Ear to the Ground
This is the week that could determine the future direction of currencies for the remainder of the year. On Wednesday, the Bank of Canada will announce its decision on interest rates (currently at 4.50%), and the Bank of England and the European Central Bank will follow with their announcements on Thursday (currently 5.75% and 4.00%, respectively). My personal opinion is that it does not make sense for central bankers to raise interest rates in the middle of a liquidity crisis, but I've seen stranger things. It wouldn't hurt for the European Central Bank and others to take a wait and see approach. After all, many of these same central bankers injected liquidity into the credit markets to prevent them from seizing up in August, and a rate hike would most likely result in a reduction of liquidity. What would be the harm in delaying a rate hike for a month or so until the dust settles?
Even if there is no change in rates by any of the central banks mentioned above, traders will pay extremely close attention to the official statements that accompany these decisions. If any of the central bank statements center on inflation and strong growth, the stance will be considered hawkish, meaning that higher interest rates may be on the way. On the other hand, any statement that is heavily weighted with comments referring to the current credit crunch and related problems will be seen as dovish, and will be interpreted to mean that borrowing costs will remain stable. Hawkish comments tend to strengthen the underlying currency, while dovish comments tend to weaken it. I'm hoping that we'll see hawkish comments out of at least one central bank, and dovish comments out of another. This would create an interesting juxtaposition and allow me to trade the "hawkish" currency vs. the "dovish" currency.
One central bank that will not be raising interest rates anytime soon is the U.S. Federal Reserve. Every day on CNBC and other financial news programs I hear analysts predict that the Fed will cut rates by 50 basis points (0.5%) instead of the generally accepted 0.25% rate move at the next FOMC meeting on September 18. Their reasoning is that the current credit situation is dire and the Fed must act decisively and dramatically to stem further damage to banks, investors, and ultimately the U.S. economy. These analysts are missing the point; Ben Bernanke and the FOMC can raise or lower interest rates anytime they please, and if they were in panic mode they would have done so already.
The Fed was caught flat-footed when turmoil hit the markets in mid-August, as indicated by their August 7 statement that suggested inflation was the greatest threat to the U.S. economy. Bernanke has clearly seen the error of his ways, as we can see from his 50 basis point reduction in the discount rate on August 17. The Fed is walking a fine line here, because if it reduces the Fed Funds Rate (currently 5.25%) too quickly, it will give the impression that the situation is not under control, possibly making matters worse. Because of this – along with the fact that lower interest rates are not necessarily a panacea - I expect a quarter point rate cut on September 18, followed by another quarter point reduction on October 31.
How to Trade Forex Volatility
Last week, I appeared on CNBC World (click here to view) to discuss the methods traders should use to approach the current high volatility environment in the Forex market. Hosts Bob O'Brien and Nick Hastings asked some excellent questions and we discussed the current strong relationship between the currency market and the stock market. The correlation between equity markets and currencies such as the Japanese Yen has been one of the truly reliable intra-market relationships this summer.
A Life Preserver for Homeowners
Under a new proposal by President Bush, an estimated 80,000 homeowners who have fallen behind on payments because their mortgages have reset would be able to refinance with Federal Housing Administration (FHA) insured loans. Bush also asked Congress for tax reforms to help troubled borrowers rework their loans. Fewer home foreclosures would help the slumping housing market, which would be welcome news for homebuilders. This is certainly good news not just for homeowners and builders, but also for any hedge funds that are currently holding investment vehicles related to the subprime mess, and for banks that have loaned money to these hedge funds.
But before we get carried away, please remember that the proposal would affect only a small percentage of the homes that are potential candidates for foreclosure. Now that home prices are falling and credit markets are tightening, there are 2 million borrowers whose mortgage payments are expected to increase soon. It is also important to note that while the plan seeks to aid homeowners, it does nothing to help the speculators who helped to create stratospheric housing prices in the first place.
Question of the Week
Q) Dear Ed, I decided to finally start reading your book. It has reinforced and boosted my confidence in trading my methodology. However, I have this question for you: What is your preferred setting for ADX?
Ed Ponsi) Thank you for your question. ADX stands for average directional index, and is used by traders to determine the strength of a trend. My preferred setting for the ADX indicator is 14 periods, which means if you were to calculate ADX on a daily chart you would measure 14 days, and in the case of an hourly chart, you would measure 14 hours. The default setting of 14 is common to several popular indicators, such as Relative Strength Index (RSI) and Average True Range (ATR). The ADX indicator gained prominence after appearing in the book "New Concepts in Technical Trading Systems", published in 1978 and written by J. Welles Wilder Jr., who also created RSI, ATR and many other indicators.
Let's take a look at the ADX indicator in action. According to this chart, the U.S. Dollar – Canadian Dollar currency pair (USD/CAD) has ceased trending, as evidenced by the ADX reading of 13.05 (see figure 1). Since the reading is below 20, trending techniques would not be used to trade USD/CAD on the daily chart, and range bound strategies would be more appropriate. If the ADX reading were to increase to a level above 20, that would be a sign that the pair is entering a trend, and a change in tactics to a trending strategy would be warranted.
Figure 1: USD/CAD is not currently trending according to ADX. Source: Saxo Bank.
Meanwhile, the daily chart of the Great Britain Pound – Japanese Yen currency pair (symbol GBP/JPY) tells a very different story. Here, the indicator gives a strong reading of 39.58. It's important to note that although the reading is high, the indicator is falling. This could be interpreted to mean that the trend is still strong but growing weaker (see figure 2).
Figure 2: GBP/JPY trend is still strong but weakening. Source: Saxo Bank.
See You In Toronto
Our next book signing will occur at the Toronto branch of Online Trading Academy at 5pm 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. See you in Toronto!
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. Ed has appeared on CNBC, CNN International and TheStreet.com, and has recently written his first book for Wiley Finance, "Forex Patterns and Probabilities" (which you can purchase through