Strategies, analysis, and news for FX traders

  June 2009
Volume 6, No. 6

            PATTERN + FILTER: Screening ...

                                                                           Trading Strategies
Margin-based FX Trading*                          Agency Execution**                      Liquidity from Multiple Global B...

     Forex News
       FIFO mandate causes headaches
       for U.S. FX dealers . . . . . . . . . . . . . . ....


                        Introducing Forex E-Micro Fu...


                             All eyes on China
The question now isn’t whether or not the world will catch...
Moody’s recently upped its 2009 China GDP        larger than most people expect,” Sun says.
forecast from 7 to...
                                          The Chinese yua...
thanks to some economic stabilization — but economists
warn the issue of protectionism is not likely to disappear

The protectionism domino effect                                  Free trade
Once protectionism starts, it...


                                         Risk aversion
           Risk appetite and aversion explain a gre...
                                         As the S&P has rallied, so has the Euro — meaning, the U....

                                           The differing paths of gold and the Euro currency futu...
                                                 FIGURE 7 — EURO PROJECTION

ing a “negative” outlook on the ...
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profitability, increased the winning        FIGURE 5 — LONG ENTRY WINNING PERCENTAGE
percentage of ...

                       Currency volatility
                    and long-term treasury returns
                                                   THREE ...

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of the yield curve — that is, a steeper yield curve driven by    2008, respectively). Because the franc is a funding curre...
Currency Trader0609p62
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  1. 1. Strategies, analysis, and news for FX traders June 2009 Volume 6, No. 6 PATTERN + FILTER: Screening intraday FX trades p. 20 HOW RISK AVERSION DRIVES the FX market p. 14 CAN CHINA LEAD THE GLOBE out of recession? p. 8 PROTECTIONISM and the forex market p. 10 CURRENCY VOLATILITY and Treasury returns p. 26 FOREX BROKERAGES chafe at new NFA rule p. 36
  2. 2. CONTENTS Trading Strategies Midpoint filter for intraday FX . . . . . . . . .20 What happens when you use the previous day’s range to determine when to take long Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 or short trades the next day? By Currency Trader Staff Global Markets All eyes on China . . . . . . . . . . . . . . . . . . . . .8 Advanced Strategies China’s recent economic numbers have been Currency volatility and long-term encouraging, but questions remain about their treasury returns . . . . . . . . . . . . . . . . . . . .26 validity and whether the Asian dragon can light The belief that higher currency volatility leads to the world economy on fire by itself. steeper yield curves and negative bond returns By Currency Trader Staff has been challenged by the 2008-2009 financial upheaval. For now, protectionist By Howard L. Simons banter recedes . . . . . . . . . . . . . . . . . . . . .10 continued on p. 4 So far, we’ve avoided a global trade war driven by protectionism. Another economic downswing could put nations to the test, though. By Currency Trader Staff On the Money Risk aversion . . . . . . . . . . . . . . . . . . . . .14 Extraordinary times call for out-of-the-box thinking about markets. By Barbara Rockefeller 2 June 2009 • CURRENCY TRADER
  3. 3. Margin-based FX Trading* Agency Execution** Liquidity from Multiple Global Banks EUR/USD D 10:02:18 Sell 1000 0.5 Buy 1000 Low 1.25338 High 1.27552 { 1.26895 Competitive 1.26870 1.26875 1.26890 0 5 Bid/Ask Spreads 1.0 87 87 1.0 1.26885 1.26880 { Bid 875 10 Offer 870 1.26875 1 1-Click 1.26870 Entry Order E Amt(M) Cpty Bid Offer Cpty Amt(M) 1.26865 1.26860 1.0 870 875 1.0 1.26855 { 1.0 866 883 1.0 New Order Display Up to o 1.0 856 884 10.0 10 Levels of 10.0 856 885 7.5 Market Depthh 7.5 855 886 10.0 20.5 ALL 861 883 ALL 29.5 Bid Alert: 1.27100 Net Open 0 1-646-432-2970 FOREX CAPITAL MARKETS, FINANCIAL SQUARE, 32 OLD SLIP, 10TH FLOOR, NEW YORK, NY 10005 USA - 1-646-432-2970 WARNING: Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. Before deciding to trade foreign exchange, you should carefully consider your monetary objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your deposited funds, and therefore you should not speculate with capital that you cannot afford to lose. *Without proper risk management, currency trading has a high degree of leverage which can lead to large losses as well as gains. **Please note FXCM Micro in its discretion may or may not offset individual transactions unlike transactions in most FXCM Standard accounts.
  4. 4. CONTENTS Forex News FIFO mandate causes headaches for U.S. FX dealers . . . . . . . . . . . . . . . . . .36 The NFA’s new rule regarding first-in-first-out trade exits has forex dealers rushing to make the necessary changes to their platforms. By Chris Peters International Markets . . . . . . . . . . . . . .38 Numbers from the global forex, stock, and interest-rate markets. Global Economic Calendar . . . . . . . . . . . .41 Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42 Important dates for currency traders. Conferences, seminars, and other events. Key concepts . . . . . . . . . . . . . . . . . . . . . . .42 New products & services . . . . . . . . . . . . . .43 Have a question about something you’ve seen in Currency Trader? Submit your editorial queries or comments to Looking for an advertiser? Consult the list below and click on the company name for a direct link to the ad in this month’s issue of Currency Trader. Ablesys Forex & Options Expo CMS Forex FXCM NinjaTrader dbFX RS of Houston eSignal Institute of Higher Earning E*TRADE FINANCIAL InterbankFX Tsunami Trading 4 June 2009 • CURRENCY TRADER
  5. 5. EW SIZE N MATTERS. Introducing Forex E-Micro Futures. 1/10 the contract size, 1/10 the risk exposure. TRADE THEM AT E*TRADE NO FEE Futures Platform powered by Trading TechnologiesTM DIRECT ACCESS to Every Secure & Regulated U.S. Market FREE EDUCATION & Dedicated Customer Service 1 For 90 days, $2.99 thereafter 1000 new accounts a day ETRADE.COM/FUTURES 1-800-ETRADE-1 Important Note: Futures and options transactions are complex and carry a high degree of risk. They are intended for sophisticated investors and are not suitable for everyone. For more information, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure Statement for Futures and Options available by visiting and or by calling 1-800-ETRADE-1. New Accounts claim based on internal E*TRADE FINANCIAL Corp. metrics for average daily gross new E*TRADE Bank and E*TRADE Securities accounts between 3/1/08–2/28/09. Net new accounts were in excess of 150,000 over the same period. 1. The new account holder will be charged 99¢ (per side, per contract, plus exchange fees) futures commissions for each futures trade executed once a qualified account is opened and funded and deposited funds have cleared. After the 90 day offer period, each futures trade is $2.99 (per side, per contract, plus exchange fees). This offer is not valid for IRAs, other retirement, business, trust or E*TRADE Bank accounts. Excludes current E*TRADE Securities customers, E*TRADE FINANCIAL Corp. associates and non-U.S. residents. Offer only applies to new E*TRADE Futures Accounts opened with a $10,000 minimum deposit. Account holders must maintain minimum funding in all accounts ($10,000 minus any trading losses) for at least six months or credit may be surrendered. Limit one new E*TRADE Futures account per customer. We reserve the right to terminate this offer at any time. In addition to the $2.99 per contract per side commission, futures customers will be assessed certain fees including applicable futures exchange and NFA fees, as well as MF Global floor brokerage charges for execution of non-electronically traded futures and futures options contracts. These fees are not established by E*TRADE Securities and will vary by exchange. E*TRADE Securities LLC and Trading Technologies are separate and unaffiliated companies. CME Group does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any product or investment strategy. The Globe Logo, CME Group and Forex E-micros® are trademarks of Chicago Mercantile Exchange Inc. Securities products and services are offered by E*TRADE Securities LLC, Member FINRA/SIPC/NFA. Futures accounts are carried by MF Global, an unaffiliated company. System response and account access times may vary due to a variety of factors, including trading volumes, market conditions, system performance and other factors. ©2009 E*TRADE FINANCIAL Corp. All rights reserved.
  6. 6. CONTRIBUTORS CONTRIBUTORS A publication of Active Trader ® For all subscriber services: Editor-in-chief: Mark Etzkorn Managing editor: Molly Goad Associate editor: Chris Peters Contributing editor: Howard Simons Howard Simons is president of Contributing writers: Barbara Rockefeller, Marc Chandler Rosewood Trading Inc. and a strategist for Editorial assistant and Bianco Research. He writes and speaks fre- webmaster: Kesha Green quently on a wide range of economic and Art director: Laura Coyle financial market issues. President: Phil Dorman Barbara Rockefeller ( is an international economist with a focus on foreign Publisher, Ad sales East Coast and Midwest: exchange. She has worked as a forecaster, trader, and con- Bob Dorman sultant at Citibank and other financial institutions, and currently publishes two daily reports on foreign exchange. Ad sales West Coast and Southwest only: Rockefeller is the author of Technical Analysis for Dummies Allison Chee (For Dummies, 2004), 24/7 Trading Around the Clock, Around the World (John Wiley & Sons, 2000), The Global Trader (John Classified ad sales: Mark Seger Wiley & Sons, 2001), and How to Invest Internationally, pub- Volume 6, Issue 6. Currency Trader is published monthly by TechInfo, Inc., lished in Japan in 1999. A book tentatively titled How to 161 N. Clark St., Suite 4915, Chicago, IL 60601. Copyright © 2009 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. Trade FX is in the works. Rockefeller is on the board of The information in Currency Trader magazine is intended for educational pur- poses only. It is not meant to recommend, promote or in any way imply the directors of a large European hedge fund. effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results. 6 June 2009 • CURRENCY TRADER
  7. 7. GLOBAL MARKETS All eyes on China The question now isn’t whether or not the world will catch cold if China sneezes — it’s whether or not the world will regain its appetite if China puts away its Kleenex and aspirin. BY CURRENCY TRADER STAFF R ecent economic reports out of China have sur- first coming out, but may not have the strength to lead the prised on the upside, leading some market world out.” watchers to cast their gaze eastward in the Stephen Webster, director of London-based TopEcon, search for the growth engine that will propel frames it differently. “I believe it is more accurate to say the global economy out of its current recession. that China [will] outperform most other economies in the The International Monetary Fund (IMF) is projecting a next two years and make a significant contribution to glob- 1.3-percent decline in global growth in 2009 — the first con- al recovery, alongside other key countries like India.” traction since World War II, and well below the 4- to 4.5- As evidence, Webster cites IMF forecasts for China to percent average global gross domestic product (GDP) post 6.5-percent GDP growth in 2009 and India to come in growth rate of the past 20 years. While the U.S. remains at 4.5 percent, vs. -2.8 percent in the U.S. and -4.2 percent in mired in negative growth numbers, with GDP plunging 5.7 the Eurozone. Webster notes the IMF expects China and percent in Q1 2009, China might have already hit its eco- India to grow at 7.5 and 5.6 percent rates, respectively, com- nomic low point and be climbing higher out of its econom- pared to a zero GDP reading for the U.S. and a -0.4 percent ic morass. GDP rate in the Eurozone. The question is, can it power the rest of the world to Although the Chinese growth engine will play a pivotal recovery? role, it is itself part of a larger system. “China’s rebound should also have an important positive impact on global confidence and on commodity prices,” The Chinese economy will play Webster adds. However, he warns this process will take time. “In part, it’s a vicious circle, with China’s revival a pivotal role in a global recovery, depending on demand from the U.S. and Europe.” but it is itself simply a part of Recent numbers: Low, but stabilizing When assessing China’s economic strength and the a larger system. progress of its recovery from the global economic crisis, “what you see from China is not always what you get,” says James Pressler, associate international economist at the Can the Dragon lead? Northern Trust Company in Chicago. Not alone, according to Sherman Chan, economist at For example, Pressler notes that China issued its first- Moody’s Despite its burgeoning clout, quarter 2009 GDP data ahead of the U.S. and that China China does not yet outweigh the U.S. and other economies does not revise its GDP figures. “The exact figures are sub- that are still floundering. ject to a degree of politicization, but what’s more important “Although China’s economy maintains a positive out- is the trajectory of slowing growth,” he says. look, the dragon is not powerful enough to end the global Released in mid-April, Q1 Chinese GDP came in at 6.1 recession,” he says. “Despite years of stellar GDP growth, percent year-over-year. That sounds stellar from an China still ranks behind the U.S. — the epicenter of the American perspective, but as Pressler points out, that num- global turmoil — in contribution to world output. The com- ber is “the lowest rate of growth they have posted this bined influence of the major economies in recession — the decade.” (Q2 2008 GDP was 10.1 percent, Q3 2008 was 9 U.S. along with Europe and Japan — is far too great for percent, and Q4 2008 was 6.8 percent.) China to offset. The most China can help in this global cri- But that, Pressler adds, might be good news in the longer sis is to cushion the downturn in some economies through run. imports.” “At this point, we feel that growth has reached its low Mingchun Sun, chief China economist at Nomura point. We feel the second quarter GDP figure will be better International, agrees. “China is still a relatively small por- than the first quarter,” he says. tion of the world economy,” Sun says. “China will be the In the wake of stronger-than-expected economic news, 8 June 2009 • CURRENCY TRADER
  8. 8. Moody’s recently upped its 2009 China GDP larger than most people expect,” Sun says. forecast from 7 to 7.5 percent. Some analysts say China’s Webster also credits China for easing credit conditions by huge fiscal stimulus package has helped propel a Chinese reducing interest rates and putting pressure on banks to be recovery. more liberal in their lending practices. Of industrial production, Chan notes that it “not only However, while the Chinese government may have avoided falling into negative territory, but its recovery earned a pat on the back in one sense, the argument can be came earlier than expected.” made that some of the steps they’ve taken might look better In inflation-adjusted terms, Chinese industrial produc- in the short term than the long term. For example, Pressler tion was 7.3 percent in April. The low point during the continued on p. 10 recent slowdown was a 5.4-percent reading in November 2008. “They are used to double-digit growth,” Pressler says. Nonetheless, the rebound in industrial production data “shows that we are seeing fiscal stimulus kicking in, or at least the fig- ures suggest it is working.” Exports rebounding Pressler says a pickup in the export sector is an important reason for opti- mism. Overall, he believes the worst of China’s export decline is over. After a July 2008 peak of $128.7 billion, monthly exports slowed to a low of $68.2 billion in February 2009. However, Pressler explains that low reading was somewhat impacted by the Lunar New Year that month, a time when “production slows down and there isn’t as much trading with regional participants.” From there, the numbers have increased. March 2009 exports were $95.5 billion, and the April number came in at 91.6 billion, which “puts China back at levels seen in the first and second quarter of 2007,” Pressler says. What did they do right? Many economists say the Chinese gov- ernment deserves kudos for an effec- tive stimulus package, which Pressler says totaled around $549 billion. “China is putting some of that money — all those reserves it is sitting on — into play,” says Pressler. Webster says the fiscal stimulus was aimed at “infrastructure, farming, and construction projects, with some addi- tional allocations to the social security, welfare, and health systems.” The measures were timely and forceful, according to Sun. “The posi- tive impact on consumption will prove CURRENCY TRADER • June 2009 9
  9. 9. FIGURE 1 — YUAN-DER WHEN IT WILL MOVE AGAIN? GLOBAL MARKETS The Chinese yuan’s (renminbi) steady appreciation vs. the U.S. dollar stopped abruptly in mid-2008; the pair has been in a tight trading range since. notes “they are shoring [exports] up through subsidies and loan- forgiveness programs — shoring them up during a time when slower growth should weed out the less-efficient companies.” What are the potential repercus- sions for this special treatment of the Chinese export sector? “They will continue to have an economi- cally inefficient export sector that will rely on an artificially weak Source: currency and government subsi- dies, rather than production FIGURE 2 — THE SINGAPORE SUBSTITUTION enhancements, innovations, and a rise up the value-added scale,” The Singapore dollar (SGD) has already rallied strongly off its February bottom and Pressler explains. is closing in on its late-2008 highs. If Asia, and China particularly, continue to rebound, the SGD could experience continued appreciation vs. the U.S. dollar, according to economist James Pressler. Yuan stalls out Meanwhile, the Chinese yuan’s steady appreciation over the past few years has stalled (Figure 1). “The yuan actually fell 0.16 per- cent against the U.S. dollar in the first quarter — the first quarterly drop since July 2005,” Webster says. By contrast, the yuan gained 2.5 percent vs. the dollar in 2005, 3.3 percent in 2006, 6.4 percent in 2007, and 6.5 percent (after being Source: up as much as 9.6 percent) in 2008. “They had taken their foot off the gas and offered a little benefit to exporters who were show- ing signs of weakness,” Pressler says. At year-end 2008, the yuan was trading at 6.82 vs. the For now, dollar and was virtually unchanged as of June 1, 2009. “Since they unofficially manage their currency, this is protectionist representative of them holding their currency to a level that will support their exporters vs. U.S. interests, which call for banter recedes a 6 or 5.9 [rate],” Pressler says. What lies ahead? The U.S. stands to lose the most “With recovery in China still in its very early stages, there is no incentive to engineer an appreciation,” Webster if protectionism sweeps the globe. argues. “On the other hand, any depreciation would risk a protectionist backlash.” BY CURRENCY TRADER STAFF For those looking for an “Asian recovery play” in the weeks or months ahead, Pressler advises looking at the T Singapore dollar (SGD, Figure 2), as the yuan is not a freely alk of protectionism usually brings to mind the traded currency. Smoot-Hawley Tariff of 1930, which many “If China is going to recover, it’s going to be through blame for putting the “Great” in the Great trade,” he says. “Look at Singapore — they are known for Depression. But in recent months, little wildfires having a great financial sector. If we witness a stronger of protectionist banter broke out in various places around growth situation and if trade volumes rise, we should see a the globe as shell-shocked nations initially faced the recovery in Singapore’s economy, which will have a sup- prospect of rebounding from the financial calamities of portive affect on the Singapore dollar.” 2008. For now, however, these fires have been doused out — 10 June 2009 • CURRENCY TRADER
  10. 10. thanks to some economic stabilization — but economists warn the issue of protectionism is not likely to disappear “Protectionism results in global trade entirely any time soon. “Protectionist measures are clearly one of the major risks wars nobody can afford to wage.” to global recovery,” says Stephen Webster, director of after he encouraged automaker Renault to shift production London-based TopEcon. “It is a big temptation for countries back into France. However, Sarkozy backed off. to resort to infringing either the rules or the spirit of free “There has also been a lot of protectionism banter in Asia trade to help encourage growth in their own economies.” between China and its neighboring countries,” Webster In one of the most notable protectionist salvos in the U.S., says. in February the $900 billion stimulus bill was initially laden continued on p. 12 with a “Buy American” clause that stipulated that only U.S.-made goods could be used in projects funded by the bill. According to Jay Bryson, glob- al economist at Wachovia, cooler heads ultimately prevailed and the final version was “watered down” to state that actions had to be consistent with current U.S. trade law. “In the West, the U.S. seems to be coming under the most fire for protec- tionist tendencies,” Webster says. “For example, Canadian Industry Minister Tony Clement has criticized U.S. Congress for its injurious ‘Buy American’ rules that bar Canadian firms from bidding on U.S. stimulus projects. Indeed, the Buy American provision in the U.S. stimulus bill has resulted in opposition not only across the globe but also from within America itself, with the big fear that it will lead to similar restrictions in other countries. “Similarly, U.S. President Barack Obama’s promise to modify tax laws that currently allow U.S. companies to pay less tax if they outsource to, or create a job in, India — rather than the U.S. — has been criticized by some Indian factions as a protectionist measure.” Ultimately, some argue, the issue boils down to jobs. “The flashpoint domestically is, where are all the jobs? We keep send- ing them abroad,” says Ken Goldstein, economist at the Conference Board in New York. “There is fancy talk about quotas, tariffs, protectionism, and immigration — but what it really comes down to is jobs.” This issue has not been confined to the U.S. in recent months. In March, for example, French President Nicolas Sarkozy found himself embroiled in the middle of a protectionist debate CURRENCY TRADER • June 2009 11
  11. 11. GLOBAL MARKETS The protectionism domino effect Free trade Once protectionism starts, it’s very difficult to stop — a Webster puts forth the economic case for free trade. “Fair problem everyone seems to understand economically, but competition resulting from free trade helps increase effi- not necessarily politically. ciency and depress world prices by allowing countries to “We are fully cognizant if we go down that path and try specialize in producing or supplying what they are good at, to put up a wall around us, everyone will put up a wall and letting other countries specialize in the areas they are against us,” Goldstein says. “It is less than a zero-sum best at,” he says. “Protection arguably leads to the opposite. game.” “If emerging markets are allowed to do what they do best Economists generally agree the Smoot-Hawley tariff is a by utilizing comparative advantage, it also helps to allevi- clear example of the perils of protectionism. ate global poverty and reduces the need for global aid from “It was damaging not only to the U.S. economy but also the richer countries,” he continues. “The fight against pro- to others economies,” Webster says. “It raised U.S. tariffs on tectionism should promote the idea that everyone can some 20,000 imported goods to record levels and many become better off and people should not be fearful of unem- countries retaliated with by raising their own tariffs on U.S. ployment and change. Trying to protect employment by goods. U.S. exports and imports were reduced by more raising tariffs or some other protectionist measure has a dis- than 50 percent. Some observers blamed the tariff for caus- torting influence, and the U.S. — perhaps more than any ing the Great Depression. That remains a controversy to other country in the world — has its industrial roots in ini- this day, but it undoubtedly soured trading relations with tiative and entrepreneurship. In any case, protecting other countries and caused the shrinkage of world trade.” domestic industries against foreign competition is ultimate- Bryson agrees. Smoot-Hawley is the “poster child for ly counterproductive, since more often than not it leads to why you don’t want to be doing this. It starts a global trade retaliation, higher costs, and lower levels of world trade.” war that nobody can afford to wage.” For now, though, rebounding equity markets and stabi- Bryson notes that any potential negative repercussions lizing economic statistics have put out the protectionist from protectionist moves are merely theoretical at this flames that were burning so hot earlier in the year. If this point. But if governments become excessively nervous turns out to be more of a respite than a reversal, however, again and enact protectionist measures later this year or the embers may regain strength. next, Bryson speculates that “some sort of trade war would “So far, we have not seen a lot of signs of protectionism, affect stock markets. Global growth would probably be but if the global recession drags on, it could very well rear slower and that would first affect companies that do a lot of its ugly head again,” Bryson says. “I don’t think this issue international business. My guess is it would be negative for has gone away yet, but for now we have avoided the worst the dollar.” of it. We’ll see.” Three good tools for targeting customers . . . — CONTACT — Bob Dorman Allison Chee Mark Seger Ad sales East Coast and Midwest Ad sales West Coast and Southwest Account Executive (312) 775-5421 (415) 272-0999 (312) 377-9435 12 June 2009 • CURRENCY TRADER
  12. 12. � �� ������������ ���������������������������������������� ������������������������������������� ��������� �������� �� ��������������������������������� ������������������������������������ ����������������������������������� ����������������������� �������������������������������������� ������������������������������������� � � � � � � ����������� � � ������������������������������� �������������������������� ������������������������� �������������������� ������������������������ ���������������������������������������� ������������� �������������� ���������������� ����������������������������������������� ������������� ����������������������������������������� ���������������� ���������������������������������������� ������������������� ����������� ���������������������������������������� ������������������������������������������ ��������������������������� �������� ������������������������������������������������� ������������������ �����������������������������������������������
  13. 13. ON THE MONEY Risk aversion Risk appetite and aversion explain a great deal, but not everything in the forex market. FIGURE 1 — DOLLAR AND VIX The dollar and the VIX moved together until January 2009, at which point the VIX continued to decline while the DXY pushed higher into March. BY BARBARA ROCKEFELLER T he forex market is driv- en by risk aversion, but to measure risk aver- sion, it’s necessary to look at factors outside the FX mar- ket, such as stock indices and the equity market volatility index (VIX). However, as warned in “Rational fear and the forex market” (Currency Trader, March 2009), you must be wary of flaky and unreliable inter- market correlations. You should never trade a currency pair based on something going in another market. Source: data — eSignal and Reuters Online; chart — eSignal For example, you shouldn’t buy the Euro/dollar pair because oil is going FIGURE 2 — DOLLAR AND DOW up or sell gold because the dollar is The dollar index and the Dow Jones Industrial Average (DJIA) appear to be better going down. This is called “sticking correlated than the dollar index and the VIX. to your knitting” — trading the mar- ket in front of you, not some dimly related security. Having warned against putting too much faith in watching other markets, conditions are nonetheless extraordinary today. Just about everyone in every market is making decisions based on risk aversion or risk appetite, and talking about them in those terms. Risk and the dollar First, let’s define “risk aversion.” The risk in question is the risk of loss of capital due to expropriation, bankruptcy, or inflation. A 100-per- cent loss results from expropriation — the sovereign simply takes away your entire capital stake. Bankruptcy Source: data — eSignal and Reuters Online; chart — MetaStock is less damaging; usually the creditor gets something, even if it’s only a 14 June 2009 • CURRENCY TRADER
  14. 14. FIGURE 3 — S&P AND EURO As the S&P has rallied, so has the Euro — meaning, the U.S. dollar has declined. few cents on the dollar. Inflation is an insidious form of expropria- tion. By creating or allowing infla- tion, the government devalues the purchasing power of the money, sometimes to an extreme degree. At the height of the global financial-sector crisis, the dollar was a safe haven from the poten- tial bankruptcy of banks in other parts of the world. Investors believed it was safe to place cash in U.S. bank deposits because U.S. banks were too big to fail and/or FDIC insurance would be effec- tive. Because the U.S. operates under the rule of law and had undergone a banking crisis in liv- Source: data — eSignal and Reuters Online; chart — MetaStock ing memory (the savings and loan crisis of the 1980s), during which equities; now it’s the dollar on the Dow? Well, yes, but only in part. no depositor lost money, using U.S. basis of inflation fear. It was a remark- Foreigners account for only a small dollar bank deposits as a safe haven ably speedy transfer of risk aversion fraction of total U.S. stock-market was a logical course of action. from one target to another. investment; domestic players such as As risk aversion had investors in its Figure 1 shows the dramatic rise in pension funds and mutual funds are grip, two other things happened: the the CBOE Volatility Index (VIX) in responsible for a much bigger percent- stock markets of developed countries autumn 2008, with a rise by the dollar continued on p. 16 fell dramatically — as much as 30 to 45 index (DXY) at the same time. The two percent — and central banks slashed indicators moved in sync until January the return on money. The truly risk 2009, at which point the VIX continued averse were pretty much stuck with to trail off while the dollar index bank deposits as the only sane place to pushed higher into March and subse- park their capital. quently trailed off by less. The VIX has As part of the financial rescue plan, fallen in a rough line downward while however, the Fed printed vast the dollar index has formed an upside- amounts of new money. So far the down V. increase in money supply is trapped in The dollar index and the Dow Jones the banking system as “capital” and Industrial Average (DJIA) appear to has not leaked out to the general econ- offer a better correlation (Figure 2). It omy. But those who fear inflation are seems, though, that when the dollar concerned that when the banks do index rose more than the Dow in their job of recycling this money sup- March and May, the Dow’s failure to ply through lending, inflation will follow dragged the dollar index back inevitably follow. As economist Milton down. Friedman said, “Inflation is always But does this make sense? On an and everywhere a monetary phenome- outright capital-flow basis, foreigners non.” Fed Chairman Ben Bernanke have gone from net divestiture of U.S. might be a smart guy and have only equities last year to net buyers. The the best intentions, but doubt runs Treasury International Capital System high he can put the genie back in the report in May showed foreigners were bottle. net buyers of $15.1 billion of U.S. equi- As a result, the target of risk aver- ties in March, up from a mere $1 bil- sion has changed. As the financial cri- lion in January (they bought $33.5 bil- sis came to a boil in September- lion in March 2008). Does this account November 2008, the initial target was for the rise in both the dollar and the CURRENCY TRADER • June 2009 15
  15. 15. ON THE MONEY FIGURE 4 — EMERGING MARKETS haven) is reduced. Given this world- The Brazilian and Indian stock markets reversed earlier than the U.S. market, and view, a rising stock market is, per- they have gained more off their bottoms than U.S. and European indices. versely, bad for the dollar. Figure 3, which shows the S&P 500 index and the Euro/dollar pair (EUR/USD), bears out this thesis: As the S&P rises, the Euro rises, too. How can both things be true — that U.S. stocks go up on foreign purchases but also go down on a reduction of risk aversion? The answer is that the “foreigners buy- ing” story is weak and the risk-aver- sion thesis is more powerful. Emerging markets and commodities The biggest outcome from the rise in risk aversion is the emerging bubble in emerging-market currencies and stock indices. Figure 4, which shows Source: data — eSignal and Reuters Online; chart — eSignal the Brazilian Bovespa stock index (BVSP) and the Indian Sensex stock FIGURE 5 — COMMODITIES index (BSESN), shows these markets actually reversed earlier than the China has continued to stockpile commodities, including copper and gold, U.S. market. Both indices were contributing to robust prices unjustified by developed countries’ fundamentals. already rising in January, and after a setback in March, they have gained more off their bottoms than U.S. and European indices as of June 1. The rise in emerging-market stocks reflects a thread in the current thinking that emerging markets may manage a v-shaped recovery (down, then right back up) rather than the L-shaped recovery (down, then side- ways for a long time) the West and Japan will almost certainly get. For one thing, China implemented its stimulus package immediately, whereas the U.S. has hardly started. Also, trade between China and Brazil has gone up, not down — unlike the trade pattern elsewhere, with exports from Germany, for example, down 9.7 percent in the Source: data — eSignal and Reuters Online; chart — MetaStock first quarter this year. China has also continued to buy and stockpile com- age. Also, official data is released very late, so unless a mar- modities, including oil, copper, and gold, contributing to ket participant hears a story from a broker that foreigners robust prices that are hardly justified by developed coun- are buying again, foreign participation would tend to have tries’ fundamentals (Figure 5). only a small effect on the Dow. The conventional wisdom is that the minute the price of In fact, in terms of the risk-aversion paradigm, the new oil goes up, the dollar goes down. This inverse relationship conventional wisdom argues the opposite: a rise in U.S. is another example of market perversity, since you’d think equities means a drop in risk aversion, which in turn means demand for dollars would go up as the price of a commod- the need for dollars parked in checking accounts (as a safe- ity denominated in dollars goes up. A rise in the price of oil 16 June 2009 • CURRENCY TRADER
  16. 16. FIGURE 6 — GOLD AND EURO The differing paths of gold and the Euro currency futures suggest there are fundamentals and market sentiment factors at work, not just risk aversion. is also commonly interpreted as a sign of fresh U.S. demand for ener- gy, which means growth prospects are looking up for the U.S. Shouldn’t this be dollar-favor- able, too? Not in the new upside- down world of risk aversion. Traders are so convinced of the inverse relationships that a knee- jerk sell-off in dollars occurs when the price of oil rises; sometimes you can see the relationship hour by hour on the charts. It’s illogical, but it is the way the market choos- es to think today. Finally, we come to gold, which has been rising, if sporadically, as the financial crisis has evolved. Figure 6 shows gold (GC) and Euro currency (EC) futures. Gold has an Source: data — eSignal and Reuters Online; chart — MetaStock unaccountably steeper slope off the October low. If both securities Poor’s ratings agency downgraded the ness, flexibility, and aggression of the reflect pure risk aversion from the dol- UK’s sovereign rating from “stable” to U.S.” lar, you’d think the slope would be the “negative” in late May 2009 on the While the rating agencies probably same or nearly the same. Besides, they basis that total public debt outstanding lack the moxie to name the U.S. as hav- peak and withdraw at different times. was nearly 100 percent of GDP. The FX continued on p. 18 Clearly there are fundamentals and market immediately turned to the market sentiment factors at work, question of whether the U.S. would be other than general risk aversion. next to be downgraded, since U.S. debt is already about $11 trillion dollars in Economic fundamentals an economy of about $13.5 trillion, and The one thing missing from all the rising by the minute. That doesn’t risk-aversion talk is the fundamentals include unfunded future liabilities of of the economies. In December and about $44 trillion for Social Security again in March, the FX market favored and Medicare. However, this potential the first-in, first-out (FIFO) story that downgrade story had a short shelf life suggested the U.S. would recover from when the Chinese quickly remarked recession faster and more widely than publicly about their preference for the any other country: Growth counts. dollar as the reserve currency, for spe- Over long time periods, currencies are cific reasons. They say the dollar is still highly correlated with inflation-adjust- the best option to meet the criteria of ed real growth. The so-called green “safety, liquidity, and profitability,” in shoots of recovery some analysts claim that order. to see poking their heads out of the An official from the State dirt are more likely to grow roots in the Administration of Foreign Exchange liberal soil of the U.S. than in the strict- said “According to exchange-rate ly regulated economies of Europe and trends, the Euro, sterling, and yen are Japan. Besides, the U.S. is a vast coun- all high-risk currencies, where the dol- try. It has, literally, room for shoots to lar has been relatively safe.” Officials appear in many places, and while say China’s dollar holdings, almost $2 some of them will no doubt be weeds, trillion, are simply too big to hedge the universal expectation is that the “without spooking the currency mar- U.S. will lead the global recovery. kets.” Moreover, the Chinese like dol- But growth is taking a back seat lar liquidity — its historic role since today on the emergence of yet another 1945. China perceives that Eurozone high-risk situation. The Standard & policy-making lacks “the responsive- CURRENCY TRADER • June 2009 17
  17. 17. ON THE MONEY FIGURE 7 — EURO PROJECTION ing a “negative” outlook on the debt The standard error channel implies the Euro will be somewhere between 1.6533 to 1.2761 at year-end. situation, the Chinese can always change their minds — or get agree- ment at some point that the IMF’s spe- cial drawing right (SDR) should be the new reserve currency (see “Treasury backs down from China currency manipulation stance,” Currency Trader, May 2009). The over-indebtedness of the U.S. is an old risk being newly named as a special risk to the dollar. This violates — in spades — the over- all risk-aversion thesis that a rise in risk aversion means a flight to the dol- lar. Possible scenarios How will the current chapter end? One likely scenario has it that a crisis will develop in an emerging market, simi- lar to 1997-1998, and soaring stock markets will again tumble like domi- Source: data — eSignal and Reuters Online; chart — MetaStock nos. It seems clear that some stock markets are in bubble mode, so it might not take much of a beginning of the Euro) indicates that at year-end 2009, we crisis to get a major pullback from emerging markets, to the can expect a range of 1.6533 to 1.2761, with the linear regres- benefit of the dollar. sion line itself landing at 1.4647. The red lines start with a Another idea floating around is that the U.S. should issue support line connecting Euro lows and spaced out to show bonds in Euros or yen, which doesn’t reduce the total resistance and a midline. indebtedness but might make it more attractive to some for- As a practical matter, now that the market is picking on eign investors. Nobody is expecting realistic plans for actu- the dollar, these are probably realistic ranges, and a stronger ally reducing U.S. indebtedness any time soon. dollar is just wishful thinking. In Figure 7, the standard error channel (drawn to one error on either side of the linear regression from the very For information on the author see p. 6. Related reading: Other Barbara Rockefeller articles “Forecasting follies,” Currency Trader, May 2009. false assumptions about how the U.S. and Europe are handling The only technicals that provide tradable forecasts are the economic crisis. patterns — but you have to be on the correct time frame and you can’t forget about the fundamentals. “The six Ds of depression,” Currency Trader, December 2008. The buck has gotten a bounce from the recent financial panic, “Listening to the chart,” Currency Trader, April 2009. but the longer-term picture isn’t quite as bullish. While everyone debates the ramifications of various policy measures, what is the Euro/dollar chart saying? “Euro and dollar at parity?” Currency Trader, November 2008. A few short months ago the world was contemplating Euro $2. “Rational fear and the forex market” Now, the talk is all about Euro $1. What are the odds it will Currency Trader, March 2009. happen? Analysis of several intermarket relationships suggests the role of risk aversion in the forex market is no cut-and-dried issue. “Crisis of confidence,” Currency Trader, October 2008. As Wall Street and Washington prove themselves equally inept, “Competitive devaluations, the EMU, and the yen” the dollar suffers. Currency Trader, February 2009. Currency devaluation never works in the long run — just ask “The dollar-oil connection,” Currency Trader, September 2008. Japan — but that doesn’t mean panicky governments won’t use it As oil broke, so did the Euro/dollar pair. What can we learn from to try to stem the flow of blood in the near term. analyzing bursting bubbles? “The Euro: Prosperity or perdition?” You can purchase and download past articles at Currency Trader, January 2009. The belief the Euro sell-off has ended may be based on some 18 June 2009 • CURRENCY TRADER
  18. 18. VT Trader Suite TM MASTER YOUR WORKSPACE
  19. 19. TRADING STRATEGIES Midpoint filter for intraday FX A basic filter technique shows some potential, but it doesn’t solve all the problems. BY CURRENCY TRADER STAFF O ne of the perennial challenges of trading is finding rules that will define the conditions in which a trade setup will perform best. A common example is the trend filter, which defines an uptrending or downtrending market and allows only signals in the direction of the trend to be executed. Typically, the trend would be defined by price being day pattern setup (using 30-minute bars) is filtered using the midpoint of the previous day’s range: Long entries are taken only when price is above the midpoint, while shorts are executed only when price is below it. The idea is that the immediately preceding price action provides the best con- text for taking short-term trades — i.e., if price is struggling to trade in the upper half of the previous day’s range, per- above or below a moving average, or above or below the haps it’s best to trade from the short side, and vice versa. price n bars ago. What inevitably happens, though — espe- The analysis was conducted on the U.S. dollar/Japanese cially in the case of moving averages — is the trend filter yen pair (USD/JPY) from Jan. 21 to May 27, which spans a can’t keep up with price action and many good trade sig- little more than four months — nearly 4,500 half-hour price nals are ignored. bars. Figure 1 shows the market initially rallied into early This strategy uses a slightly different approach. An intra- March, pulled back, rallied to a higher high in early April, and then declined into May before bouncing at the end of the month. FIGURE 1 — ANALYSIS PERIOD The analysis period spanned Jan. 21 to May 27 and included uptrending and The pattern downtrending price action. The pattern used to trigger entries iso- lates bars that establish seven-bar lows or highs, which are also a certain amount lower or higher than the immediately preceding low or high. This setup was selected for its simplic- ity, based on observation of several intraday turning points in March and April. No effort was made to optimize the pattern in any way. The pattern itself is relatively unimportant; the object is to see whether its performance improves or degrades with the addi- tion of the filter. The rules for a buy setup are: 1. The low of the current 30-minute bar must be lower than the lows of the previous seven 30-minute bars. Source: TradeStation continued on p. 22 20 June 2009 • CURRENCY TRADER
  20. 20. TRADING STRATEGIES FIGURE 2 — PATTERN SIGNALS 2. The current low must be at least Entry signals were abundant — perhaps too abundant — during the review win- 0.12 lower than the previous dow, with more than 700 total signals occurring over the course of four months. low. Formulas for these rules are: 1. Low0 < Lowest(Low1…7); 2. Low1-Low0 >= .12 Where the subscripts 0, 1, etc., refer to the current bar, 1 bar ago, etc. The rules are reversed for short entries: 1. The high of the current 30-minute bar must be higher than the highs of the previous seven 30-minute bars. 2. The current high must be at least 0.12 higher than the previous high. Source: TradeStation Formulas for these rules are: FIGURE 3 — RAW SIGNAL Long signals outperformed the market's slight upside bias during the analysis 1. High0 < Highest(High1…7); period, while short signals were erratic but followed more often by selling than 2. High1-High0 >= .12 buying. Figure 2 shows several of these setup bars, both long and short. Figure 3 shows the median close- to-close gains or losses for 16 bars after long and short setups, along with the median one- to 16-bar moves for all 30-minute bars in the analysis period. Overall, the dollar-yen pair had a very mild upward bias during this period (black line). Price action after buy signals (blue line) was notably more bullish, while price action after short signals (red line) was erratic, but more bearish than the typical price action. The raw signals results are about what we hoped for (in that they 22 June 2009 • CURRENCY TRADER
  21. 21. FIGURE 4 — ALL SIGNALS weren’t flat-out wrong), so we pro- The filtered long signals outperformed their raw counterparts, while the filtered short signal performance was mixed. The most notable result of the filter was a ceeded to see if taking trades based on 68-percent reduction in trade signals. the previous day’s midpoint might help performance. Some filtering is certainly necessary, based on the num- ber of trades that were triggered: There were 703 signals (339 long and 364 short) in the review period, and given the typical gains are not particu- larly large, commissions would nega- tively impact profits disproportionally. Filtering with the midpoint A midpoint filter rule was applied as follows: 1. Take long trades only if the closing price of the current 30-minute bar is above the midpoint of the previous day’s range. not dramatic. The improvement was 2. Take short trades only if the most apparent in the final three bars. closing price of the current (The relatively high winning percent- 30-minute bar is below the age for both sets of signals from bar 10 midpoint of the previous day’s to bar 16 — above 60 percent — might range. be surprising, but it is likely a function of the market’s upward bias during Figure 4 shows how the filtered sig- this time.) nals compared with the raw signals. Figure 6, however, shows the filter The differences are not dramatic, but had no real improvement on the win- they are evident. For both long and ning percentage of short trades. The short signals, improvement is most filter increased the winning percent- noticeable in the first five bars after age at half the bar intervals, decreasing entry, after which results diverge. The the other half — although the filtered bullish pattern slightly outper- improvement from bars 13-16 was formed the raw signal for almost the noteworthy. entire 16-bar follow-up period, while The most dramatic difference in the filtered short pattern was more applying the filter was in the number erratic, but still turned lower in the of trade signals, which decreased 68 final four bars. percent to 221 (109 long and 112 short). Figure 5 compares the winning per- centages of raw and filtered long sig- Sizing things up nals. The filtered signals had higher Although the midpoint filter winning percentages at 13 of the 16 improved the trade setup’s overall intervals, but the improvement was continued on p. 24 CURRENCY TRADER • June 2009 23
  22. 22. TRADING STRATEGIES profitability, increased the winning FIGURE 5 — LONG ENTRY WINNING PERCENTAGE percentage of long trades, and reduced The filter improved the winning percentage of long trades, but not dramatically. the number of trades dramatically, the benefits were very modest. However, given the large number of trade exam- ples, there is an indication the basic trading approach has some promise. There are a few additional ideas to test, and ways results might be enhanced: 1. Find a better-performing setup pattern. The fact the rules were simply inverted for the long and short sides of the market leaves room for immediate improvement. Also, the results were based on entering on the close of the signal bar and exiting on the close one to 16 bars later. These rules provided robust results but are likely to provide fertile FIGURE 6 — SHORT ENTRY WINNING PERCENTAGE ground for designing better- performing techniques, not to The filter had a less-positive effect on the short-trade winning percentage, with mention the use of a stop-loss. the exception of the final bars. 2. Both the time frame and filter reference point (the previous day’s midpoint) were representative. In addition to researching other time frames (e.g., trading daily signals using a weekly or monthly filter), other ideas include adjusting the filter level higher or lower based on whether the previous day closed up or down, or to average or weight the midpoints of the past n days. The challenge is to balance the bene- fits of filtering a signal with the unavoidable compromises. 24 June 2009 • CURRENCY TRADER
  23. 23. ADVANCED STRATEGIES Currency volatility and long-term treasury returns Despite the recent currency-volatility/interest-rate disruption, the relationship should return — which means higher long-term interest rates and lower risk multiples for stocks. BY HOWARD L. SIMONS FIGURE 1 — LONG-TERM RATES SELDOM EQUAL SHORT-TERM RATES PLUS INFLATION EXPECTATIONS Despite theory and conventional wisdom — that the long-term rate should equal the short-term rate plus expected inflation — the 10-year Treasury note’s yield (green line) does not add up to the sum of three-month Treasury bills (red) and the 10-year TIPS H (blue) breakeven rate of inflation. ow can we describe this sorry decade for financial mar- kets? A good start might be, “Everything you know is wrong.” After all, lower interest rates are supposed to be good for equities, and yet that was dis- proven in both directions. How about higher commodity prices and a weaker dollar being nega- tive for bonds? That didn’t work either. And the benefits of global diversification? Um, no, that just seemed to mean you lost money in a large number of places simulta- neously. Let’s get a little more specific and turn to one of those yield- curve theories taught in business FIGURE 2 — JAPANESE YEN VOLATILITY AND U.S. TREASURY YIELD CURVE: THREE MONTHS - TEN YEARS schools and economics programs everywhere: the “liquidity premi- Increased yen volatility was associated with four yield curve steepenings — three bearish (green lines) and one bullish (turquoise line). um.” Like other theories with wide acceptance, this one makes sense upon initial examination. It states long-term lenders demand a higher interest rate in compensa- tion for expected inflation. This should mean the long-term rate should equal the short-term rate plus expected inflation, with adjustments for what are called “preferred habitats” and “market segmentation.” What do the data say? Prior to the introduction of Treasury Inflation-Protected Securities continued on p. 28 26 June 2009 • CURRENCY TRADER
  24. 24. ADVANCED STRATEGIES FIGURE 3 — JAPANESE YEN VOLATILITY AND U.S. TREASURY YIELD CURVE Japanese yen HLC volatility rises during a bullish steepening. (TIPS) in January 1997, there was no concrete, market-derived measure of inflation expectations. The TIPS breakeven inflation rate, which is the difference between nominal Treasury yields and TIPS yields at a given maturity, is an imperfect measure (see “TIPS, treasuries and insurance,” Active Trader, May 2008). Even with that caveat in mind, no one can look at Figure 1 and match the 10-year Treasury note’s yield to the sum of three-month Treasury bills and the 10-year TIPS breakeven rate of inflation. Something other than inflation expectations must be affect- ing the liquidity premium. Currency volatility The U.S. is highly dependent on for- eign investors to fund its massive trade and budget deficits. While nei- ther of these deficits affects the dollar
  25. 25. FIGURE 4 — SWISS FRANC VOLATILITY AND U.S. TREASURY YIELD CURVE: THREE MONTHS - TEN YEARS as we might think (see “What The Swiss National Bank has been far less interventionist than the Bank of Japan, pro- drives the dollar index?” Currency viding a cleaner picture of its effects on the FRR between three months and 10 years. Trader, January 2006), the opposite is not true. A foreign investor in the U.S. is long the dollar and will need to sell those dollars at some point in the future. Two risk factors arise for the foreign investor in the U.S. The first and most straightforward is the risk of dollar depreciation over time. That risk, which has been realized many times over the entire floating exchange-rate era, can be hedged using known techniques and instruments. The second risk is less straight- forward but just as real: high cur- rency volatility. Even within a long-term static trend, such for bond investors that risk must be accounted for in lower as the one between the dollar and the Japanese yen between prices and higher yields. late 1999 and mid-2008, higher volatility raises the disper- If this is indeed the case, we should be able to see some sion of outcomes for the ultimate repatriation of funds — measure of a long-term relationship between the liquidity that is, higher currency volatility is a risk for investors, and continued on p. 30
  26. 26. ADVANCED STRATEGIES premium and currency volatility. Let’s examine the long- HLC volatility will be mapped against the yield curve term high-low-close volatility (HLC) for the Japanese yen over three different segments: three months against 10 and the Swiss franc, going back to 1977. Japan has been an years, one year against 10 years, and two years against 10 important creditor to the U.S. for the past three decades. years. The Federal Reserve’s constant-maturity measures The Swiss franc was chosen because it has a continuous his- from the H15 report are used for the interest-rate data at the tory uninterrupted by the advent of the Euro. HLC volatil- note horizons. ity is defined as: The the yield curve’s shape will be normalized by the for- ward rate ratio (FRR) between the maturity pairs. The FRR is the forward rate between two bonds divided by the yield of the longer-dated instrument. For example, the FRR between two and 10 years is the rate at which we can lock in borrowing for eight years starting two years from now, divided by the 10-year rate itself. The more a FRR exceeds where N is the number of days between 4 and 29 that 1.00, the steeper the yield curve is; a FRR less than 1.00 minimizes the function: denotes an inverted yield curve. The yen and the yield curve Much of the trade in the yen during recent years has been driven by the yen carry trade, the borrowing of low-interest yen to lend elsewhere (see “A closer look at the carry trade,” Currency Trader, June FIGURE 5 — SWISS FRANC VOLATILITY AND U.S. TREASURY YIELD CURVE 2007). Whenever the Bank of Japan threatens to tighten credit The FRRs starting at one and two years track Swiss franc HLC volatility similarly to yen or whenever the world’s HLC volatility. The relationship during the bullish 2007-2008 steepening is especially strong. investors flee risk, as happened in late 2008 and early 2009, the yen strengthens and its volatility jumps. A policy response by the Federal Reserve often is associat- ed with this trade; it certainly was after the onset of the credit crunch in August 2007. This is not, however, a rule. Yen volatili- ty spikes during the late 1980s, in 1995, and during the 1998 Long Term Capital Management crisis, occurred within the context of a flattening yield curve. Both the Federal Reserve and the Bank of Japan were trying either to stem the dollar’s slide, the yen’s rise, or both, during these episodes. Let’s map the yen’s HLC volatility against the three FRRs mentioned above. First, let’s look at the FRR between three-month Treasury bills and 10-year Treasury notes (Figure 2). Three periods of a bearish steepening continued on p. 32 30 June 2009 • CURRENCY TRADER
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  28. 28. of the yield curve — that is, a steeper yield curve driven by 2008, respectively). Because the franc is a funding currency rising long-term rates — are marked with green lines. A for carry trades, its HLC volatility rose after the onset of the fourth, marked with a turquoise line, is the 2007-2008 bull- 2007 credit crunch as these positions were unwound. ish steepening. All are associated with increases in yen HLC As the Swiss National Bank has been far less interven- volatility. tionist over the years than the Bank of Japan, we should get We should not expect the effect to be as pronounced dur- a cleaner picture of its effects on the FRR between three ing bearish steepenings for the other two FRRs, those months and 10 years, and we do (Figure 4). The same com- between one- and two-year notes on the short end and 10- ments made for yen HLC volatility apply and the chart is year notes on the long end (Figure 3): If 10-year note yields marked identically to Figure 2. are rising during periods of rising inflation, rising econom- In Figure 5, the FRRs starting at one and two years track ic growth or both, the incentives to maintain yen carry franc HLC volatility similarly to yen HLC volatility in trades are high. However, we should expect yen HLC Figure 3, and for the same reason. The relationship during volatility to rise during a bullish steepening, one defined by the bullish steepening of 2007-2008 is especially strong. a change in American monetary policy and one where the dollar’s interest-rate advantage to the yen may be decreas- Implications for long-term Treasury returns ing. That is the case for both of these FRRs. If rising currency volatility steepens the yield curve and if the best time to buy bonds is when the yield curve is flat to The Swiss franc inverted, it should stand to reason a combination of high and the yield curve currency volatility and a steep yield curve should lead to The Swiss franc’s HLC volatility history has differed con- poor returns on 10-year Treasury notes. siderably from the yen’s. It reached its highs during the We can gauge this effect visually by mapping three- strong inflation of the late 1970s and early 1980s as the month-ahead returns on 10-year T-notes against the three world sought refuge in the franc, so much so the Swiss FRRs and each currency’s HLC volatility. In Figure 6, posi- imposed an interest-rate penalty on foreign deposits (see tive returns are marked with blue bubbles and negative “Franc-ly my dear, I don’t give a carry,” and “The Swiss with white; the size of each bubble corresponds to the mag- franc’s commodity connection,” September and October continued on p. 34 FIGURE 6 — THREE-MONTH AHEAD PERCENTAGE RETURNS ON TEN-YEAR TREASURIES: AS FUNCTION OF JAPANESE YEN AND SWISS FRANC VOLATILITY AND FORWARD RATE RATIO Positive returns are marked with blue bubbles, negative returns with white; the size of each bubble represents the magnitude of the return. 32 June 2009 • CURRENCY TRADER