of currency reserves at $840 billion, up record low? The total amount of dollars for sale from
$170 billion over the past year. Japan puts nearly all of it reserves was probably less than $1 trillion — and this in a
into dollar-denominated assets, and government officials market that routinely processes $1.5 to $2 trillion per day. In
periodically affirm they do not intend to change the com- this light, it looks like “reserve diversification” was — and
position of their reserves. is — an unfounded scare tactic the market chose to accept
China has been reporting since 2002 that it has been uncritically as a trigger for anti-dollar hysteria.
reducing dollar holdings from 90 percent of total reserves to
about 60 percent today, while Russia, South Korea, and Who’s pulling the strings
Taiwan have also reduced their proportional share of dol- Who benefits from spreading such a story? Just like traders
lars. “talking their position,” countries get an announcement
Was this a sufficient reason to drive the dollar down to a effect from talking about diversification that adds immedi-

44 October 2005 • CURRENCY TRADER

 It is a peculiarity of the foreign exchange market
that it is attracted to the unknown and unforecastable.
ately and measurably to their bottom line. What is shocking is the amount of money the U.S. owes the
But wait a minute. If central banks are long-term holders rest of the world — as of the end of June, the date of the
of reserve assets, such “profits” are only paper gains that most recent data, over $5.2 trillion, an increase of $600 bil-
can vanish the next time the currency reverses direction. lion from the year before. It’s scary to think that during
That is true, but meanwhile they derive a sense of power 2004, foreign investors bought 98.9 percent of all new
from being able to produce an announcement effect. This Treasury issuance — $358.5 billion of $362.5 issued. They
could come in handy in high-level negotiations over things also took almost 90 percent of Agencies (the debt instru-
such as whether a 2.1-percent Chinese yuan revaluation ments of U.S. government agencies such as Fannie Mae and
really qualifies as delivering on the G7’s urgent calls for a Freddie Mac) and 43 percent of corporate bonds. Note that
“more flexible forex regime.” China has hinted more than this is all foreigners, including private investors, not just
once it feels it has the upper hand on this score. In central banks (www.gillespieresearch.com/cgi-bin/s/arti-
September, a Chinese state research official said China cle/id=666). At this point, foreigners own 45 percent of all
should be diversifying reserves into oil and oil-producing the Treasuries ever issued.
assets, a comment the government had to “clarify” the next Well, so what? The U.S. bond market is bigger than the
day by saying it wasn’t seriously considering any such other top three bond markets put together (UK, Eurozone,
thing.
Who really has the upper hand — TABLE 1 — SHARE OF THE DOLLAR IN TOTAL OFFICIAL FOREX RESERVES
the big Asian economies, which hold
so many dollars and so much U.S. gov- Despite worries the U.S dollar’s status as the world’s reserve currency was
waning, world dollar holdings actually increased in 2004.
ernment paper, or the U.S. itself, which
is, after all, the source of the dollars in 1999 2000 2001 2002 2003 2004
the first place? An Asian central bank
can threaten to sell dollars and get an 64.9% 66.6% 66.9% 63.5% 63.8% 65.9%
instant effect, whereas the U.S. cannot Source: International Monetary Fund
realistically threaten to stop buying
everything from socks to stents from
Asia, because the U.S. literally does have a free market. and Japan), and we saw from the ease with which Citibank
Ultimately, the status quo is in both parties’ best self- manipulated the European bond market over the summer,
interests. Both businesses and consumers in the U.S. get an by far the most liquid. In July, net capital inflows into the
endless supply of cheap goods, which holds inflation down. U.S. totaled $87.4 billion (and June was revised up to $80.9
The Asian economies get income from export sales that fuel billion), or a two-month total of $168.3 billion.
their factories. Without the American consumer, where We don’t have the Q3 current account deficit yet, but the
would all those people work? Until these economies are Q2 deficit was $195.7 billion, or 6.3 percent of GDP. If Q3
self-sustaining — able to support their domestic manufac- delivers a similar deficit and if capital flows are about the
turing bases with domestic sales — they need the U.S. same, we have no problem. The world is willing to fund the
Talk of reserve diversification probably won’t go away current account deficit. In fact, the world should be worried
any time soon, even if every trader in the business comes to the U.S. will stop running deficits, since it lacks low-risk,
believe it’s just a scam to manipulate the market. Like inter- high-liquidity capital markets of its own.
vention, it’s too big a factor to ignore even if you know This leads to the observation that the U.S. couldn’t “fix”
you’re being jerked around. It’s not an empty threat, as we the deficit by itself even if it tried. Treasury Secretary John
saw in the fall quarter last year, but increasingly market Snow says other countries have responsibilities too. They
participants are coming to question whether it’s the U.S. need to encourage higher growth in their own economies,
current account deficit and accompanying dollar accumula- not only to provide markets for their own factory output,
tion or the emerging economies’ dependence on the U.S. but also to raise the return available to investors. If you
consumer that is “unsustainable.” were a Japanese pension fund manager and you had a
The question is unanswerable; it seems like a stalemate. choice of 1.30-percent domestic bonds or 4.30-percent U.S.

CURRENCY TRADER • October 2005 45

 THE BIG PICTURE continued
It is not an unimportant question whether Europe will take over the mantle of world
financial leadership from the U.S., as the U.S. took over from Great Britain after
the war. But is it an immediate, real-life prospect on which to trade today? No.
bonds of the same maturity, which one would you prefer?
It’s a no-brainer.
Same old same old
None of this is new. Many analysts have been making these
points for several years now. So why did the market allow
itself to get snookered by the reserve diversification scare
last fall? And why does the market continue to flail around
on rumors and threats rather than hard facts and data?
It is a peculiarity of the foreign exchange market that it is
attracted to the unknown and unforecastable. Everyone can
get economic data and political news, and thus most data-
based trading is routine. If a release is expected at X and
comes in at X minus 30 percent, the dollar is sold off, at least
briefly. If it comes in at X plus 30 percent, it will be bought.
How boring. At any one time, we have three or four factors
in the market and a delicate balancing act as to what aggra-
vates or offsets something else.
The one big exception is the payrolls report — the least
forecastable member of the forex data pantheon. No forecast-
er ever predicts this report correctly, which makes it more
exciting. The payroll report is the darling of the bond market,
too, which partly accounts for the fascination of forex traders.
And it doesn’t matter that Fed officials and normally respect-
ed economists alike are declaring that an unexpected change
in payrolls will not affect policy or the real economy.
Whatever the payrolls release turns out to be, the forex mar-
ket is going to spike on it, sometimes in both directions on the
same day. The one time you should be sure not to have a posi-
tion in currencies is the morning of the first Friday of each cal-
endar month when payrolls is released. You can’t win even if
you did forecast the correct number.
In fact, according to analysis by S.A. Johnston, on the pay-
roll date each month from January 1999 to September 2005,
the Swiss franc delivered up days (close higher than the day
before) 40 times and down days 40 times. The maximum
spike up during the day was 166 points; the maximum spike
down was 179 points. In the Euro, 42 payroll date-days closed
up, while 36 days closed down. The maximum spike up was
240 points and the maximum spike down was 249 points. For
all the major currencies, the number of up days and down
46
days is about equal, and the amount of the biggest spike in
either direction is about the same, too. In short, trading the
payrolls release is a waste of time unless you are trading in
terms of minutes and can exploit the spikes as they are hap-
pening. This is presumably why the market is so enamored of
this release—but for traders looking to incorporate funda-
mentals into their trading, it’s not a worthy piece of data.
At a guess, the reserve diversification story, which has so
little meat on its bones, is like the payrolls story, only more
glamorous because it contains a tinge of high-stakes, high-
level, secret politics, and the illusion of history-in-the-mak-
ing. It is not an unimportant question whether Europe will
take over the mantle of world financial leadership from the
U.S., as the U.S. took over from Great Britain after the war.
But is it an immediate, real-life prospect on which to trade
today? No.
FX traders just want to have fun
It’s no fun to trade boring old data such as the Chicago
Purchasing Managers Index or retail sales. Even top-tier
data such as the Consumer Price Index can be tedious. With
reserve diversification, it’s a thrill to imagine you are trad-
ing on a partly glimpsed piece of global capital flows. Only
about 20 people in the world know the real-money reserve
flows — 10 central banks and their commercial bank traders
— and they are not talking. It feels glamorous and sophisti-
cated to be part of the process.
But it’s an illusion. You don’t really know. Hundreds and
maybe thousands traded on the reserve diversification
story last year and now we find out they were deluding
themselves.
It’s certainly acceptable to trade with the market —
that’s how to make profits and avoid losses. But it’s impor-
tant to know a hawk from a handsaw. The reserve diver-
sification story was, in the end, a hoax, nourished by pure
fantasy. If you had detected the story was probably
untrue, you might have been better prepared for the dol-
lar rally that started immediately after the start of the new
year.
So here’s the question: What do we believe today that
will turn out to be untrue tomorrow?
October 2005 • CURRENCY TRADER
 THE BIG PICTURE
Fundamentals duel
the technicals
Fundamentals may rule the den in the long run, but short-term reactions
in the market are often based on anything but rational analysis.
BY BARBARA ROCKEFELLER
W e like to say that a really juicy piece of
fundamental information will trump the
technicals every time. Technicals are the
quantification of what traders think and
believe, and what they think and believe is shaped by the
fundamentals. Fundamentals include economic news, insti-
tutional arrangements, business conditions, and the occa-
sional dash of politics.
But is it really true that fundamentals trump technicals?
The forex market has become so enamored of technical
analysis that today we have to question whether the funda-
mentals actually do rule the market. Sometimes it seems
traders are perverse in their response to “real” events, inter-
preting them to suit the chart instead of adjusting the chart
to reflect economic reality.
Let’s look at a few cases from the past few months and try
to name a winner.
Three types of fundamental events
The “fundamentals” are real economic data, developments
in related markets, and “institutional” changes, such as cen-
tral bank policy decisions. Very little of what passes for
“news” is actually new. In nearly every case, we know the
news is coming — usually to the exact minute — and we
also know the likely range of the data or the expected con-
tent of the announcement.
It is a triumph of the electronic age that we have so much
information and can usually slot it into context, to boot.
Newspapers and newswires tell us, for example, the current
quarterly GDP growth rate vs. the previous quarter, the
annualized rate, the last time it was so high or low, how it
compares to the growth rate for the same period in other
countries, and so on. Traders in the foreign exchange mar-
ket keep track of about a dozen of these “factors” and gird
47
themselves for action if the news varies significantly from
the consensus forecast.
News encompasses three types of events. The first is eco-
nomic data and developments, which rotate in importance
over time. Sometimes trade balance is important, some-
times it’s not. For the past few years as we have all puzzled
over the jobless recovery, the U.S. non-farm payrolls report
has been a zinger, causing one-day price spikes, sometimes
in both directions on the same day. The short list of news
items that move the forex market includes:
• GDP
• Inflation (various forms — PPI, CPI, PCE, GDP
deflator, ECI)
• Trade balance and current account balance
• Capital flow reports
• Payrolls
• Institute of Supply Management (ISM) Index and
regional indices (Chicago, Empire State)
• Leading indicators, business confidence, and
consumer confidence
• University of Michigan consumer confidence
• Durable goods orders
• Housing starts and existing home sales
• Retail sales
Notice that money supply growth, bank lending, and
other financial sector information is not of much interest
today for evaluating the U.S. economy and the dollar,
although it was the only thing traders looked at in the early
80s (it is still watched today in Europe and Japan).
Truthfully, traders are bored by this type of news. They
respond to it in the expected ways — buying, grudgingly, if
a number surpasses the upper limit of an estimated range.
November 2005 • CURRENCY TRADER
And while a few points can be made by responding swiftly, last fall. But this is often an excuse that forex traders use to
the period surrounding a news release hardly ever delivers justify taking trades they wanted to take, anyway.
a real change in the direction of a price. You don’t get a The price of oil is a good example. We went through a
trend reversal from “ordinary” fundamental data, at least period late last summer when the rising price of oil was
not from a single news release, although sometimes you get considered especially bad for Japan, because Japan imports
a break of support or resistance from a single release. As we all its oil. In fact, Japan is the most energy-efficient country
have seen with the breakouts caused by spikes on the pay- in the G7, producing more units of output per unit of ener-
roll news, those breakouts
usually fizzle. It takes a build-
up of additional releases FIGURE 1 — MARKET OVERREACTION
pointing in the same direction There may have been no logical reason for the dollar to sell off so severely as Hurricane
as the breakout release for Katrina hit the Gulf Coast at the end of August, but the price action was already fueled by
perception to shift and a new the approximately 61.8-percent retracement of the Euro’s up move from July to mid-August.
trend to form.
It is tedious to keep track of
the economic releases. Often,
one-time nuggets of informa-
tion, such as the Research and
Development “Scoreboard” of
the world’s largest 1,000 com-
panies released in October by
the UK Department of Trade
and Industry, are more inter-
esting than the same old data
series. U.S. companies
increased R&D by 7 percent in
each of the past four years,
while European companies
spent only 2 percent. The
Lisbon accord said Europe
would aim for R&D spending
of 3 percent of GDP per year
by 2010 to become the world
leader in high-tech, bio-med,
and other areas. Now that is a
lost dream. Returning to capi- Source: Chart — MetaStock; Data — eSignal and Reuters
tal investment in R&D, Japan
spent 4 percent. (The surprise was South Korea, with a spec- gy input than anyone else, so to tar Japan with oil’s brush
tacular annual growth in R&D investment of 40 percent.) was just a rationalization for shorting the yen.
If you are trying to predict where global equity capital When Hurricane Katrina hit the U.S. Gulf coast, the mar-
will flow based on success in R&D, assuming success is a ket sold off the dollar against the Euro from 1.2188 on Aug.
function of spending, you’d have to pick the dollar over the 31 to 1.2589 on Sept. 2. There is no true economic basis for
Euro and the yen over the Euro, too. But, as you no doubt such an overreaction. One barrel of oil is the same as any
already know, you wouldn’t buy dollars for this reason for other barrel of oil, so it makes no difference whether the
a long-term holding period any more than you would sell U.S. produces oil or buys its oil from the world market. It
dollars for a long-term holding period because of the cur- certainly makes sense for the price of oil to rise, but almost
rent account deficit. none for the price of the dollar to fall. The real reason for the
dollar to fall was that traders had already observed a near-
Related markets 61.8-percent retracement of the Euro’s up move from July to
News from related markets sometimes dominates overall mid-August (Figure 1).
sentiment toward the dollar, as we have seen with the Many traders in the forex market keep track of Fibonacci
widening interest-rate differential favoring the dollar since continued on p. 49

CURRENCY TRADER • November 2005 48

 THE BIG PICTURE continued

FIGURE 2 — A PATTERN UNFOLDS

The Euro/dollar up move in early September quickly failed, and the market formed a that removed 0.5-1 percent of
double top. growth from German GDP
would be an economic disas-
ter, too. But in the U.S., with
GDP at 3.3 percent in Q2 and
headed for 4 percent or more
in Q3, the temporary reduc-
tion in growth from the natu-
ral disaster is manageable.
Here is where context
counts. Anyone observing the
dollar fall on Sept. 1 and 2
could deduce the move was
unjustified based on the fun-
damentals and that the
“news” was being interpreted
incorrectly. And the chart
immediately began to exhibit
a double top, which is one of
the more reliable standard
patterns (Figure 2). If the price
falls below the lowest point of
the “M” (see mid-August), it
almost always follows
Source: Chart — MetaStock; Data — eSignal and Reuters through with a substantial
drop. (A little move back
numbers and this was an especially easy one to spot. The upward, such as the one that occurred on Oct. 6, is also very
bounce up off the retracement line was facing a heavy head- common.)
wind in the form of talk about upcoming interest-rate To draw a tentative conclusion: Currencies are joined at
increases in the U.S., so traders needed a better-than-usual the hip to the fixed-income and money markets because,
after all, real capital flows are based on competing real rates
of return. But real capital flows constitute only a small por-
Forex prices move more on each of tion of total forex trading and we often see forex price
moves that are contrary to the rational comparison of finan-
the five days leading up to a FOMC cial returns.
Other markets, such as equities, oil, and gold, are only
sporadically decisive factors in forex prices, and even then
meeting than they do afterwards. can be exploited for their shock effect rather than any rea-
sonable and plausible economic scenario.
excuse to keep the move going. Hurricane Katrina fit the You want to know what is right and reasonable in the
bill nicely and had the added benefit (for dollar shorts) of fundamentals, but you shouldn’t always trade on it right
creating the spectacle of the world’s richest country failing away when the market is in a perverse frenzy.
to provide timely and adequate relief to its own citizens.
The can-do country couldn’t. This is an instance where the Institutional news
giant miasma of anti-U.S. sentiment that hangs over the dol- Institutional news has the potential to be the biggest mover
lar took concrete form. of them all but, again, it is often used for shock effect to get
It quickly became clear, however, that the hurricane a move that was already pre-ordained by the technicals on
would take away only 0.5 to 1 percent of GDP in the near- the chart.
term — and actually add to GDP in later quarters as re- Consider the rejection of the European Union
building began. Germany, the Eurozone’s biggest economy, Constitution. The first “no” vote came from France on May
will get 0.8-1.2 percent growth this year. A natural disaster 29. The Euro had already swooned from above 1.3600 to

49 November 2005 • CURRENCY TRADER

1.2535 on May 27, so it was hardly a surprise the public’s The forex market has a preference
rejection of the constitution took the Euro further down to
1.2385 on May 31 and 1.2159 on June 1, when the Dutch
voted.
for big events that are also a shock,
The failure of the Europeans to forge a constitution is a
reflection of dissatisfaction with the way the EU is working
whether they are true and useful
and evolving, a malaise some analysts say could even spell
the end of the Union. Any system that delivers low growth information or not.
and persistent high unemployment may have a humane
social model, but it cannot be said to be a successful eco- the euro traded under the launch rate for the rest of 1999 to
nomic model. However, the Euro stopped dropping barely near the end of 2003, but traders got the idea in their minds
one month later, in July 2005. Nothing had changed. Europe last spring the Euro “should” trade in a range of 1.20 to 1.25
was still rejecting the principles of ruthless capitalism and during summer 2005, and sure enough, any forays beyond
market economics, still turning its head from competition those boundaries have been short-lived.
and open borders (for services, at least), and still (mostly)
against enlargement to include countries like Turkey and The yield playing field
even the Baltic states. Finally we come to the main event — the ever-rising yield
Did traders forget the giant risk to the European experi- advantage of the dollar over the Euro and yen. The news
ment only one month after this stupendous failure? In a events associated with this rising relative return are the
word, yes. And the reason is not hard to find — the trains Federal Open Market Committee (FOMC) meetings — the
are still running, the stock markets are open (and rising), continued on p. 51
banks are still busy acquiring
one another, and business
goes on as before. Most of all, FIGURE 3 — TESTING A LEVEL
nobody — not even the The idea formed last spring that the Euro should trade in a range of 1.20 to 1.25, and
Italians — is seriously consid- any moves beyond those boundaries have not lasted very long.
ering the death of the Euro
and a return to the legacy cur-
rencies. The Euro is a done
deal. The accounting has all
been switched over, the old
banknotes burned.
The market was willing to
respond to the rejection of the
Constitution right after the
vote because it was consistent
with the trend already in
place, but it was unwilling to
let it hang like a stone around
its neck for very long, espe-
cially when the Euro was
approaching the “historic”
low from May 30, 2004 at
1.1760 (Figure 3). This level is
very close to the January 2,
1999 euro launch rate at 1.1670
and the opening price the next
day at 1.1786.
We have no idea why a
return to this level is being Source: Chart — MetaStock; Data — eSignal and Reuters
resisted so strenuously, since

CURRENCY TRADER • November 2005 50

 THE BIG PICTURE continued
big Kahuna of events. FOMC meetings marry economic and
financial expectations with hard institutional news.
Everyone knows when the Federal Reserve will release its
decision, and since it started raising rates in June 2004, the
outcome has not been a surprise. All the same, you’d think
the Fed’s periodic decisions would deeply influence prices
in the forex market.
Alas, you would be wrong. Using data prepared by
Stuart Johnston at TimeandTiming.com, forex prices move
more on each of the five days leading up to a FOMC meet-
ing than they do afterwards. The Swiss franc, for example,
has consistently moved
down more often than it
has moved up in every The best — but by no means
five-day, four-day, three-
day, two-day and one-day
period ahead of the past 62
satisfactory — conclusion is that the
FOMC meetings. The aver-
age move over the five fundamentals do not rule the market
periods is 11.3 points.
On the day of the meet-
ing, and in the one-day,
consistently and reliably.
two-day, three-day, four-
day, and five-day periods after the 62 meetings, it has also
moved down more often than up, but by tiny amounts —
3.9 points, on average. Note that in those 62 meetings, the
Fed was not always raising rates; on many occasions, it was
lowering them.
The same conclusion arises from examination of the data
for the Euro, Japanese yen, Canadian dollar, Australian dol-
lar, and Mexican peso. The Japanese yen moves (usually
down) by an average of 13.08 points per day on each the five
days ahead of meetings and by a mere 4.32 points the day of
a meeting and the five days after it. In the Euro, the pre-
meeting move is 29.4 points per day, and the post-meeting
move is 6 points. Of course, the swings are far wider — the
average disguises the range — but the principle holds that
pre-meeting swings are bigger than post-meeting swings.
This means more than the market anticipates a move and
buys on the rumor. It means the rate-change FOMC event is
not “news” because it is not also a shock. This is a testament
to the good public relations of the Fed, but at the same time,
it deprives traders of what should be a value-laden news
item.
The forex market has a preference for big events that are
also shocks, whether they are true and useful information or
not. Some commentators in the forex market have taken to
combining all three sets of factors and weighting them
according to “riskiness.” An abrupt rise in the price of oil, for
example, raises the level of risk. Risk-averse FOREX market
participants would sell dollars on a rise in the overall riski-
ness of holding dollars, even when sound economic analysis
51
would indicate higher oil prices are no more damaging to
the U.S. economy than elsewhere, and maybe less so.
Another case comes from the institutional side of the
news. Last February when the Euro was falling, European
Central Banks (ECB) President Jean-Claude Trichet warned
that the central bank could raise interest rates specifically to
protect the Euro from free-fall. The threat carried very little
credibility but the Euro spiked upward anyway. Again in
October, both Trichet and another ECB policy board mem-
ber have made the same threat, this time with a little more
credibility since inflation is indeed on the rise in Europe,
although most money market
observers think an actual rate
hike is not going to occur
until after the new year, if
then. And even if the ECB
does raise rates, the U.S. will
still have a decisive yield
advantage (200 or more basis
points) over Europe. Still, the
possibility of an ECB rate
hike raises the riskiness of
holding a long dollar posi-
tions, so the “news” of a possible European rate hike
prompts a dollar sell-off.
But the market has again showed it likes the thrill of
uncertainty, and it responded by buying Euros even in the
last few days leading up to an FOMC meeting, where the
outcome is known. It is perverse to buy the Euro when the
next real-life central bank outcome favors the dollar; a sign
the market is not operating on hard facts and clear-eyed
analysis, but rather thrill-seeking — and using a rise in “risk
aversion” to justify it. It’s no wonder the chart sometimes
seems to rule the interpretation of serious economic materi-
al instead of the other way around.
Long run vs. short run
The best — but by no means satisfactory — conclusion is
that the fundamentals do not rule the market consistently
and reliably. Maybe the fundamentals rule in the long run,
but the long run is nothing more than a series of short-runs,
and in the short run, the market is often in the grip of a chart
pattern that tickles the imagination, a rumor that defies
common sense — a story or scenario that is patently false,
or just plain thrill-seeking.
In the end, the duel is not between the fundamentals and
the technicals, but between rational decision-making based
on facts and analysis, and traders who need to make money
by going with the flow, even when that means taking seem-
ingly irrational positions.
November 2005 • CURRENCY TRADER