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Bouncing Right Along
Bonjour from Montreal! It has been another thrilling week in the currency markets, and as the fear of a major market meltdown has subsided (at least temporarily), we are seeing the Forex market return to the patterns that existed prior to the beginning of the credit crunch. In last week's article, I mentioned three currency pairs that seemed to have found support. How have they fared since then? Let's have a look.
The Euro – Japanese Yen currency pair (EUR/JPY) rocketed away from its support level to capture a dramatic gain of over 500 pips in only 5 days. Compare this chart to a similar weekly chart from last week's article, titled "Shelter From the Storm", and you can see the dramatic shift in sentiment (see figure 1).
Figure 1: EUR/JPY bounces sharply to gain over 500 pips last week. Source: Saxo Bank
Even more astounding was the gain in the volatile Great Britain Pound – Japanese Yen (GBP/JPY) pair, which exploded into the stratosphere for an 800 pip gain last week. Please refer to last week's column for the "before" shot, and then have a look at the "after" chart below (see figure 2).
Figure 2: GBP/JPY rallied for over 800 pips last week. Source: Saxo Bank
This week's Great Britain Pound rally had all the earmarks of short covering, as evidenced by the ferocious move higher in GBP/JPY on August 23rd. Here on the hourly chart we can see the pair spike an incredible 300 pips in one hour! Prior to the recent turbulence, this currency pair traded in a range of about 150 pips on an average day. The intensity of this move indicates to me that GBP shorts have lost their nerve and are running for the hills. After a mild pullback, the GBP/JPY pair is trading back at its recent hourly highs, and even appears to have formed something similar to a cup formation (see figure 3).
Figure 3: Great Britain Pound shorts retreat as GBP/JPY spikes. Source: Saxo Bank
This brings us to the third member of last week's trio of charts, the Australian Dollar - U.S. Dollar currency pair (AUD/USD). Seen here on the monthly chart, the Aussie rallied away from major support for an impressive gain of nearly 300 pips (see figure 4).
Figure 4: AUD/USD rallies nicely away from support. Source: Saxo Bank
Understanding last week's bounce in these and other currency pairs is key to trading currencies during what could be described as abnormal market conditions.
The Fear Factor
What is really going on here? These currency pairs, along with stocks and some commodities, are simply trading on fear. In this environment, economic fundamentals and technical indicators have taken a back seat to emotion. In other words, when traders are afraid that the whole system is about to cave in, they really don't care whether Retail Sales figures are stronger than expected, or if a currency pair is oversold according to an oscillating indicator. One way to trade under these conditions (which are clearly not for everybody) is to follow the ebb and flow of fear and greed. In my opinion, the best way to do this is to simply follow the equity markets around the world. If we see a big sell off in stocks, the weaklings of the major currency world, the Japanese Yen and the U.S. Dollar, should rally. So, if those rumblings that a major hedge fund, broker or bank is having liquidity issues should resurface, world stock markets will sell off and the greenback and Yen should benefit. If on the other hand we continue to see fear wane, the buck and the Yen should suffer at the hands of the fundamentally stronger Euro, Great Britain Pound, Canadian Dollar and Australian Dollar currencies.
Why is this happening? Imagine that you run a hedge fund that can invest in anything, including stocks, commodities, currencies, bonds, derivatives, and more. Maybe you are doing just fine but you hear a rumor that some of your competitors may be facing a margin call, perhaps because an investment in subprime "toxic waste" has blown a gaping hole in their funds. What does this mean to you? If the rumors are true, your competitors will have to close positions, both profitable and unprofitable, in order to raise money to meet margin calls. These positions may be in stocks, currencies, or any other form of investment. If you believed that some of your competitors might be forced to sell a large quantity of stock, possibly depressing the market, wouldn't you want to start selling before they do? And so everyone races for the exit at the same time, causing stocks to tumble.
Now let's take this a step further; what if your competitors have profitable positions in carry trades, which focus on shorting low yielding currencies like the Japanese Yen? A rumor begins to circulate that some of your competitors are in trouble. Wouldn't you be concerned that they might have to close out these winning trades? This means that your competing funds will be forced to buy the Japanese Yen to cover their positions, so in anticipation of this, you begin to close your winning carry trades (which means you'll have to buy the Japanese Yen) and once again, everyone is rushing for the exit at the same time. This is one of the reasons why EUR/JPY, GBP/JPY, and other carry trade pairs plunged earlier this month.
No Happy Ending
Why did the U.S. Dollar gain strength during the credit crisis? The buck went from zero to hero vs. most major currencies because scared money was pouring into U.S. Treasuries. Treasuries are an excellent vehicle for safeguarding capital during times of upheaval. When markets are spooked, traders will "park" some of their money in this liquid investment that is guaranteed by the U.S. government.
But what is going to happen next? Since the Fed cut the discount rate last week, traders have calmed down and money that had been stashed in Treasuries is beginning to flow back into riskier investments like stocks. This flow of capital out of Treasuries is hurting the greenback, which once again has a familiar appearance of weakness. It is really hard to see how the U.S. Dollar can come out of this situation in a positive way. If the worst is over, the fall of the buck is likely to accelerate due to the aforementioned exodus out of Treasuries. If there is still more bad news to come, what will the U.S. economy look like six months from now? Housing and related businesses make up a huge portion of U.S. Gross Domestic Product (GDP). Will we see a series of Fed funds interest rate cuts? If so, those rate cuts will draw capital away from the U.S. Dollar and toward higher-yielding currencies, resulting in – you guessed it – a weaker dollar.
See You In Toronto
Our next book signing will occur at the Toronto branch of Online Trading Academy on Friday, September 7, so I hope to see you there! I'll be autographing copies of my new book, "Forex Patterns and Probabilities" (which you can also purchase through Amazon.com or Trader's Library) and giving away prizes. Thanks again to Georgie Cox and the gang at the London branch of Online Trading Academy for making last week's book signing such a phenomenal success, and of course thanks to all of you who turned out.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience.He is a regular contributor to TradingMarkets.com, SFO Magazine and FX Street, and has recently finished his new book "Forex Patterns and Probabilities" (which you can purchase through