Lessons from the Pros

Never a Dull Moment!

Greetings from New York! It’s been an amazing week with the Fed cutting rates to a historic low, and the U.S. Dollar rally collapsing like a ton of bricks. Let’s face it; there is never a dull moment in the currency markets! We have a couple of great questions from our readers, so let’s get to it…

Q) Hi Ed, I see Head & Shoulder pattern forming in Dollar index daily chart. Does it mean dollar is going back into a down trend again? What’s your opinion? Thanks much.

Ed Ponsi) Thanks Nilesh, as usual you were right on target. Some referred to the following pattern as a Head and Shoulders, others called it a Triple Top, but the end result is the same – a sharp move lower in the U.S. Dollar Index (see figure 1).

Figure 1: The USD Index forms a top and breaks support at 85. Source: Saxo Bank

You made a great call by sending this email before support was broken, so thank you for that. I apologize for the delay in getting it into the newsletter. On November 11, I wrote a newsletter called "The Fear is Falling, and the Tide is Turning", which laid out my reasons for believing that the USD rally was doomed. EUR/USD traded below 1.25 that day, and now, just over a month later, it is trading above 1.44. Since mid-November, we have seen a 1900 pip move in just over a month – not too shabby! Please note that the chart of EUR/USD is nearly an inverted version of the US Dollar Index chart in figure 1 (see figure 2).

Figure 2: The daily chart of EUR/USD is a mirror image of the USD Index chart. Source: Saxo Bank

Could it be that markets are catching on to the fact that all of these bailouts and injections of liquidity are just going to destroy the U.S. currency? We can print and borrow money until the cows come home, we can create billions of dollars out of thin air, and what will be the end result? The course we are on will lead to a huge deficit and a damaged U.S. Dollar. There are countries in the world today where a million dollars cannot purchase a loaf of bread, because the currency is essentially worthless. Is this really what we want? Check out these remarks by William Poole, the former president of the St. Louis Fed. When asked about the FOMC’s decision to cut interest rates to virtual zero on December 16, here was his reply: "The Fed is sending a message that it will print money to an unlimited extent until it starts to see the economy expanding." As usual, "Helicopter Ben" Bernanke is showing little concern for the future of the greenback.

Q) Hi Ed enjoyed your appearance on TV yesterday. I have 2 questions: 1) what is happening to the inverse correlation between equities and the dollar? 2) For those trading the yen crosses, what signal, if any, will we get when the Bank of Japan is about to take action to reverse the upward trend of the yen? Is there a support level beyond which they will be spurred into action? Are you concerned that this could happen in the middle of a trade? When they do take action, is it likely that they will buy dollars rather than, say, Euros? Thanks a lot.

Ed Ponsi) Hi Pat, great questions! The inverse correlation between the equities market and the USD was pretty strong, but the relationship was actually stronger in the Japanese Yen, as currency pairs like the GBP/JPY and EUR/JPY were following the stock market almost tick for tick. I wrote about this relationship in earlier articles such as "Using Stocks to Trade Forex" from October 21. The relationship is changing because it is based on fear; when fear was at its greatest height, the correlation between equities and currencies was stronger, but the markets are slowly calming despite all of the horrible news. This is not unusual; markets are forward-looking so it would be fair to assume that at least for now, the market just may be seeing a light at the end of the tunnel. In other words, the market will recover before the economy recovers in the same way that the markets were falling long before a recession was declared.

As for the Bank of Japan, they have been giving clear signals regarding a potential intervention. On December 17th, Finance Minister Shoichi Nakagawa said Japan is ready to "take every necessary move to tackle the fluctuation in foreign exchange market." Even innocent sounding comments such as "we are watching the currency markets closely" can be interpreted as a threat of intervention when coming from a Ministry of Finance official.

As you know, intervention occurs when a central bank enters the open market to strengthen or weaken its own currency. Japan last conducted a currency market intervention via the central bank on March 17, 2004. There has been no indication where the BoJ’s "line in the sand" is located, but if I were to guess I’d say 85.00 vs. the U.S. Dollar. In the past, Japan has intervened by selling the Yen vs. the U.S. Dollar, and I suspect that will be their course of action in the future. What if an intervention occurs in the middle of a trade? If you are long the Yen and it has been confirmed that the BoJ is pushing the currency in the other direction, get out quick – you might even consider flipping the script and shorting the Japanese currency. You don’t want to fight against the Bank of Japan on this one; it was hazardous to do so back in 2004 and the result could be the same in 2009.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.

Ed Ponsi