British Pound “Pauses for Breath” [Part 1 of 2]

After a nearly 20% rise against the Dollar, the British Pound has been rangebound for nearly the entire month of June, with one columnist likening the situation to a “pause for breath.” For him, this amounts to a temporary cessation on the Pound’s inevitable upward path: “Compared to long term levels, the pound was still better value than its peers. He said: ‘It’s still cheap - about 10% below it’s trade-weighted average at present.’ ” For others analysts, however, the picture is not so cut-and-dried.

Forgetting about purchasing power parity for a minute, there are numerous factors which could halt the Pound’s rise. First and foremost is the British economy, which is still struggling to find its feet. “The U.K. economy will recover ‘mildly’ next year, according to the OECD, compared with a previous projection of a 0.2 percent contraction. Gross domestic product will drop 4.3 percent this year, versus a March forecast of 3.7 percent.”

Some economic indicators have begun to stabilize, but the two most important sectors, housing and finance, are still wobbly. Economists warn that “any recovery could be slow and uneven because banks are still unwilling to pump loans into the economy.” In the latest month for which data is available, mortgage lending slowed to a record low, with consumer lending not far behind. With regard to housing,”The annual fall in house prices in England and Wales slowed for a third consecutive month in June, according to property data company Hometrack, but prices were still 8.7 percent lower than a year ago.”

There is the possibility that the BOE’s quantitative easing plan and the government’s fiscal stimulus will provide the economy with the boost it needs. At the same time, both programs will have to be reined at some point, sooner rather than later in the case of government spending. With UK national debt predicted to reach 90% of GDP by 2010, “Most people - the prime minister excepted, apparently - believe that taxes will have to rise and/or public spending fall after the next election. This would at least threaten to hold back economic activity.” Not to mention that both QE and government spending could actually backfire and generate inflation without economic growth (i.e. stagflation). BOE Governor Mervyn King captured this overall sentiment, when he said, “I feel more uncertain now than ever. This is not the pattern of a recession coming into recovery that we’ve seen since the 1930s.”

In short, from a purely economic standpoint, it doesn’t look good for the Pound Sterling. But of course forex is about much more than GDP…stay tuned for Part 2, in which I’ll elaborate on this point, and bring interest rates and inflation into the discussion.

Is Risk Aversion Back?

At the end of last week, I posed a question: what will be the next theme to dominate forex markets? Perhaps the answer can be found in Monday’s massive market selloff (”Triple-M Monday” anyone?), the worst day for stocks in over two months. Commodities and currencies- both of which have taken their cues from stocks of late- also trended downwards.

While I would be the first to caution against reading too much into one day (especially since the early indications are that some of these losses will be erased today), it’s possible that yesterday marked the breakout that many technical analysts have called for over the last few weeks. Asked one such analyst last week, “Taking a step back to look at the daily price action of the EUR/USD, we can clearly see that the currency pair is consolidating and a sharp breakout is imminent. The big question is, will it be an upside or downside breakout?”

What was the catalyst for Monday’s selloff? Perhaps it was my blog post on uncertainty: “The World Bank said Monday that prospects for the global economy remain ‘unusually uncertain,’ and it cut its 2009 growth forecasts for most economies” from 1.7% to 2.9%. But really, the World Bank was only echoing what every investor already knew- that the stock market rally rested on a house of cards, and that in fact the arguments in support of an economic recovery are still quite tenuous. In other words, “Some of the buying since early March was been based on a conclusion by many investors that government intervention had forestalled the threat of a doomsday scenario, such as another Great Depression…expectations were so low that stocks rose merely on news that indicators such as manufacturing activity or the service economy were shrinking less than had been feared. Investors didn’t require signs of actual growth.”

From trough to peak, stocks rallied 34%, pushing P/E levels back to normal levels. Now that all of the temporary pricing inefficiencies have been “corrected,” investors are taking a step back and looking to see whether the data supports further buying. Until there is solid proof that the “green shoots” are real, it’s my prediction that markets will trend either sideways or downwards.

What does this mean for forex markets? Investors will probably shun riskier currencies in favor of the Dollar and the Yen, which are still perceived as relative safe-havens. “Risk aversion has resurfaced as market participants take profits on riskier exposures. There are “renewed concerns about the extent of the ongoing global recession and the sustainability of the ‘green shoots’ of recovery,” said one analyst.

Of course, some would argue that that the emerging markets forex rally was built on a more solid foundation than US stocks. If this is the case, then perhaps the correlation between stocks and currencies will break down in the coming weeks. For now, at least, risk-averse investors will probably start to unwind carry trades and pile back into the mainstays of forex. Those with the highest interest rates will suffer the most. Until the day comes that bad economic news in the US doesn’t paradoxically buoy the Dollar, we can be certain that the current narrative is once again one of risk aversion.

G-8: Thinking of reversing $2 Trillion in Stimulus!

This past weekend, the G-8 (Group of Eight - 8 largest industrialized nations) met and started the talks that will eventually reverse the $2 trillion in global stimulus. Of course, they aren’t about to start this process yet since it was just their Finance Ministers at this meeting…but they were setting up the process for when their central bankers will gather in early July (10th - 12th). Why is this important? Because if these central bankers are comfortable enough in talking about reversing the stimulus, then it means that they really think that the global economy is close to being able to stand on its own two feet once again. If this is the case, it will end up helping riskier currencies in the long run (AUD, NZD, CAD, GBP, etc.) and will hurt the defensive currencies that benefited when the world was falling off of a cliff (USD, JPY, CHF). Now this effect will not be immediate. In fact, the dollar and yen are gaining a bit as of this writing. But after a good pull back, look for the trend to return towards “risk seeking” and not back into the defensive mode as we had before. My top picks, of course: AUD/USD and AUD/JPY to benefit the most…as the G-8 acknowledged the rise in commodities as the global economy is recovering.

Chinese Yuan Inches Towards Reserve Currency Status

The last week brought a few more developments in China’s quest to turn the Yuan into a viable reserve currency. Don’t get me wrong - I used the term “inches” in the title of this post for a reason - the Yuan will not supplant the Dollar anytime soon, if ever. Still, China deserves credit for their resolve on forcing the issue, as well as for providing an alternative to the Dollar monopoly.

An important boost came from Russia’s Finance Minster, who suggested that, “This could take 10 years but after that the yuan would be in demand and it is the shortest route to the creation of a new world reserve currency,” as long as it was accompanied by economic and exchange rate liberalization. The Head of the World Bank, Robert Zoellick, agreed: “Ultimately, that’s a good thing. And ultimately it’s good if you’ve got, I think, some multipolarity of reserve currencies to create, to make sure that people manage them well.”

These soft endorsements were precipitated by comments from a top Chinese banker that companies should start to issue bonds denominated in Yuan. “Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB), also said he is exploring the possibility of issuing loans to trading companies in yuan, allowing Chinese and foreign companies to settle their bills in yuan rather than in dollars.” This would serve two ends simultaneously; not only would Chinese capital markets be strengthened, but the Chinese Yuan would benefit from the increased exposure. Already, “HSBC and Standard Chartered have both said they are preparing to issue bonds denominated in yuan” and international monetary institutions might not be far behind.

Conspiracies aside, the Chinese Yuan will become a reserve currency when it is ready to become a reserve currency. I’m sure this seems self-evident, but it’s important for China (and China watchers) not to get ahead of itself. It doesn’t make sense for risk-averse investors to hold a currency that is still essentially pegged to the US Dollar and that isn’t fully convertible. If there’s no pretense that the Yuan fluctuates in accordance with market forces, and if investors aren’t guaranteed the ability to withdraw RMB if need be, what possible reason would they have to hold it in the first place?

Summarizes one columnist, “China would have to gradually make the yuan convertible on the capital account; it needed a more liquid foreign exchange market; its bond markets and banking system needed to be more developed; and there had to be proper monitoring of cross-border capital flows.” The importance of having functioning capital markets cannot be understated. Simply, investors and Central Banks buying Yuan would not want to simply invest in paper currency; instead they would want stocks and bonds that trade transparently.

Currently, foreign investors are limited to savings accounts and investing/lending to firms that record earnings opaquely and are ultimately subject to the whims of the Central government. This system has functioned well in the past, only because investors were betting generally on the Yuan’s appreciation, and not necessarily on specific opportunities within China. If China wants the Yuan to be a serious contender with the Dollar, it needs to give investors more and better options. Ironically, if China had taken these steps in the past, it wouldn’t have found itself with $2 Trillion worth of Dollar assets that it is desperately trying to dispose of.

What is the biggest “market moving event” of the month typically?

By Sean Hyman

NFP: Non-Farm Payrolls in the U.S.

This event draws traders like bugs to a light.

However, it’s not always the most prudent thing to trade, especially for newer traders. Why? The volume can be thin before and during the event and even up to about 30 minutes to an hour or so afterwards.

You see, the big banks usually stop making new trades in the marker WELL BEFORE the NFP announcement because they don’t want to put on their huge trades (usually a billion units or more, no lie) right before an “unknown” like this. The pros aren’t much on gambling on what they don’t know and can’t quantify.

No, they want to know what they are facing before placing trades. So since the “big boys” are out of the picture, so is a lot of the “huge” fx volume that we’re all so accustomed to most of the time.

Why the huge draw to NFP? Because, since the volume is thin and the numbers can routinely come out well off of expectations, it set up an environment for huge pip moves. Take a look at the last NFP for EUR/USD. This pair normally moves an average of 180 pips over 24 hours right now. However, upon the NFP announcement, it moved well over 215 pips.

If you dare to trade this event…be aware that you should trade FAR FEWER lots than you normally trade…and stops would have to be wide. Be comfortable with the potential dollar loss that could happen and make sure it is no more than 5% OR LESS of your account equity. Get a demo to trade, here: http://www.fxedu.com/practice-forex-account

Sean Hyman

Trading in Different Time-Frames!

When trading different currency pairs, it is important to be aware of the time-frames you are trading in so that you can take advantage of different moves. Today is a perfect example of this scenario. So far this AM’s biggest losers are the commodity currencies. The Aussie dollar (AUD), Canadian dollar(CAD), and New Zealand dollar (NZD) are all losing ground against the US dollar (USD) and the Japanese Yen (JPY).Does this mean it is time to get short? Not so fast. In previous articles Sean Hyman has made a great case for these currencies and frankly the charts don’t lie! The uptrends on the commodity currencies have been going up steadily and the fundamentals are in place for their rally to continue. But what to do about a day like today?This is where looking at different time-frames can help you. Take a look at the charts below. The first chart is a 5-minute chart of the AUD/USD pair. The lines drawn on the chart represent short-term resistance, so trades entered on the short side near those resistance points would provide low-risk entries for a short position.(click on charts to enlarge thumbnail) The chart on the right side is the daily chart of the AUD/USD pair. As you can see, the trend is clearly up. Which means that you want to be long, and brings us to the theme of the day, that you can be in opposite positions on the same pair at the same time! This is known as “hedging”, and can really help add to your profits and help limit your losses.Recently the NFA (National Futures Association) outlawed this practice here in the US, but savvy currency trading firms have figured out a work-around. If you would like to learn more about hedging or how you can participate, email us at: sales@fxedu.com.