News Trading Perspective

Better than expected reports on Australian GDP and Chinese manufacturing gave a predictable lift to the Australian dollar against the USD. But the reports also helped the euro reach its best level in nearly two weeks of trading. Why?

Aussie GDP grew by 1.2% in the April to June period from the previous three months, when it rose a revised 0.7 %. Much of the increase was attributed to China’s insatiable demand for coal and iron ore. Overall exports gained by 5.6%, adding 1.1 percentage points to overall GDP. Amazingly, real gross domestic income rose 4.0%, the largest quarterly growth since March 1973. Real net national disposable income increased by 5.1% in the quarter and by 9.5% over the past four.

Australia is incredibly productive as well; Unit labor costs in real terms decreased by 0.2%, and indication that inflation will stay relatively muted.

In China, The Purchasing Managers’ Index rose to 51.7 from 51.2. July’s reading had been the weakest since February 2009. All in all, the number is an indication that manufacturing in China may have reached its lowest point and is due to increase in coming months.

So, why did all this news from the other side of the world affect EUR/USD?

The reason lays with the reports effects on S&P futures, which are a reliable guide for movement in EUR/USD. S&P futures, like the spot FX market, moves throughout the day (except between 5pm and 6pm ET). The euro moves with S&P futures just as it moves with the actual S&P 500 during its trading hours in NY, and these reports helped S&P futures to a gain of just over 1% in overnight markets.

I’m writing this article about two hours before the Institute for Supply Management’s report on manufacturing, which is due out at 10am ET. Should that report print worse than economists’ expectations (53.2) you can expect to see things reverse very quickly, i.e. the euro and Australian dollar will fall against the USD as the S&P 500 retreats (assuming an absence of unexpected positive news). But look especially at the employment index within the report; should that slide for a second month you might really see traders become even more risk-averse than they generally are.

Things will probably reverse very quickly on Friday when the Bureau of Labor Statistics (BLS) reports on the August job numbers. Expect to see the report show a gain or actual loss of private sector jobs of 10,000 either way. The reason I say this is because of the report on weekly unemployment claims which came out on August 19, which showed that there were 500,000 new claims.

The BLS report is the result of a survey that is taken over a one week period and in August, that week coincided with the August 19th report on unemployment claims. As it happens, that reading was the worst in many weeks and had risen from a low of 438,00, which means the trend in new private sector jobs has to be moving lower.

Therefore, I suspect that new private sector jobs will grow by 10,000 or so, at best, and that an outright loss of about 10,000 is well within the realm of possibility. What’s interesting is how the market might react.

Because Mr. Bernanke conditioned the Fed’s response to a lack of employment growth “regardless of the risks of deflation,” we could see the dollar weaken dramatically should these numbers prove to be correct. Why? Because the market could assume that a weak report on jobs will lead to another round of “electronic printing” by the Federal Reserve.

Some Musings From Chairman Bernanke:

“For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.”-August 27, 2010 at Jackson Hole, Wyoming.

“The economic outlook remains unusually uncertain.”-July 21, 2010 in the semiannual monetary report to Congress.

Mr. Bernanke wisely decided to avoid repeating his now infamous quote, but his assurances that the Fed “will do all it can” to promote a continued recovery appears to have had a limited effect on jittery investors. Why? Because the reality is slowly dawning on market participants: monetary policy alone cannot solve all problems, which means that growth will be weak, unemployment will remain high, and the recovery, at best, will be slowly protracted over an extended period.

The one solace that investors might have taken could be at risk as well. After Mr. Bernanke announced back on March 15, 2009 (on 60 Minutes) that the Fed was indeed “electronically printing,” the dollar predictably depreciated and stocks advanced. This time around, should the Fed decide to purchase another trillion dollars or so of longer-term securities, investors might very well panic at the notion that what had already been done proved to be insufficient at that more is needed.

The whole idea of creating another trillion dollars of bank reserves might be pointless anyway since there already is about $1.2 trillion sitting at the Fed now doing nothing but collecting 0.25% (and a mountain of dust). And lest anyone think that lowering the rate paid on reserves will somehow spur bank lending, it isn’t going to happen anyway because the Fed believes that the Fed Funds market, and hence its ability to control the benchmark overnight rate, would be irreparably damaged if a zero interest rate policy on reserves was adopted.

The point here is that what good will it do for the overall economy if the Fed enlarges its mountain electronic dollars since basically all of that newly printed currency has to just sit there in isolation anyway?

Actually, the biggest fear that everyone, especially the Fed, has to have at this juncture is this: What happens if the Fed prints and the economy does not respond? Other policy measures, such as additional fiscal stimulus which involves increasing the deficit, are not likely to be available. Bernanke acknowledged in his Jackson Hole speech that the cost of borrowing is not the primary factor affecting firms’ willingness to expand and hire but rather, it is the expected aggregate demand for their product which drives those decisions.

Forcing down interest rates is apparently not spurring demand for home purchases, as potential buyers wait for prices (and rates) to decrease further. Indeed, it seems as if the Fed can’t help but avoid creating a deflationary environment (and the attendant delay of purchases) as it ramps up the printing press. The law of diminishing returns in action!

Still, traders should be aware that Mr. Bernanke conditioned the Fed’s response to a lack of employment growth “regardless of the risks of deflation.” And after this Friday’s report on Non-Farm Payrolls, which at best will only show a meager gain in private sector jobs (if not an outright loss), market participants may very well react by selling the dollar in anticipation of the inevitable response from the Federal Reserve.

Using the market’s bias and price action, here’s a fairly reliable technique for trading with optimal entries and exits.

First, we will take advantage of that fact that when the market in stocks is negative, the resulting risk-off trade will cause the dollar to strengthen. Second, will we strictly adhere to the maxim of “buy low and sell high,” which in this case (because the bias is negative) is “sell high and buy low.”

The candles where the Fib has been placed covers the fall in EUR/USD which started about 2 hours after the dismal report on New Unemployment Claims was released. As you can see, EUR/USD actually rose after this report, exactly the opposite of what you would expect to see. This likely happened because:

1. There were a lot of stop orders on short trades that the banks wanted to wipe out
2. There were a lot of sell orders clustered around 1.2890 or so from the large players, and banks moved the price to accommodate them
3. Both of the above

In any event my bias was short the pair, especially after it was reported that 500,000 people filed new unemployment claims. I am not looking at the way price is moving  in order to gauge the sentiment; What I am doing is using my own judgment regarding the bias and price on the charts to provide the entry and exit.

We did have a clue that price might fall as seen by the large bearish pin bar candle to the left of the Fib. For now, let’s assume that we missed the pin bar and the decline covered by the Fib-What do we do next?

Well, the bias is still short so we want to sell. But let’s also remember that the goal here is to “sell high and buy low,” which means that we want to see price retrace the decline to a certain level. The question now becomes where.

My first rule is to look for a retrace to the 61.8 Fib level and if price had gotten that high, I would have taken a short. As it turned out, price only retraced to the candle labeled “A” but at that point, you have no way of knowing whether price will go up or down. So when price retraces to “A,” all I am doing is waiting for a retrace to the 61.8.

As we can see, price ends up taking a downturn from candle “A.” My next plan of attack will be to go short if price returns to that level because what I am looking to do is to sell from some established resistance (sell high).

Finally, price does retrace back to the level of candle “A” and at that point, you can look to go short with a target at the bottom of the Fib (we can have a reasonable expectation that price will decline that much because we have seen recent sellers in the market take it that low).

**Extra Credit**

Suppose you had been trading when the bearish pin bar appeared. Where might you have entered?

At the present time, due to the lack of a strong, one-sided fundamental driver, it is looking more and more likely that the forex market will trade in a range.

U.s growth looks set to slow as the year progresses, but this outcome has pretty much been baked into market sentiment. The Fed is holding its balance sheet steady although it is rolling over agency debt into Treasuries as those assets mature.

The risk here is with the employment picture which, if the latest unemployment figures are any indication, will show an anemic level of growth in private sector jobs if not an outright loss.

Speaking of jobs, we really shouldn’t expect to see any sort of significant growth going forward. Of the three main drivers of jobs (significant technological advances, credit bubbles, and exports) only the latter has the potential to make a contribution. However, that will depend on two things; investors becoming more accepting of risk, or the Fed expanding its balance sheet (which means it will print more dollars).

Could the market become more daring and get back into stocks? It is doubtful given that jobs do not figure to gain much going forward, which means investors will figure that U.S. consumer spending will remain constrained.

That leaves the Fed as the main backstop for the economy, but the only option left open at this point is to resume printing dollars and expand the balance sheet. This of course presents many risks as well, specifically the loss of confidence that investors now have in U.S. debt.

There is one other option available although we are not likely to see it happen-the Fed can begin talking about eliminating the “extended period” language in its statements. Here is why this could offer an avenue to economic growth:

The simple fact is that people tend to buy (assuming they can) if they believe that prices will be moving higher in the not too distant future. At this time, consumption is being negatively affected because the general perception is that prices on things like homes are bound to fall. In other words, people expect to see further price deflation so they are delaying their purchases.

If the Fed were to indicate that the extended period language was to be eliminated soon, it would become obvious that interest rates were bound to rise at some point. Higher interest rates of course mean that the cost to carry debt will increase. And if people thought that the cost to carry debt was going up, they might buy now rather than wait.

The obvious market likely to be most affected by this perception would be housing. If consumers believed that interest rates were going up soon, those who can buy now would have more of a motivation to do so, especially with prices as depressed as they are and with interest rates still at rock-bottom lows.

With the results of second quarter Japanese GDP, China has passed Japan to become the world’s second-largest economy behind the United States, finally laying to rest the long-held theory that a nation cannot depreciate its way to economic prosperity.

Japanese GDP  totaled $1.288 trillion in the 3 months ending June 30, less than China’s $1.337 trillion

To be more specific in the case of China, what is now evident is that a nation can create prosperity by preventing its currency from appreciating and by artificially raising the value of competitor’s currency. The recent goings on vis a vis Japanese government bonds being just the latest case in point.

In June, China extended its record buying spree of Japanese debt, purchasing a net $5.9 billion of short term bills. As a result of all these bond purchases, the Yen has appreciated dramatically even as its economy limps along barely above water.

The surge in buying of Japanese bonds by the Chinese has stirred talk that China may be diversifying its foreign reserves into the yen and away from the euro and the dollar, which is of course what China wants the world to think. The real reason is much simpler; appreciate the yen and eliminate a competitor in exports.

China’s plan is apparently working as well as hoped-Japan’s economy expanded at the slowest pace in three quarters for the period ending June 30, rising at just a 0.4% annualized pace, as company’s like Sony and Toyota see their profits threatened while the yen rises to a 15 year high against the dollar.

China, much like everyone else, is concerned that the nascent global recovery will weaken going forward as the U.S. fails to make a significant dent in its unemployment rate, an assessment that seems to be all the more likely as time goes on.

To give you an idea of how dangerous the situation is for Japan, Honda’s CFO said on Aug. 5 that “if the Japanese economy is forced to create a production structure based on 85 yen to the dollar, that would be disastrous,” as the nation wouldn’t earn enough from exports to pay for commodities from overseas.

As you can see on the attached CNY/JPY chart, the yen has appreciated by nearly 7.5% against the yuan since the beginning of May, a move which is completely out of touch with economic fundamentals. But there is no country willing to criticize China on this issue because the global economy is becoming ever more dependent on China to fuel growth. The U.S. passed on its latest chance to label China a currency manipulator in June, even as the Secretary of the Treasury said the U.S. was hoping to see China allow its currency to appreciate vs. the USD!

Here is another way that I use Fibonacci to make entries and place stops. Always remember that Fibonacci is used for support and resistance, not for bias.

As you can see on the chart, I have set up a Fib retracement to measure the decline of the up move from July 21. Let’s assume that the bias has been shifted to dollar strength on this pair, given the current risk-aversion mood off the recent weak economic data and the market’s disappointment in what the Fed decided to do Vis a Vis additional Quantitative Easing.

Yesterday’s candle closed below the 38.2 retrace level, and indication that price will eventually move to the 61.8. With a short bias, the question now becomes where to place an entry and stop. Here are your choices:

1. Short entry if price retraces to the 38.2 on 1.5663
2. Let price retrace up to some point, then enter short

Keep in mind that the target will be at the 50 level on 1.5560 and that I always want to have at least a 3:1 reward to risk ratio. If I enter at 1.5663, hoping that the 38.2 will  hold, my stop will be on 1.5696 because I need 33 pips as a stop. As it turns out, the trade gets stopped out before eventually going our way.

Using option 2 will help us avoid this. Here’s how to do it:

Take the daily range of the previous day, which was 235 pips, and multiply it first by .236 and then by .382. This will give us 2 price points where price can retrace to before resuming the downward trajectory. We will then choose one of these levels as a short entry.

For example, 235 x .236 = 55 pips. Adding 55 pips to the previous day’s low gives an entry on 1.5682, which means we are waiting for price to retrace to the 23.6 fib level of the previous day’s range before going short. Since my target is on 1.5560, and I’m looking for 122 pips on this trade (with the target still at the 50 retrace level), my stop will be 41 pips above the entry.

As an alternative, you could have set up this trade using the .382 but on this day, price didn’t retrace that high. You would have never entered this trade waiting for a .382 retrace.

Now for the big question: how do you know which entry to use?

Short answer: you don’t. That’s why it’s called trading.

The only thing the Fed accomplished today with this weak attempt at “QE II” was to create a deflationary environment for interest rates. And just as in any deflationary situation, it’s a killer for the economy.

The problem here is that the Fed has not gone far enough in their efforts because all they are doing is rolling over Treasuries, or recycling Agency principle payments into Treasuries, while keeping the amount of assets held on the balance sheet level (i.e. they are not printing).

The goal here is to drive down interest rates on things like residential mortgages, which policymakers believe will spur people to buy homes. But the theory is entirely wrong and if you don’t believe me, then answer the following questions:

1. Do you think interest rates will be moving up or down over the next few months? Most will say they believe rates will fall because if the Fed is buying, we are likely to see the increased demand raise prices and lower rates.

2. Are you more apt to purchase something now if you believe the price will be higher or lower next week? Of course you will wait until next week because you want to get a lower price.

Now for the big question-If you are one of the lucky few looking to buy or refinance a house, are you going to do so now when you expect that rates will be going down further over the next few months? Of course not! You are going to WAIT a bit for a better interest rate!

That is what a deflationary environment does; it forces people to delay their purchases as they wait for a lower price. Or look at things this way-home sales accelerated in the spring when people understood that the tax rebate was ending. Why? Because people will buy as quickly as they can (assuming they are able) if they believe that price will be going up in the near future.

Aside from that, if the Fed’s balance sheet is not being expanded it means they are not printing. And if they are not printing, they are not depreciating the dollar and therefore cannot create higher values in assets like stocks, homes, etc. Remember, it wasn’t until Bernanke was interviewed by 60 Minutes back on March 15, 2009 and “admitted” they were “electronically printing” that things really took off. It is a very simple relationship-depreciate the dollar and anything that is bought with dollars has to go up in price.

What their plan is also bound to fail miserably at is creating jobs. I mean, what, someone who owns a business is going to hire more workers because the rate on Treasuries is going down? This diluted version of QE II does not make any sense and it is bad monetary policy because nothing is being done for the employment portion of the dual mandate.

Additionally, because they are trying to create a bond rally, other asset classes like stocks are bound to suffer from the competition. But then again, more Americans than ever are keeping their money in bonds so perhaps they will have a chance to see some appreciation.

What is clear from the first estimate of Q2 GDP was that the rise in imports which occurred as the dollar rose over the period did a huge amount of damage to the U.S. economy as the trade deficit widened.

Second quarter imports increased at a 28.8% annualized pace over the first quarter while exports increased by only 10.3%. Contrast this to the fourth quarter of 2009 after the dollar had weakened considerably from March of that year; By then, exports were increasing by 24.4% while imports grew by just 4.9%.

Now, I’m not claiming to make any big revelation here because depreciating the currency to boost exports is something that has been going on for centuries. But it is obvious at this point that with U.S. consumer spending constrained by a very weak job market, to say nothing of the balance sheet repair that is going on, the best avenue for growth in the U.S. economy at this time is via the export market.

Simply put, the Fed has to do all it can to murder the dollar.

Large amounts of job creation have historically been a result of 4 major factors:

1. War

2. Radical technological advances

3. Credit bubbles

4. Exports

To put it simply, choices 1, 2 and 3 are no longer available. War is now an economic drain (aside from being something that no one wants to see happen), there are no world-changing technological advances like autos or computers on the horizon, and we are not likely to have a credit bubble forming any time soon.

That leaves option 4 as the best chance for the U.S. economy at this time, given that fact that currency depreciation is not difficult to do and that millions upon millions of Asians figure to become more affluent consumers as time goes on.

So, it is now up to the Fed to do its job and depreciate the currency, which is what the recent talk about expanding its balance sheet is really all about. Remember, in order purchase assets the Fed has to get some cash and the way it does this is by pushing the “print” button on the electronic press. But there is another way to increase the supply as well; the Fed can to lower (or eliminate entirely) the interest it is paying to the commercial banks on the $1.2 trillion in reserves now being held by them at the Federal Reserve banks, reserves that were created during the ramping-up of Quantitative Easing.

Indeed, the question of why the Fed is paying interest now is one that has not been explained at all. Chairman Bernanke has said that a tool which the Fed could use to cool the economy (if and when that ever becomes necessary), would be to increase the rate it pays on reserves (or offer term deposits). So, if the Fed wants to expand economic activity at this time, which presumably it does, and paying interest on reserves is a tool it will use to slow the economy, then why is interest on reserves being paid now given the very weak state of the the job market and overall economy?

My personal guess is that paying interest on reserves is a way for the Fed to keep some of its powder dry. In other words, lowering the rate it pays on reserves is a tool the Fed has been planning to use to expand economic activity if and when it sees the need to do so. My thinking is that the time to use this tool is now. Here’s why:

First, it is evident that private sector job creation peaked in March and April and that the economy is set to slow further as the year progresses. The job of the Fed now is to manage the worst case scenario from the 2 risks it must deal with-inflation and deflation. While it can be debated whether the economy is truly heading towards deflation, what is apparent is that we are now in a dis-inflationary period. But what cannot be debated is the fact that deflation is a much more insidious and difficult problem to deal with than inflation and that the greater risk to the economy, given the enormous amount of slack which now exists in aggregate demand and in the labor force, is coming more from the threat of deflation than inflation.

What it all comes down to is what the Fed says in its statement this week. While no one is expecting the Central Bank to announce any specific actions, investors will be looking to see if there has been additional discussion on the subject of re-starting Quantitative Easing and/or lowering or even eliminating the practice of paying interest on reserves. The market is getting nervous and it needs to see that Bernanke & Co. has its back.