Lessons from the Pros

After being treated like a punching bag by the
world’s major currencies for the past few weeks, the U.S. Dollar has finally gotten up and started swinging back. This is evident in many of the major pairs, such as the Great Britain Pound vs. the U.S. Dollar (GBP/USD). This currency pair has given back about 300 of the 1000 pips gained during its recent rally, and currently lies about 90 pips above its 38.2% Fibonacci retracement
(see figure 1).

The greenback also bounced nicely against the Euro, Japanese Yen, and Swiss Franc among others, as the week drew to a close. To be fair, some profit taking was inevitable after the tremendous recent rally.
Don’t be surprised if weakness in the U.S. Dollar returns before the end of the year – the buck has suffered a late-year swoon in three of the past four years, with the only exception being 2005
(see figure 2).

Figure 2: Euro rises against the U.S. Dollar in 2002, 2003, and 2004.

Source: FXtrek IntelliChart™. Copyright 2001-2006 FXtrek.com, Inc.

Carefully Crafted Words

When the ECB (European Central Bank) raised interest rates on December 7, it came as a surprise to no one.
That’s because the head of the ECB, Jean Claude Trichet, has a brilliant way of
“telegraphing” the central bank’s next move, with the use of carefully chosen code words. These words act as a sort of
“shorthand for traders”, who use the code to quickly interpret the
ECB’s intentions.

Why does Trichet signal the bank’s intentions ahead of time? This is done to avoid
“shocking” the markets and creating unnecessary and unwanted volatility. By conditioning traders to respond to code words, central bankers have found a convenient way to manage market expectations.

Alan Greenspan became quite polished at managing expectations in his later years as chairman of the Fed. The phrase
“pace that is likely to be measured” was used extensively in 2005 in Fed statements as an indicator that interest rates would be raised at the next scheduled Fed meeting. Once the phrase disappeared from Fed statements, traders understood that US interest rates were about to peak.

Trichet’s widely accepted code word is ‘vigilant’, and it’s usually used in a context similar to this comment from November 20:
“We have to continue to be, in particularly as regards my own institution, strongly
vigilant.” In this case and in others, Trichet was specifically referring to inflation. Note that this comment was made just 15 days prior to
Thursday’s ECB rate hike.

However, the language in the Trichet’s statement immediately following the December 7 rate hike
didn’t include the term “vigilant”. Instead, Trichet repeatedly used the expression
“monitor very closely” in reference to inflation.

Does this mean that the ECB has changed course, and is finished raising interest rates? Not necessarily. According to the Three-Month EURIBOR Futures (symbol FEU3), there will be at least one and very possibly two more rate hikes in 2007
(see figure 3).

Figure 4: Bollinger Bands Tighten Ahead of U.S. Employment Report (hourly chart)

Source: FXtrek IntelliChart™. Copyright 2001-2006 FXtrek.com, Inc.

What can we learn from the currency market’s reaction to the December 8, 2006 employment report? Look at the price action prior to the release of the report – the volatility of the Euro vs. the US Dollar (EUR/USD) can be tracked using a variety of indicators, including Bollinger Bands.

On the hourly chart, notice the shrinking size of the candles as the NFP release nears. We can clearly see the Bollinger Bands converge just prior to the release of this report, which includes the notorious Non Farm Payroll number (see figure 4). Why do the bands constrict so tightly? This happens because traders simply
aren’t willing to commit to positions ahead of this report – they know that the wild market swings that occur after the Non Farm Payroll report are dangerous and can devastate an account.

For this reason, many traders simply go “flat” prior to the report, and wait for the dust to settle before entering trades afterward. Like the sailors on
Ulysses’ ship, who stuffed their ears with wax to avoid hearing the refrain of the Sirens, they are taking the necessary precautions to ensure a safe journey through troubled waters.

The volume of questions that I’ve received through the years regarding this report indicates that it is very much on
traders’ minds – especially newer traders. It’s easy to understand why – an individual looks at the chart and thinks,
“Hey, I could’ve made 100 pips in one direction and then 150 pips in the other direction in a just couple of
hours.” When you look at the move on the 5-minute chart, it all seems deceptively simple
(see figure 5).

Figure5: EUR/USD reacts to the NFP report (5-minute chart)

Source: FXtrek IntelliChart™. Copyright 2001-2006 FXtrek.com, Inc.

The problem that most traders have when it comes to this report is that they
don’t look beyond the headline number – they only focus on the Non Farm Payroll number. In reality, NFP is just one portion of a report called the Establishment Survey. The Establishment Survey is concerned with employment from the
employers’ point of view, and measures job creation in various
“establishments” such as banks, retail stores, factories, and other businesses.

In addition to the Establishment Survey, we have the simultaneous release of the Household Survey. The Household Survey is a completely separate report, and it is concerned with employment from the
employees’ point of view. It features the Unemployment Rate, which is another closely watched economic indicator.

Also included with this report will be closely watched statistics on Hourly Earnings (if they rise too quickly, they can jump-start inflation) and the length of the Average Workweek (currently 33.9 hours – clearly some of us
aren’t working very hard!). As if this weren’t enough, we also get revisions to the two previous NFP reports. All of this hits the newswire at 8:30 am Eastern time, on a Friday – these reports usually are released on the first Friday of the month.

The point is that there is a tremendous amount of information hitting the market simultaneously when these reports are released, and the result is a swirling vortex of volatility that can prove difficult for even the most experienced trader to navigate.

Trading this report is sort of like trying to fly a kite in a hurricane – sure,
there’s plenty of wind, but the direction and velocity can shift quickly and dramatically. Like Ulysses’ crew, inexperienced traders should take extra care when approaching this unpredictable and volatile event.

Until next week – happy trading!