Trading University, Chicago Blog

Much has been written about the so called “risk trade” where asset class markets – carry currency pairs included – rally steadily while the U.S. dollar goes down, and then fall sharply while the U.S. dollar corrects violently higher. If your trading plan is behavioral based this dynamic is not so much a concern because your trading decisions depend on an individual market’s behavior, and not on sorting out the relationships between markets. Relationships evolve and change by nature while individual behavior generally does not. Certainly a macro understanding of the global economy and the major markets that feed it lend a trader confidence, yet there’s no point getting attached to parallel analysis this year when the relationships can change next year.   

Much of the adverse relationship between the dollar and asset class markets has been a consequence of U.S. economic policy aimed at stabilizing the world’s largest economy. The way they’ve accomplished this is by supporting the treasury and corporate securities markets because this has the effect of both calming savers and investors – bonds and notes have always far outnumbered other securities and investments in professionally managed portfolios – and keeping interest-rates low so that businesses can continue to re-borrow at low rates. Buying billons of treasuries and corporate bonds and notes also nudges investors in these securities into taking a profit and deploying funds into riskier assets – i.e. lending money. One residual effect of this has been a weakening U.S. Dollar as the profits migrating out of American securities go into the fast money lane of the global economy, which currently favors shorting the U.S. Dollar –using it as a funding pair – and investing in securities and stocks in emerging markets where both interest-rates and short-term prospects for growth appear better. A benefit for America from this low interest rate policy – popularly called quantitative easing — is the weaker U.S. Dollar, which gives U.S. companies the much valued cheaper currency advantage. In the global economy if goods and services are generally of the same quality and availability, those businesses which can provide them at the most competitive prices will generally do the most amount of business.  A weak currency automatically provides a pricing advantage across whole industries. But this is also a self-correcting mechanism of currency markets. As businesses that enjoy the cheap currency benefit start to capitalize on it, their share prices bump up, attracting astute international investors. This collective action, across the different industries, is how markets roll from down to up, or from up to down. If an industry group is on average priced 20% below the same industry group in another country because of a weaker currency, but is increasing its market share because of that cheaper currency, forcing companies in the competing country to cut prices thus hurting profit margins, investors will forego the interest rate advantage and try to take advantage of the shift by buying the cheap currency companies because of the pricing advantage and sell the more expensive currency companies to take advantage of falling profit margins. The most important thing to understand about such a trade is not the price relationship between the two but that one market gives a buy signal – bullish change of direction — and the second market gives a sell signal – bearish change-of-direction. The relationship, or spread, between the two will take care of itself once each market has shown individual strength or individual weakness. 

I think of the importance of measuring individual market behavior now after seeing the U.S. Dollar index in a position to shift its Monthly direction from down to up at month end — see Figure 1 – while the U.S. stock market is maintaining its current monthly direction which is also up — Figure 2. 

Figure 1

Figure 2

And I’m reminded of the benefit of subscribing to a behavioral trading plan, because while relationships by nature change, behavior does not.        

Jay Norris is the Chief Market Strategist at Clovernest Financial Group and the author of  Mastering the Currency Market, McGraw-Hill, 2009 which is the text book for the intermediate level trading course offered though Trading-U.com see: Trading Courses  Jay’s second book Mastering Trade Selection and Management, McGraw-Hill will be in book stores in 2011.  

DISCLAIMER: Forex (off-exchange foreign currency futures and options or FX) trading involves substantial risk of loss and is not suitable for every investor.  Any charts shown here represent market conditions at a particular point in time. Such conditions may not be replicated in the future. Past performance is not indicative of future results.

admin "Forex Trading" "Forex Education" "Trading Education", Behavioral Trading, Jay Norris, Quantitative easing and marklet relations, relationship between currencies and stock market, relationship between stock market and dollar