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March 2013
Volume 10, No. 3
Strategies, analysis, and news for FX traders
GAUGING A EURO REBOUND P. 31
U.S. dollar new-high pattern analysis p. 18
Canadian dollar: Loonie comes back to earth p. 6
Foreign exchange rules of engagement p. 10
The price of currency union p. 20
Perspective on currency war p. 12
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CONTENTS
Contributors................................................. 4
Global Markets
Has the loonie lost its luster? ....................6
Sluggish economic data and looming resistance
could put a cap on a major dollar/Canada rally.
By Currency Trader Staff
On the Money
Rules of FX engagement .........................10
There might be new rules of engagement in
foreign exchange, but that hardly means a cur-
rency war is inevitable.
By Marc Chandler
Straight talk about currency wars ..........12
Perspective is needed when addressing the
overheated currency war topic.
By Barbara Rockefeller
Spot Check
Dollar dance .............................................18
A markets phase will dictate the performance
of a price pattern. What mode is the dollar
currently in?
By Currency Trader Staff
Advanced Concepts
The interest rate price
of a currency union..................................20
Until it abandons its separate national histories
andadoptsacommonscalpolicy,the
Eurozone will suffer the consequences of its
fundamental contradiction.
By Howard L. Simons
Global Economic Calendar ........................26
Important dates for currency traders.
Currency Futures Snapshot.................27
BarclayHedge Rankings........................27
Top-ranked managed money programs
International Markets............................ 28
Numbers from the global forex, stock, and
interest-rate markets.
Forex Journal ........................................... 31
Dollar analysis prompts Euro trade.
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CONTRIBUTORS
4 March2013CURRENCY TRADER
Editor-in-chief: Mark Etzkorn
Managing editor: Molly Goad
Contributing editor:
Howard Simons
Contributing writers:
Barbara Rockefeller,
Marc Chandler, Chris Peters
Editorial assistant and
webmaster: Kesha Green
President: Phil Dorman
Publisher, ad sales:
Bob Dorman
Classifed ad sales: Mark Seger
Volume 10, Issue 3. Currency Trader is published monthly by TechInfo,Inc., PO Box 487, Lake Zurich, Illinois 60047. Copyright 2013 TechInfo,Inc. All rights reserved. Information in this publication may not be stored orreproduced in any form without written permission from the publisher.
The information in Currency Trader magazine is intended for educationalpurposes only. It is not meant to recommend, promote or in any way implythe effectiveness of any trading sys tem, strategy or approach. Traders areadvised to do their own research and testing to determine the validity of atrading idea. Trading and investing carry a high level of risk. Past perfor-mance does not guarantee future results.
For all subscriber services:www.currencytradermag.com
A publication of Active Trader
CONTRIBUTORS
qHoward Simons is president of Rose-
wood Trading Inc. and a strategist for Bianco
Research. He writes and speaks frequently
on a wide range of economic and nancial
market issues.
qBarbara Rockefeller(www.rts-forex.com) is an interna-
tional economist with a focus on foreign exchange. She has
worked as a forecaster, trader, and consultant at Citibank
and other nancial institutions, and currently publishes two
daily reports on foreign exchange. Rockefeller is the author
ofTechnical Analysis for Dummies, Second Edition (Wiley,
2011), 24/7 Trading Around the Clock, Around the World (John
Wiley & Sons, 2000), The Global Trader (John Wiley & Sons,
2001), and How to Invest Internationally, published in Japan
in 1999. A book tentatively titled How to Trade FX is in the
works. Rockefeller is on the board of directors of a large
European hedge fund.
q Marc Chandler([email protected]) is
the head of global foreign exchange strate-
gies at Brown Brothers Harriman and an
associate professor at New York Universitys
School of Continuing and Professional Stud-
ies. Chandler has spent more than 20 years
analyzing, writing, and speaking about
global capital markets. He is the author ofMaking Sense ofthe Dollar: Exposing Dangerous Myths about Trade and Foreign
Exchange (Bloomberg Press, 2009).
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.rts-forex.com/http://www.rts-forex.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected] -
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http://clk.atdmt.com/FXM/go/438305665/direct/01/ -
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GLOBAL MARKETS
The Canadian dollar started 2013 with a thud, falling near-
ly 5% vs. the U.S. dollar from mid-January to late February.
Once a pillar of economic envy, Canada is running into
some trouble in that area, and is expected to experience a
modest slowdown in growth this year from 2012 levels.
During and after the global financial crisis, Canadas
economy held up relatively well and its recession was
shallow, mild, and accompanied by little job loss. Also,
Canadas banking sector was a strength rather than aweakness. Overall, stringent and conservative banking
practices had been seen in Canada, which limited the type
of balance sheet rebuilding that had to occur in the U.S.
However, it appears Canadian consumers may have fall-
en prey to a temptation that helped sink the U.S. economy.
Driven by low interest rates, a housing boom has unfolded
in Canada, with house prices soaring and consumers bor-
rowing against their climbing home equity. Now, with eco-
nomic conditions slowing amid a weak export picture and
a bottleneck in Canadian oil supplies, debt-ridden consum-
ers are no longer able to step in and drive the economy
forward with more spending.Also, a spate of recent economic data out of Canada
has disappointed, pressuring the Canadian dollar to the
downside. Since the start of the year, the dollar/Canada
pair (USD/CAD) has climbed (reflecting Canadian dollar
weakness) from .9815 to 1.0300 a relatively big move in
a short time for a currency that has a reputation for stabil-
ity (Figure 1).
Lets take a look at the underlying economic fundamen-
tals for Canada, how monetary policy might unfold, and
the implications for the Canadian loonie in the coming
months.
Economy: A shaky housing market
After generating gross domestic product (GDP) growth
at an approximately 1.9%-2% pace in 2012, economists
expected Canadas economy to slow down this year.
Nomura and BNP Paribas both forecast contraction to a
1.5% pace, and while Moodys Analytics currently fore-
casts a 1.9%-2% rate for 2013, one economist there admits
the risks associated with this outlook are to the downside.
BNP Paribas economist Bricklan Dwyer points to two
key factors weighing on Canadas economic outlook: hous-
Has the loonie lost its luster?Sluggish economic data and looming resistance could put a cap on a major dollar/Canada rally.
BY CURRENCY TRADER STAFF
FIGURE 1: EARLY 2013 SURGE
The USD/CAD pair gained more than 5% between early
January and mid-February, and more than 7% since mid-
September 2012.
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ing and household debt. They have an economy
that has been consumer driven and benefit-
ted from fast acceleration in house prices, he
says. Consumers have borrowed against their
homes.
According to Dwyer, Canadian home prices
have gained 125% since December 1999. Its a
huge concern, he says. There is a real question
about when or if the housing market has topped
out if the froth is just going to be removedand the economy will keep chugging, or if it will
face a more substantial correction.
The parallels are striking to the housing boom
and bust that unfolded in the U.S. However,
while in recent years U.S. consumers have worked to
improve their balance sheets, the Canadians have been
going in the opposite direction. Dwyer notes that house-
hold debt as a percentage of disposable income is 155.5%
in Canada, compared to 139.4% in the U.S. But now
Canadian consumers are beginning to pull back on spend-
ing, which is removing one of the props from the economy.Is Canada set up for a U.S.-style housing collapse and
recession? Dwyer says no, at least for now. Our base case
is that we see a 15% price correction to take some of the
froth out of housing, he says.
The U.S. connection and exports
In addition to its uncertain housing market, Canadas
economic picture is further clouded by declining exports
to the U.S. About three-quarters of Canadian exports go
to the U.S., and the U.S. is still not back to full employ-
ment, says Mark Hopkins, senior economist at MoodysAnalytics. The Canadian economy has been running on
ginned-up consumption spending to help replace the miss-
ing export growth.
Comparing some numbers before and after the global
financial crisis reveals how Canada has suffered on the
export front. Canadian merchandise exports in 2012 totaled
$462 billion, a 5.2% decline from the 2008 figure of $487
billion, according to Hopkins. Exports to the U.S. in 2012
stood at $338 billion, down 8.4% from $369 billion in 2008.
That trend isnt likely to reverse soon. The U.S. economy
continues to face fiscal challenges that still have the poten-
tial to trigger government spending cuts, which in turn
could slow the U.S. economy. Canada has the blessing and
the curse to have the close ties to U.S. economic growth,
and its fortunes will rise and fall accordingly.
Depending on how things go with sequestration, the
Canadian [growth] forecast could come down, Hopkins
says. A rule of thumb I use is that exports to the U.S. areabout three-quarters of all exports of goods and services,
which in turn are about a third of GDP. Thus, roughly one-
quarter of Canadian GDP is sold to the U.S. market. So, for
every 1% drop in U.S. demand, we could expect roughly a
quarter-point reduction in Canadian GDP. This is a direct
impact.
However, Hopkins also notes there is potential for
growth in the Pacific Rim. The biggest market [in the
Pacific Rim], not surprisingly, is China, he says. In addi-
tion to having the largest economy, China has had a vora-
cious demand for resources, which it has sought to acquirenot simply through Canadian exports, but also through
offers to purchase large Canadian resource companies.
There are a wide range of commodities in question, mostly
ores and minerals, such as nickel and copper, but also
wood products.
Hopkins adds that the biggest potential growth area for
exports to Asia is energy coal, oil, and liquefied natural
gas. For the moment, exports of these products almost
all go to the U.S. because Canada lacks the transporta-
tion infrastructure to get these resources onto ships in the
Pacific, he says. Plans to build a pipeline from Alberta
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GLOBAL MARKETS
through British Columbia to the coast are in development.
Although by no means certain, this would greatly improve
the ability of Canada to ship its vast energy resources to
Asian markets, where oil and gas sell for a much higher
price than in North America.
Ironically, a supply bottleneck currently skews Canadas
oil picture. There is too much supply and they cant get it
out, Dwyer says.
Although Canada is an oil producer, there are no pipe-
lines linking production in Alberta in the west to consump-
tion in Ontario or Quebec in the east. Because there is
no pipeline, Canada still has to import roughly 40% of all
the oil it consumes, explains Charles St-Arnaud, foreign
exchange strategist at Nomura.Currently, Western Canada Select (WCS) oil from Alberta
flows to the U.S. Midwest and Cushing, Okla., the main
U.S. oil storage hub, and is ultimately land-locked. But
because of increased U.S. oil production, Canadian oil is
in oversupply. The Western Canada Select has been sell-
ing at a $50 discount to Brent [crude oil] since October,
St-Arnaud says. This, in turn, has weighed on Canadian
oil company profits and, ultimately, on government tax
revenues. Oil producers are receiving less money for their
oil exports and the lost revenues for the economy is $2.5
billion per month, he says.
Central bank policy
The expected slowdown in 2013 growth has the Bank of
Canada (BOC) backpedaling on its interest-rate tightening
bias. The current BOC interest rate is 1%.
In late February, analysts seemed to think the BOCs
changing outlook would be reflected in its March 6 meet-
ing. I think they will shift their rhetoric, Dwyer says.
Inflation is now below their target band. They are more
likely to cut than raise rates in 2013 if things deteriorate
more quickly. Since the beginning of 2012, the BOC hasbeen suggesting rate hikes could be in the works.
The banks inflation target is 2% with a +/- 1% band,
and right now numbers are nowhere near that level. In
January, headline inflation was 0.5% year over year, reflect-
ing weak demand and weaker energy and food prices,
Dwyer says.
The BOCs softer tone at its January meeting was a major
factor behind the Canadian dollars decline since the start
of the year. Traders had already begun to price in expecta-
tions for a rate hike, but now a lot of investors are looking
for the BOC to turn even more dovish at the March meet-
ing, according to Vassili Serebriakov, FX strategist at BNP
Paribas.
Also, the USD has been independently stronger. The
U.S. dollar has been doing a little better against a number
of currencies, including the Canadian dollar, in part due
to the more open debate on how much more Fed easing
will be seen, says Bob Lynch, head of G-10 FX strategy
Americas at HSBC. If the market needs to scale back onFed expectations, risk currencies might suffer.
Dollar/Canada near resistance?
However, despite the recent weakness, several forex strate-
gists believe the loonie could be ready to level out. In June
2012 the USD/CAD pair hit its high for the year around
$1.0445; its high the previous year was 1.0657 (Figure 2).
Last year it poked briefly above $1.04, Lynch says. As
you get up toward those levels it might be more difficult to
extend, barring new [Canada-] bearish developments.
Serebriakov agrees the recent Canadian dollar weaknessmight be about to run its course. I dont think this is the
beginning of a substantial weakness in the Canadian dol-
lar, he says. I think its a readjustment to the economic
news. I dont think its the next yen or the next pound. I
dont see what would sustain this sell-off very strongly.
St-Arnaud sees the potential for additional short-term
Canadian dollar weakness, but expects a ceiling around
$1.05 in the dollar/Canada pair. Over the next few weeks
dollar/Canada could continue to go higher if we see con-
tinuing weakness in the economic data, he says. We
know the first quarter could be relatively weak.y
FIGURE 2: NEARING RESISTANCE
A longer-term picture shows the dollar/Canada pair
approaching the resistance of its 2012 high.
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7/27/2019 Ctm 201303
10/3110 October2010CURRENCY TRADER
Traditionally, the international arena has been the realm
within which nation-states pursue their national interests.
The forex market is a subset of this international stage.
This state of affairs held true before, during, and after the
1944 Bretton Woods conference, but a new understanding
has emerged over the past couple of decades that is pro-
ducing new rules of engagement, as it were.
The Group of Seven (G7) industrialized nations often
reiterates the current rules of engagement in its vari-ous statements. There are essentially four rules. First,
exchange-rate prices are best set by the market. Second,
officials should avoid making foreign exchange prices an
object of policy. Third, excessive volatility should be avoid-
ed. Fourth, in the rare case where official action is needed,
coordination is vital.
Beggar-thy-neighbor policies
When Brazils Finance Minister Guido Mantega first
coined the term currency war in 2010, it seemed primar-
ily directed at the U.S. The implication was the U.S. waspursuing unorthodox monetary policy to offset household
and government deleveraging and reflate the worlds larg-
est economy.
More recently, the new Japanese government was
criticized for resorting to beggar-thy-neighbor policies.
Officials in the government, led by Prime Minister Shinzo
Abe, had been quoted in the press providing bilateral
exchange targets for the dollar/yen rate. Since the election
in the mid-November 2012, the yen has declined about
13.5% against the U.S. dollar. The yen has easily been the
weakest of both major emerging-market currencies (out-
side of the Venezuelan bolivar, which had been devalued
by 32%).
In the weeks leading up to the recent G20 meeting in
mid-February 2013, there was much consternation and
official push-back at what appeared to be official efforts to
manage a depreciation of the yen. The statements issued
by the G7 and G20 essentially reiterated the rules of
engagement, but did not single out Japan or any other
country for that matter.
Softening stance
Indeed, even in the days before the G20 meeting, Japanese
officials had begun tempering their comments and had
ceased to cite specific yen targets. Instead, they empha-
sized the extremely accommodative monetary and fiscal
policies they were pursuing.
The criticism levied against the Japanese officials has
other policy implications. Shortly after the G20 meeting,
senior Japanese officials backed away from a public-
private fund to buy foreign bonds, which probably wouldhave seemed too much like intervention. In addition,
despite earlier threats, senior officials downplayed the
need to change the Bank of Japan charter. The suggestion
had appeared to be too much of a threat to the central
banks nominal independence.
Arbitrary nature of rules
The rules of engagement recognize the right of countries
to pursue monetary and fiscal policies that promote stable
prices and sustainable growth. This means the long-term
asset purchases of the U.S., Japan and, maybe soon, the
Rules of FX engagement
There might be new rules of engagement in foreign exchange,
but that hardly means a currency war is inevitable.
BY MARC CHANDLER
ON THE MONEY
10 March2013CURRENCY TRADER
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UK (again) are not in violation of the rules.
Many observers are troubled by this prospect. They
dont see the difference between a currency that falls
because officials prod the market and a currency that
declines because of eased monetary policy.
But every game or institution has rules the uninitiated
find arbitrary. Its difficult for some people to understandwhy the Americans call a game they play with their hands
football. In basketball, you must dribble the ball as you
walk. However, youre allowed to take a step and a half to
shoot the ball. In baseball, if you catch a fly ball, the bat-
ter is out. But if there are fewer than two outs and runners
on second and third base, a pop-up ball in the infield is an
automatic out. Fielders need not even catch the ball.
Essentially, pursuing domestic policies for domestic
goals is sanctioned by the rules of international conduct,
even if a currency declines as a consequence. It is not prop-
er, though, to specifically target or manage an exchangerate. Its as if the temptations and dangers of beggar-thy-
neighbor competitive devaluations are so great that, under
the rules of engagement that have evolved since the late
1980s, high-income countries have generally forsworn their
use.
The fear is that competitive devaluations can lead to
trade wars, and then shooting wars. Of course, the clear
reference is to the 1920s and 1930s. However, this fear is
just as much a case of Godwins Law of Nazi Analogies. In
1990 Mike Godwin postulated: As an online discussion
grows longer, the probability of a comparison involvingNazis or Hitler approaches 1. (Meme, Counter-meme,
Wired magazine, 1994). Although Godwin was referring
to online discussions, we can broaden it to include discus-
sions of all kinds.
Easing market tensions
There are several compelling reasons tensions in the cur-
rency market will not lead to a trade war or a shooting
war. First, the main participants, the U.S., Europe, Japan,
China, and the International Monetary Fund do not view
current behavior as an act of war. Second, there are circuit
breakers and a trade-conflict-resolution mechanism under
the auspices of the World Trade Organization. Third, as
noted above, Japanese officials have ceased their offensive
behavior.
Currency war was, arguably, a useful metaphor to illus-
trate the tensions, but it took on a life of its own. There are
numerous reasons investment capital has flowed into some
emerging markets and, as a rule, those flows have slowed
during the last couple of years even as several high-income
countries pursue unorthodox monetary policies. These
include stronger macro fundamentals, such as stronger
growth and higher interest rates. Some investors are also
attracted to countries where the currency is perceived to be
deeply under-valued.
In the final analysis, numerous factors drive exchange
rates. Official talk may have short-run impact but, ulti-
mately, foreign-exchange prices are driven by interest
rates, the larger investment climate, and other macro-eco-
nomic variables. Typically, central banks prefer currency
movement that is consistent with the thrust of their mon-
etary policy.
The synchronized economic downturn prompted a cor-
responding policy response, and led to increased tensions
in the foreign exchange market. Look for such consterna-
tion to ease in the months ahead.y
Marc Chandler is head of global foreign exchange strategies atBrown Brothers Harriman. His blog is called Marc to Market(www.marctomarket.com). For more information on the author,see p. 4.
Ultimately, foreign-exchange
prices are driven by interest
rates, the larger investment
climate, and other macro-
economic variables.
http://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.marctomarket.com/http://www.marctomarket.com/http://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.wired.com/wired/archive/2.10/godwin.if.html -
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Are we in the midst of a currency war, as the financialpress is pushing us to worry about? Yes. But its not whatthe press wants us to think. In fact, much of the talk aboutcurrency wars is pure nonsense. As Winston Churchill saidin 1949, There is no sphere of human thought in which itis easier to show superficial cleverness and the appearanceof superior wisdom than in discussing questions of cur-rency and exchange.
A currency war is deliberate devaluation to promoteexports that triggers retaliation by other countries. Theresevidence several countries including Japan, Australia,
New Zealand, and many developing countries (SouthKorea, Philippines, et al) are doing just that.
But the U.S. and Europe are not using currency warrhetoric on the contrary, they have plans to improvetrade relations with one another in the form of a free-tradepact. Together, the U.S. and Europe account for almosthalf the worlds output, and a free-trade deal benefits notonly both parties, but also improves competitiveness withChina, the one country that really has been waging a tradewar. Currency war rhetoric is only the first step in a tradewar, and so far no country except China has taken the hardactions tariffs, quotas, subsidies that spell trade war.
If two of the top three currency issuers are not engagedand, indeed, speak out against currency war, is it really awar?
A currency war is really the first shot fired in a tradewar. Historically, trade wars result in lower trade volumesfor everyone and, we can safely assume, a lowering ofhousehold well-being everywhere, too, since export-orient-ed jobs may be saved but the cost of imported goods goesup.
In the days before floating exchange rates, the mecha-nism for implementing a competitive devaluation policywas simple just declare it. Such a case of devaluation by
fiat occurred on Feb. 14, 2013 when Venezuelan PresidentHugo Chavez, speaking from Cuba, devalued the bolivarby 32% (from 4.3 to the dollar to 6.3). Venezuela had deval-ued five times since 2003, most recently in January 2010.Because oil is about 95% of Venezuelas exports and oil isdollar-denominated, Venezuela gets no export advantagefrom devaluation, but it does get more bolivars per dollarto pay domestic expenses, such as Chavezs costly re-elec-tion campaign. Devaluation also inhibits imports and thusinflation, which was running above 22% in January. To theextent imports are essential and cannot be cut, in the lon-
ger run devaluation raises inflation.Much of todays currency war talk assumes countries
can simply announce devaluation, when this is true onlyfor fixed currencies. For example, in an op-ed article in theWall Street Journal a former hedge fund manager wrote theFed should halt quantitative easing right away and, at thesame time, incoming Treasury Secretary Jack Lew shouldimplement a strong-dollar policy. What would that entail,exactly? Aside from interfering with trade or some othertax or subsidy measure, historically, you get a stronger cur-rency by raising interest rates. The Treasury doesnt do that the Fed does. Currency policy resides at the Treasury,
but the only entity with the tool to execute policy is theFederal Reserve.
Therefore, in speaking of currency wars, we have to keepthe facts consistent with the structure of the FX markettoday, not in centuries past. Countries with fixed exchangerates can engage in currency wars directly. A president,central bank governor, or finance minister can stand up infront of a TV camera and simply command devaluation,and financial parties like banks need to obey or they losetheir license to operate.
In contrast, countries with floating exchange rates can-not declare devaluation. To do so they would have to
On the Money
12 March2013CURRENCY TRADER
ON THE MONEY
Straight talk
about currency warsPerspective is needed when addressing the overheated currency war topic.
BY BARBARA ROCKEFELLER
http://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Concepts -
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make changes elsewhere in the economy that have thesecondary effect of causing currency devaluation. Inthe floating-rate era, only one instance of a countrychanging interest rates specifically to influence a cur-rency comes to mind: Japan, which raised rates afterthe Plaza Accord in 1985 at the request of the U.S.specifically to drive down the dollar against the yen.Germany and the rest of the Europe declined to par-ticipate.
Is it fair to accuse a country of currency war if it imple-ments a policy targeting a certain economic condition that
has the secondary effect of causing devaluation? Saneand reasonable people say no. If the Federal Reserve isengaging in quantitative easing to nurture an ailing finan-cial system and to stimulate the economy, can it be blamedwhen the dollar falls? No, since the Feds mandate is tokeep inflation in check (no more than 2%), unemploymentat an acceptable level (most recently defined as 6.5%), andthe financial system stable. The Feds job is not to manageequity or currency prices. As Fed Chairman Ben Bernankehas said, changes in the dollar that arise from Fed policiestargeting the domestic U.S. economy are unintended.
In fact, Bernanke said at the October 2012 annual IMF
meeting in Tokyo that perception of the currency warconcept is one-sided by the emerging-market countriesthat feel aggrieved. Remember, it was Brazilian FinanceMinister Guido Mantega who revived the term currencywar at the G20 meeting in Seoul in November 2010.Bernankes rebuttal is more than a simple denial. He saidcapital inflows to higher-yielding emerging markets area function of many more factors than interest rate differ-entials. Relative higher growth is one factor, and besides,the correlation of flows with interest rate differentials hastended to diminish over time; it takes a bigger differentialto get a lesser flow.
Moreover, Bernanke continued, emerging markets arenot helpless. They have tools, including taxes and outrightcapital controls, to tame hot-money inflows. But perhapsthey should reconsider the capital-control form of currency
market intervention after all, a stronger currency allowsa lower cost of capital imports, like machinery, that eventu-ally leads to a stronger economy. Finally, emerging marketsshouldnt complain about the U.S. and other countrieshaving an easy-money policy, because its keeping alivethe source of demand for developing-country exports. Nocountry benefits if the U.S. economy remains mired in theGreat Recession.
Bottom line, the Fed and other super-accommodativedeveloped-country central banks are not out to swindleand harm emerging markets. Bernanke, tactfully, didnot add the Fed doesnt work for the Brazilian voter and
Brazilian business it works for the U.S. economy. Hecould have noted total U.S. exports of goods and servicesare only 14% of GDP, whereas the percentage is 32% in theUK, 50% in Germany, and 107% in Ireland. In Brazil, thegreat complainer, exports of goods and services are lessthan in the U.S., only 12%, according to World Bank datafor 2011 (Table 1). Meanwhile, total merchandise trade(exports plus imports), is 25% of U.S. GDP and 19.9% ofBrazils GDP. According to this table, among developedcountries Germany and Ireland, not to mention Canadaand the UK, should want a devalued currency.
In addition, Bernanke could have pointed out that dollar
TABLE 1: TRADE AS PERCENTAGE OF GDP 2011
Country
Exports of goods and
services as % of GDP
Total merchandise
trade as % of GDP
Bolivia 44% 66.8%
Brazil 12% 19.9%
Canada 31% 52.7%
China 31% 49.8%
France 27% 47.3%
Germany 50% 75.8%
Ireland 107% 88.9%
UK 32% 45.4%
US 14% 25%
The data suggests Germany and Ireland, and perhaps Canada
and the UK, should want devalued currencies.
Source: http://data.worldbank.org/indicator/TG.VAL.TOTL.GD.ZS
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ON THE MONEY
devaluation harms incoming capital flows. Foreign directinvestment (FDI) in the U.S. fell from about $94 billion inthe first half of 2011 to $57 billion in the first half of 2012.Even China had a drop in FDI, from $62 billion to $59 bil-lion. Brazils drop was smaller, $30 billion from $33 billion.The World Bank reports that over a longer period, Brazilgot $50.7 billion in FDI in 2008, rising to $71.5 billion in2011, while the U.S. showed a drop from $332.7 billion in2008 to $275.5 billion in 2011. These are absolute dollaramounts, and really should be expressed as a percentage ofGDP. In the U.S., FDI is only 1.5% of GDP (1.6% in China),but in Brazil, its 2.7%.
Then theres investment in equity markets. The TreasuryInternational Capital System (TICS) report shows globalequity investors seem to respond far more to changesin equity index levels than to changes in the dollar.
Meanwhile, inflows to Brazilian equities are robust andonly sometimes correlated to the real again, as Bernankesaid, a function of high growth and expectations of a posi-tive growth differential (Figure 1). From December 2011 toJune 2012, as the real was weakening, so was the Bovespastock index. Elsewhere the relationship is wobbly. In themost recent period, as shown by the linear regression lines,the real is falling while the Bovespa is rising. Net-net, aconsistent cause-and-effect relationship cant be deduced.If foreign investors consider the currency a factor in decid-ing to invest in Brazilian equities, its not the top-most fac-tor.
Where it is a top-most factor is Japan. In fact, the onlylongstanding and consistent stock market-currency rela-tionship is between the Nikkei and the yen, a tribute tothe export orientation of the big Japanese companies.Generally, the direction of causality is from the yen toequity prices; the Nikkei rises in lockstep with the dol-lar/yen rate (Figure 2). Now heres a chart showing thatpolicymakers have a logical reason to consider the levelof their currency as having a direct effect on the wealth oftheir citizens.
Denials
One reason the currency war story fizzled after MantegasG20 comments in 2010 was cooler heads prevailed. Butthen Japan held an election in December 2012, and incom-ing Prime Minister Shinzo Abe made it clear from the very
beginning the linchpin of all policy would be aggressivestimulus using quantitative easing and deficit spending.In the early days of Abes regime, his political allies andnewly appointed officials told the press the goal was toweaken the yen and get the Nikkei to 13,000 (from about10,000). Abe threatened the independence of the Bank ofJapan, which, in a rare joint statement, dutifully agreed todouble its inflation target. The governor agreed to resignearly, too.
As Figure 2 shows, anticipation of the Abe electoral vic-tory and nearly daily comments from Tokyo about the yenwas very effective in creating and maintaining the dollar
FIGURE 1: BRAZILIAN REAL (BLACK, INVERTED) VS. BOVESPA STOCK
From December 2011 to June 2012 Brazils Bovespa stock index was weakening
along with the real, but elsewhere the relationship between the two is weak.
Source: Chart Metastock; data Reuters and eSignal
2010 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2012 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2013 Feb M
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uptrend/yen downtrend, about 13% from mid-Novemberto mid-February. The Japanese yen depreciated to 94.46 perdollar on Feb. 11, the weakest level in almost three years
By the time of the G20 meeting in Moscow in mid-February, complaints were becoming more raucous thatJapan was starting a currency war. In an unprecedentedmove, the G7 issued a statement two days before the G20meeting that was interpreted as meaning the G7 was satis-fied Japans policy actions were not directed specificallyat devaluation, and therefore Japan was not to blamefor starting a currency war: We, the G7 Ministers andGovernors, reaffirm our longstanding commitment to mar-ket-determined exchange rates and to consult closely inregard to actions in foreign exchange markets. We reaffirmthat our fiscal and monetary policies have been and willremain oriented towards meeting our respective domestic
objectives using domestic instruments, and that we willnot target exchange rates. We are agreed that excessivevolatility and disorderly movements in exchange ratescan have adverse implications for economic and financialstability. We will continue to consult closely on exchangemarkets and cooperate as appropriate.
The G7 statement was a warning to the G20 not to singleout Japan, or even use the phrase currency war, andindeed thats exactly what the G20 did.
There is a certain amount of sympathy for Japans eco-nomic plight more than two decades of deflationaryrecession, punctuated by the occasional short-lived recov-
ery. The trade surplus has gone to a deficit, too. The IMFreports Japanese growth from 1994 to 2003 averaged amere 0.9%, or about one-third the growth rate of advancedcountries and that includes occasional bouts of yenweakness of more than 10% in 1996-1997 and 2000-2001.One analyst estimates a 10% drop in the yen will producea 0.6% gain in GDP if it can be sustained.
Economists admit they dont have any policy prescrip-tion other than QE and stimulus spending. If it devaluesthe currency, so be it. One idea still floating around withinthe Japanese government is that it buy foreign bondsas well as its own JGBs. Surely buying foreign govern-ment bonds would violate the G7 commitment to seekingdomestic objectives using domestic instruments andmay yet cause some fireworks.
Japan dodged the bullet this time but no one has any
doubt if sentiment were to come down on the side of QEand stimulus failing (as it has done before), this time theyen will be restrained from returning to too-strong levels,presumably by outright intervention. After all, theres alimit to how much words can achieve alone, isnt there?
Words count
Floating currency countries cannot arbitrarily decreedevaluation, but words count. A phrase may not be anactual command, but it can still have the same effect. TheFX market responds instantly to comments like the onefrom Japanese Finance Minister Akira Amari that, golly,
FIGURE 2: USD/JPY (BLACK) VS. THE NIKKEI STOCK INDEX
The stock market-currency relationship between the Nikkei and the Japanese
yen is a tribute to the export orientation of big Japanese companies. Generally,
the Nikkei rises in step with the dollar/yen rate.
2011 Apr May Jun Jul Aug Sep Oct Nov Dec 2012 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2013 Feb M
4.04.55.05.56.0
6.57.07.58.08.59.09.50.00.51.01.52.02.53.03.54.04.55.05.56.06.57.07.58.08.59.09.50.00.51.01.52.02.53.03.54.04.55.05.56.0
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he hadnt expected the yen to move so far, so fast. Yenshorts covered, only to restore the position the next daywhen a different comment was published. The CFTCCommitments of Traders Report shows speculativeaccounts had a net yen short position of 65,891 contracts asof Feb. 19, from 61,306 contracts the week before. Tradershad a bigger short position on the Dec. 11 report, 94,401contracts. This was the biggest number since 188,077 con-tracts on June 26, 2007. The implication is there are plentyof fence-sitters waiting to short the yen if this move turnsout to be more than a flash in the pan.
Japan is not the only country to speak out about cur-rency levels. Bank of England Governor Mervyn Kingrecently said real recovery would be much aided by aweaker pound. French Finance Minister Pierre Moscovicicalled for an ECB exchange rate policy, and President
Francois Hollande, evidently jealous of Japans success,demanded coordinated action to push the Euro lower so itbetter represented fundamental values. Bundesbank chiefJens Weidmann shot back within hours that exchange-rate policy to specifically weaken the Euro would lead tohigher inflation in the end. He also said the ECB wouldnot consider a rising Euro alone in considering a rate cut.Besides, calling for exchange rate system changes simplydiverts attention from the need to make their economiesmore competitive. Only governments can solve theseproblems, the central banks cannot. In this respect, thediscussion about a supposed overvaluation of the Euros
exchange rate simply deviates from the real challenges.Austrian Finance Minister Maria Fekter agrees with
Weidmann. Eurogroup chief Jean-Claude Juncker saidEurope must not be nave on currencies. Even thepresident of the Swiss National Bank which set a capfor the Swiss franc in the Euro-Swiss cross and intervenedto get it, denies a currency war, saying central banksmonetary policies are internal programs. And ECB chiefMario Draghi denounced chatter about currency warsas either inappropriate or fruitless, in all cases self-defeat-ing. Effective exchange rates are near their long-termaverages and besides, Draghi says, The exchange rate isnot a policy target but important for growth and price sta-bility.
Draghi seemingly used a little currency war rhetorichimself when he added the ECB would still have to assess
the economic impact of the Euros strength, and he is con-cerned a stronger Euro will be a drag on growth and maycause inflation to drop too far, i.e., deflation. The Euro fell120 points in under an hour. The charitable interpretationof Draghis drag remark is that he couldnt resist beingan economist. At the time, the remark made him appeartwo-faced and, at a guess, he wont do it again.
The Australian dollar gyrated up and down in a widerange (1.0222 to 1.0375) during February on commentsalmost every day about whether the Reserve Bank will cutrates to tame the AUD (Figure 3). Reserve Bank GovernorGlenn Stevens said the Australian dollar remains stronger
FIGURE 3: AUD/USD WIDE RANGE, HIGH VOLATILITY
The Australian dollar swung in a wide range in February on virtually daily
comments about whether the Reserve Bank will cut rates to tame the
currency.
013
7 14 21 28 4
February
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than expected and a relevant factor in setting interest rates:As we have noted repeatedly, the exchange rate remainssomewhat higher than one might have expected given thedecline in export prices so far observed. This has been arelevant factor in the setting of interest rates. A cut in therate would not be aimed at achieving a particular responsein the exchange rate, but rates are being set with a recog-nition of the exchange rates effect on the economy.
Also, New Zealand central bank Governor Graeme
Wheeler said, The kiwi is not a one-way bet. Speakingto a conference, he said he was prepared to intervene toinfluence the kiwi. The NZD fell 1% in response. Othercountries are making grumbling noises, too SouthKorea, Taiwan, even Norway, which maychooseto cutinterest rates to counter the krones strength. Centralbankers in the Philippines and Indonesia have spoken outabout policy changes to address currency levels.
The Japanese are now refraining from mentioning theyen in the same breath as comments about stimulatingthe economy, but other countries are blatantly referenc-ing their currencies when they speak of interest ratepolicy. Australia and New Zealand are the latest cases, butSwitzerland and Norway deserve mention, too. This is afar cry from the G7 statement and G20s acquiescence. In anutshell, plenty of countries are, indeed, engaging in influ-encing currency markets.
Newcomers to the FX market may not know it, but thisis an unwelcome return to conditions during the 1970s and1980s when comments from officials and summits were themain fodder for traders to choose positions. For example,after Black Monday in 1987, the G7 issued a communiquon Dec. 23 (called the Christmas Communiqu), sayinga further decline in the dollar would be counterproductive.As usual, the G7 was a day late and a dollar short. (Black
Monday was Oct. 19 so the Christmas Communiqu wasabout two months late.) To read the early history of theFX market, replete with hundreds of interventions andmarket-moving comments and communiqus, check outVolcker and Gyohten, Changing Fortunes, 1992.
We dont know when, exactly, keeping quiet about FXbecame the norm. We think it was Treasury SecretaryRubin during the Clinton Administration, circa 1995,who declined to say anything other than the now-famousRubin mantra a strong dollar is in the U.S. best interests.Whoever started it, we do know who put the final nail inthe coffin of officials making FX comments it was the
first ECB chief Wim Duisenberg, who misspoke so oftenduring the first year after the Euro launch (1999) thatsilence on FX matters became the preferred stance.
Increasing numbers of comments about currency levelsfrom top officials seem to back up the idea that govern-ments are deliberately trying to manipulate currencieswith rhetoric and the occasional interest rate change. Butnot a single country has proposed an actual trade war inthe form of the hard actions tariffs, quotas, and sub-
sidies. The real trade war participant, China, is actuallyrelaxing its measures.So far the currency war is just hot air. Moreover, G7 and
G20 are blowing smoke, too. Their communiqus donteven mention trade and focus instead on the intent ofinterest rate policy as directed solely to the domestic econ-omy. This is a feint. G7 and G20 seem to be hoping that bydefending a sovereigns right to manage its own economy,nobody will notice the real implications of currency war that its really trade war.
The Fed and the ECB are not part of the currency wargang, but with so many other countries engaged in curren-cy war talk, this is going unnoticed. But we should notice;it implies that unless someone escalates to real trade warmeasures, this currency war talk will fizzle just like it didin 2011. The odd part is that no country ever depreciatedits way to prosperity and we all know that. Small advan-tages from higher exports get dissipated and even over-whelmed by other effects, such as imported inflation orglobal investors fleeing your equity market.
The current spate of comments from finance ministersand central bankers is a symptom of lack of disciplineamong top officials and an absence of leadership fromthe U.S. or the G7. We need somebody important to standup and call a halt to it, whereupon we can all go back to
second-guessing central bank intentions. The obvious can-didate is new Treasury Secretary Jack Lew, but he is a bud-get expert rather than an international markets guy, and helacks the stature Rubin brought to the job on day one.
Who will save us from currency war officials? We pro-pose Bernanke and Draghi have tea and issue an ultima-tum.y
Barbara Rockefeller (www.rts-forex.com) is an internationaleconomist with a focus on foreign exchange, and the author of thenew book The Foreign Exchange Matrix (Harriman House).For more information on the author, see p. 4.
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The U.S. dollar index (DXY) rallied around 4.5% between
the first day of February and the first day of March, post-
ing four consecutive weeks of higher highs and closes.
The run-up swept the short-side implications of the
20-day low breakdown analysis featured in last months
Spot Check out the window. (The article also included
analysis of DXYs behavior after new 20-week lows; the
market failed to trade below its September 2012 low and
trigger that signal, however.)
Feb. 1, in fact, turned out to be the low of the early-
2013 down swing, marking just two days of downside
follow-through after making a new 20-day low on Jan.
30. By Feb. 18, DXY had swung far enough to the upside
to establish a 20-day high, and two days later on Feb. 20
it made a new 63-day (three-month) high the first of
several over the next couple of weeks.
Figure 1 highlights the 12 most recent instances offour-week runs of higher highs and higher closes, the last
one occurring the week ending March 1. The examples
date back to 2005; there have been a total of 55 four-week
(or longer) runs since March 1973. Of the 11 previous
instances in Figure 1, all were followed by a lower close
the following week, seven were followed immediately by
two- to four-week down moves, a couple were followed
by declines two or three weeks later, and only a couple
others (the most notable occurring in Q3 2009) were fol-
lowed by significant upswings.
SPOT CHECK
Dollar danceA markets phase will dictate the performance of a price
pattern. What mode is the dollar currently in?
BY CURRENCY TRADER STAFF
FIGURE 1: DXY FOUR-WEEK RUNS, 2005-MARCH 2013
Most of the instances of four consecutive weeks of higher
highs and closes during this period were followed by bearish
price action.
FIGURE 2: WEEKLY PATTERN PERFORMANCE,2005-MARCH 2013
Performance after the four-week runs was a little more
bearish than the market benchmark in the first three weeks.
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Ignoring for a moment the fact there were only 11
examples in the past eight years, Figure 2 shows the
performance after these four-week higher-high, higher-
close (HH/HC). The blue lines represent the average andmedian moves from the close of the final week of the pat-
tern to the closes of the subsequent 12 weeks; the red lines
represent the average and median performance for all one-
to 12-week moves during the analysis period, and reveal
DXYs downside bias during this period. The performance
after four-week runs was a little more bearish than the
market benchmark in the first three weeks, peaked (some-
times above the benchmark) into week 7, and then turned
back down.
Overall and especially given the performance after
the most recent examples in Figure 1, and the fact thatall examples were followed by a lower close the follow-
ing week a trader might be tempted to look for selling
opportunities after four-week runs of higher highs and
higher closes. However, Figure 3 shows the performance
after all 54 previous examples dating back to 1973. Even
though it incorporates the marginally bearish data from
Figure 2, here the post-pattern performance is unambigu-
ously bullish, with positive average and median returns at
all intervals.
The big difference between the two data sets is that DXY
has been dominated by a general downtrend and consoli-
dation (with some sharp counter-rallies in 2008 and 2010)
since 2002. The preceding period included the dollars
monster rally from 1980 to 1985 and the somewhat smaller
uptrend from 1995 to 2002 periods during which four
weeks of consecutive higher highs and higher closes were
more often than not followed by additional up weeks.
Faced only with this conflicting information a long-
term history that implies upside follow-through and the
most recent data suggesting the possibility of weakness
what would a trader do?
The daily time frame: Three-month highsFigure 4 shows DXYs performance from March 1973 to
March 2013 in the 12 days after making new 63-day highs.
The dollar index made a new 63-day high 772 times during
this period, prior to the six most recent instances shown in
Figure 5.
Figure 4 suggests, other factors notwithstanding, expect-
ing DXY to continue to rally after making a new 63-day
high was a good bet. The percentage of higher closes was
lowest (at around 53%) at day 2 and climbed to 58-59% at
FIGURE 3: WEEKLY PATTERN PERFORMANCE,1973-2013
The price action after all 54 examples of the pattern is clearly
bullish, with positive average and median returns at all
intervals.
FIGURE 4: AFTER 63-DAY HIGHS, 1973-2013
Overall, DXY continued to rally after making a new 63-day
high.
FIGURE 5: RECENT 63-DAY HIGHS
The upside follow through after the initial 63-day highs
shown here is in keeping with the signals statistics over the
past 40 years.continued on p. 25
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TRADING STRATEGIESADVANCED CONCEPTS
Certain acts define desperation. These include cubicle-
dwellers self-identifying as contrarian, paying tuition for
a course on entrepreneurship, subscribing to any diet plan
and, of course, repeating any management buzz-phrase
such as thinking outside of the box. When you hear the
latter term, replace it with thinking with a childs natural
curiosity and be done with it.
Lets take the subject of a currency union, please. Having
witnessed the construction of the Berlin
Wall and its toppling a mere 28 years
later, I wonder if the Euro will endure for
longer than that tribute to human oppres-sion. You can conceive of the Euro as a
single entity or you can think of it as a
set of fixed exchange rates between all
of its members. As there are 17 members
of the Eurozone in early March 2013, the
Euro actually converts 136 currency pairs
[(172 17)/2] into a set of 17 national cur-
rencies trading at fixed rates to each other
and at a floating rate to the rest of the
world. This type of network economics
is why centralized nodes, including stockand commodity exchanges, have such cost
efficiency in sharing information.
Two asides are in order: While the
United Nations, an organization never
known as a bastion of efficiency in any-
thing, settled on a small set of official
languages (just six at last count), the
European Union insists on simultaneous
translations into all member languages
during its proceedings; this may strike
notoriously mono-lingual Americans who
The interest rate price of acurrency union
Until it abandons its separate national histories and adopts a common fiscal policy,
the Eurozone will suffer the consequences of its fundamental contradiction.
BY HOWARD L. SIMONS
Portugal, Spain, and Italy have the flattest yield curves, while stronger credits
such as Germany, Finland, and the Netherlands have the steepest.
FIGURE 1: GLOBAL CURRENCY SWAP EXPANSION STEEPENEDYIELD CURVES
Nov-11
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Portugal
Italy
Spain
Belgium
France
Austria
Netherlands
Finland
Germany
0.90
0.93
0.95
0.98
1.00
1.03
1.05
1.08
1.10
1.13
1.15
1.18
1.20
1.23
1.25
1.28
ForwardRateRatio,
2-10Years
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are impressed with Europeans multilin-
gual skills as unnecessary, and it certainly
is cumbersome. The second is the move
to the Euro was devastating to the large
population of oddball currency tradersat European banks and money-changers:
Some people actually made their living
trading the Finnish markka against the
Portuguese escudo, or some-such, regard-
less of its general flouting of the principles
of economic utility.
But there is a significant downside to
fixing currency rates, and that is a country
can fix its short-term interest rates or it
can fix its currency exchange rates, but it
cannot fix both simultaneously. Thus, ifGreece, just to take the prime example of
the whole 2009-2012 European sovereign-
debt mess, has a de facto fixed exchange
rate against Germany, all macroeco-
nomic adjustments have to be achieved
through higher short-term interest rates as
opposed to a combination of higher short-
term interest rates and a weaker currency.
Consequences of the fix
Accordingly, we should expect the weakercredits within the Eurozone to have
higher short-term interest rates and flatter
yield curves than they would have other-
wise, and the stronger credits within the
Eurozone to have lower short-term inter-
est rates and a steeper yield curve than
they would have otherwise.
A second consequence is the interest
rate distortion makes the common cur-
rency weaker than it would be otherwise
for the stronger credits and stronger than
Here, and in Figures 4-8, the FRR2,10tends to lead two-year zero-coupon
implied volatility by 13 weeks. These charts show how the one variable
allowed to operate in a currency union, short-term interest rates, drives
volatility and the cost of insuring financial risk.
FIGURE 3: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: PORTUGAL
60%
65%
70%
75%
80%
85%
90%
95%
100%
105%
110%
115%
120%
125%
130%
0.80
0.82
0.84
0.86
0.88
0.90
0.92
0.94
0.96
0.98
1.00
1.02
1.04
1.06
1.08
1.10
1.12
1.14
May-10
Jul-10
Sep-10
Nov-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Two-YearZero-CouponVolatilityLed13Weeks
Forwar
dRateRatio,
2-10Years
Yield Curve
Volatility
The flood of money into the short-term paper of the higher-quality credits, such
as Germany, drove volatility higher.
FIGURE 2: TWO-YEAR ZERO-COUPON IMPLIED VOLATILITY SINCENOV. 30, 2011
Ireland
Portugal
Belgium
Austria
Netherlands
Germany
10%
100%
Nov-11
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
ImpliedVolatility
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ON THE MONEY
22 March2013CURRENCY TRADER
ADVANCED CONCEPTS
it would be otherwise for the weaker
credits.
The third consequence is a bit stranger.The implied volatility of any short-term
interest rate viewed as artificially low and
at the anchor end of a yield curve steeper
than it would be otherwise rises. The
reason is devilishly simple: The market
knows once the suppression of short-term
interest rates ends, those yields will snap
higher and flatten the yield curve in con-
sequence.
If we sum these effects, we see lose-lose
propositions all the way around: Weakercredits have to struggle with higher
short-term interest rates and a stronger
currency, while stronger credits have to
deal with higher implied volatility and a
steeper yield curve. As improperly val-
ued currencies affect all segments of an
economy, and as interest rates equilibrate
current and future consumption, the
mechanics of a currency bloc create a large
and differing number and distribution of
winners and losers in its member states asthe price of avoiding those extra trading
pairs.
Two measures over time
Lets illustrate the distortions of the
Eurozone currency bloc across two dimen-
sions. The first is the sovereign yield
curve as measured by the forward rate
ratio between two and 10 years (FRR2,10).
This is the rate at which borrowing can
be locked in for eight years starting two
FIGURE 5: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: ITALY
39%
45%
51%
57%
63%
69%
75%
81%
87%
93%
0.98
0.99
1.00
1.01
1.02
1.03
1.04
1.05
1.06
1.07
1.08
1.09
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
May-10
Jul-10
Sep-10
Nov-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Two-YearZe
ro-CouponVolatilityLed13Weeks
ForwardRateRatio,
2-10
Years
Yield Curve
Volatility
FIGURE 4: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: SPAIN
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
1.02
1.03
1.04
1.05
1.06
1.07
1.08
1.09
1.10
1.11
1.12
1.13
1.14
1.15
May-10
Jul-10
Sep-10
Nov-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Two-YearZero-CouponVolatilityLed13Weeks
ForwardRateRatio,
2-10Years
Yield Curve
Volatility
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years from now, divided by the 10-year
rate itself. The more this ratio exceeds
1.00, the steeper the yield curve is. (As an
aside, neither the Greek FRR2,10, nor theIrish FRR2,10 are shown. Greece defaulted
in March 2012 and restructured; Ireland
similarly stopped issuing 10-year notes.
Both yield curves had moved into and out
of inversion. The second dimension is the
implied volatility of two-year zero-coupon
sovereign debt.)
How have these measures traded since
the expansion of currency swaps into the
Eurozone at the end of November 2011?
First, the weakest remaining member ofthe former PIIGS quintet, Portugal, was
the last country to have an inverted yield
curve (Figure 1). However, Portugal,
Spain, and Italy have the flattest yield
curves, while stronger credits such as
Germany, Finland, and the Netherlands
have the steepest yield curves.
Next, the picture for two-year zero-
coupon implied volatility is as expected
as well (Figure 2). The weaker credits
(Greece after its March 2012 restructur-ing excepted) have the lowest volatility
for the counterintuitive reason the market
does not consider them accidents waiting
to happen. The flood of money into the
short-term paper of the higher-quality
credits, such as Germany, drove volatility
higher, with deleterious consequences for
insuring against interest rate volatility.
National histories
Now lets step back and look at the select-
FIGURE 7: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: NETHERLANDS
FIGURE 6: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: GERMANY
60%
110%
160%
210%
260%
310%
360%
410%
460%
510%
560%
610%
660%
710%
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
1.18
1.19
1.20
1.21
1.22
1.23
1.24
1.25
1.26
1.27
1.28
May-10
Jul-10
Sep-10
Nov-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Two-YearZero-CouponVolatilityLed13Weeks
ForwardRateRatio,
2-10Years
Yield Curve
Volatility
50%
75%
100%
125%
150%
175%
200%
225%
250%
275%
300%
325%
350%
375%
1.115
1.125
1.135
1.145
1.155
1.165
1.175
1.185
1.195
1.205
1.215
1.225
1.235
1.245
1.255
1.265
May-10
Jul-10
Sep-10
Nov-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Two-YearZer
o-CouponVolatilityLed13Weeks
ForwardRateRatio,
2-10
Years
Yield Curve
Volatility
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ON THE MONEY
24 March2013CURRENCY TRADER
ADVANCED CONCEPTS
ed paths of various strong
and weak credits. TheFRR2,10 tends to lead two-
year zero-coupon implied
volatility across a number
of markets by 13 weeks,
or one calendar quarter.
This is consistent with the
quarterly expiration and
debt issuance cycles in
many countries. These are
presented in Figures 3-8
without further commentas they show us how the one variable allowed to operate
in a currency union short-term interest rates drives
volatility and the cost of insuring financial risk.
Kick that bloc
As Keynes noted famously, The ideas of economists
and political philosophers, both when they are right and
when they are wrong, are more powerful than is com-
monly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt
from any intellectual influence, are usually the slaves of
some defunct economist.
The world of currencytrading has been driven by
the ideas of several Nobel
laureates, including Milton
Friedman, who espoused
floating exchange rates as a
way of getting to self-correct-
ing current account balances,
and Robert Mundell, the real
architect of the Euro.
Both floating exchange
rates and the Euro weredesigned to replace existing regimes found wanting and
in perpetual crisis mode, and both went on to create their
own rolling and somewhat quasi-permanent crises. Until
the Eurozone both abandons its separate national histories
and adopts a common fiscal policy, it will suffer at the
interest rate cost defined by its internally fixed exchange
rates. That is quite simply a given.y
Howard Simons is president of Rosewood Trading Inc. and astrategist for Bianco Research.For more information on theauthor, see p. 4.
FIGURE 8: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: FINLAND
40%
80%
120%
160%
200%
240%
280%
320%
360%
400%
440%
1.115
1.125
1.135
1.145
1.155
1.165
1.175
1.185
1.195
1.205
1.215
1.225
1.235
1.245
1.255
1.265
May-10
Jul-10
Sep-10
Nov-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Two-YearZero-CouponVolatility
Led13Weeks
ForwardRateRatio,
2-10Years
Yield Curve
Volatility
A country can fix itsshort-term interest rates or
it can fix its currency
exchange rates, but it cannot
fix both simultaneously.
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days 10-12.
Figure 6, however, shows the DXYs performance
after the 349 instances of 63-day highs that took place
the most recent 20 years, March 1993 to Feb. 19, 2013
(again, prior to the examples shown in Figure 5). Now
the post-pattern performance looks more bearish,
although until day 10 it was mostly a more volatile
version of the DXYs downside bias; it was only at day
11 that the post-pattern performance was clearly more
negative than the benchmark performance.
The same phenomenon apparent in the weeklyanalysis is evident here: The patterns performance is
notably determined by the markets mode or trend at
the time. When DXY is trending higher, a four-week
run of higher highs and higher closes or a new 63-day
high presages additional buying; when DXY is in a
downtrend, these patterns both tend to be signs of
exhaustion.
Figures 7 and 8 provide some final perspective on
this dichotomy: The former shows the 1985 to March
1993 performance after 63-day highs that closed within
0.06 of the days high (as was the case on March 1,2013), while the latter shows this patterns perfor-
mance from March 1993 to March 2013. The difference
between the two is more extreme than in previous
examples: The bullish trajectory in Figure 7 is strong
than that in Figure 4, while Figure 8 is more clearly
bearish than Figure 6.
Right here, right now
As of March 4, the dollar index had rallied to nearly
82.50 and was poised to challenge the resistance of
its 2012 high around 84 (refer to Figure 1). The ques-tion is, does the recent run mean the dollar is in a new
uptrend, or is the prevailing environment still side-
ways/down, which would imply selling into strength
will offer a chance to profit on a pullback? DXY cer-
tainly rallied smartly off the support zone defined in
the final four months of last year, which was discussed
at length last month. But on a longer-term basis, the
DXY has been trendless for the better part of four
years.
The Forex Trade Journaldetails a trade based par-
tially on this analysis.y
SPOT CHECK
FIGURE 6: AFTER 63-DAY HIGHS, 1993-2013
Instances of 63-day highs that took place between March
1993 and Feb. 19, 2013 were followed by much more
bearish action than that shown in Figure 4.
FIGURE 7: 63-DAY HIGHS W/ HIGH CLOSE, 1985-1993
After 63-day highs that closed strongly (within 0.06 of the
days high), the DXY tended to rally.
FIGURE 8: 63-DAY HIGHS W/ HIGH CLOSE, 1993-2013
Over the past 20 years, strongly closing 63-day highs were
followed by more selling than buying.
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CPI: Consumer price index
ECB: European Central Bank
FDD(rstdeliveryday):Therst
day on which delivery of a com-modityinfulllmentofafutures
contract can take place.
FND(rstnoticeday):Also
knownasrstintentday,thisis
therstdayonwhichaclear-nghouse can give notice to abuyer of a futures contract that itntends to deliver a commodity infulllmentofafuturescontract.
The clearinghouse also informsthe seller.
FOMC: Federal Open MarketCommittee
GDP: Gross domestic product
ISM: Institute for supplymanagement
LTD(lasttradingday):Thenal
day trading can take place in a
futures or options contract.
PMI: Purchasing managers index
PPI: Producer price index
Economic Releaserelease(U.S.) time(ET)
GDP 8:30 a.m.
CPI 8:30 a.m.
ECI 8:30 a.m.
PPI 8:30 a.m.
SM 10:00 a.m.
Unemployment 8:30 a.m.
Personal income 8:30 a.m.
Durable goods 8:30 a.m.Retail sales 8:30 a.m.
Trade balance 8:30 a.m.
Leading indicators 10:00 a.m.
GLOBAL ECONOMIC CALENDAR
March
1
U.S.: February ISM manufacturingreportBrazil: Q4 GDPCanada: Q4 GDPJapan: January employment reportand CPI
23
4
5
6
U.S.: Fed beige bookAustralia: Q4 GDPBrazil: February PPICanada: Bank of Canada interest-rate announcement
7
U.S.: January trade balanceFrance: Q4 employment report
Japan: Bank of Japan interest-rateannouncementMexico: February PPI and Feb. 28CPIUK: Bank of England interest-rateannouncementECB: Governing council interest-rateannouncement
8
U.S.: February employment reportBrazil: February CPICanada: February employmentreportLTD:
March forex options; MarchU.S.dollarindexoptions(ICE)
9
10
11
12Germany: February CPIJapan: February PPI
13U.S.: February retail salesFrance: February CPI
14
U.S.: February PPIAustralia: February employmentreportHong Kong: Q4 PPIIndia: February PPI
15 U.S.: February CPI
16
17
18Hong Kong: December-Februaryemployment reportLTD: March forex futures
19
U.S.: