Thoughts from the Trading Trenches
19 Years ago | June 30, 2014 12/2/23, 12:00 AM
July, 2014 In this issue:
Who Wins? Race to the Bottom or Race to the Top
Forex Trading Outlook for July
Who Wins? Race to the Bottom or Race to the Top
The forex market seems torn between a race to the bottom and race to the top, with the dollar in both camps. By race to the bottom I mean competition to be the favored funding currency for carry trades. By race to the top, I mean competition to be the first major currency to see central banks start to normalize policy by raising rates. Which currencies are in which camps?
Any currency with near zero interest rates is a potential funding currency so there are plenty to choose from, such as the USD, JPY, EUR and CHF. Coming into the year, the JPY was the favorite but that has not worked out well as the Japanese currency has appreciated rather than continuing to fall as most had predicted. The EUR has fallen towards the bottom of the forex food chain after recent ECB easing but has not gone far enough to be called the favorite.
On the race to the top, there are two main competitors, the USD and GBP. In each case, these central banks have recently tried to cool expectations of a nearer than expected rate hike, which suggests that markets may have to force the issue if data indicates they are falling behind the curve.
Inflation Expectations May Hold the Key
The race to the bottom and top comes in a market that has elevated inflation indicators to the top of the economic food chain. I addressed this in our December newsletter and rather than rehashing what I wrote, see below for an excerpt:
Would Force the Market to Test the Central Banks?
In one word, INFLATION. Until now, central banks have had the cover of low inflation to pursue extraordinary monetary policies (i.e. quantitative easing) that in other times would have been deemed radical or even heresy by mainstream economists. These economists are probably rolling over in their graves at the sight of central banks printing money by buying government bonds that fund budget deficits.
I am not saying the inflation genie is waiting around the corner or is even close to popping out of the bottle but if you are looking for something that would cause central banks and markets to turn cautious, it would be a shift in trends towards higher prices. At the current time this does not seem to be a risk as there is no inflation threat now because the major economies have very large excess capacity, especially labor, that will be very, very slow to change. This is one reason why central banks, such as the Fed and Bank of England, have been focusing on the unemployment rate as a key indicator although both have indicated that this is more of a moving than stationary target.
Inflation is thus the wild card as the lack of pricing pressures has allowed central banks to pursue dovish monetary policies. This includes the use of forward guidance to indicate there is no risk of a near-term rise in short-term rates, which has helped fuel a rise in stock prices, even as the Fed starts to taper its bond purchases. Forward guidance is like verbal intervention, markets will follow the central bank lead until conditions suggest it is no longer wise to do so. At this stage, it would take a rise in inflation to lead the sheep away from slaughter.
This view worked out well as the ECB has responded to low inflation by easing policy and both the Fed and Bank of England have used the cover of low inflation to maintain current policies although the end game seems to be coming closer for the latter two central banks. This raises the question which inflation indicators would force the Fed and BOE to speed up normalizing policy. The answer is probably wage inflation more than rising consumer prices as that would be a sign of tighter labor conditions. One theory is that rising consumer prices while wages stay low is actually deflationary. In this case, consumers have less money to spend on goods and services due to stagnant wages. This is why central banks are likely to keep a focus on wage data as much or perhaps more than consumer prices.
What does this suggest for the forex market?
Forex markets continue to suffer from a lack of volatility and that is likely to continue until central banks start to normalize monetary policy by raising interest rates. In this regard, markets will not wait for central banks and will likely anticipate the start of the normalizing interest rate cycle when data suggests it is time to do so. This will make markets even more hyper-focused on economic data as the year goes on but until then, it may be more of this choppy, low volatility trading, especially while bond yields remain tame. This should favor the dollar and GBP over the EUR over time given divergent monetary policies but that is just stating obvious. It may not be until the market starts to smell blood by pushing up interest rate expectations that volatility will pick up.
The wild card is geopolitics, specifically Iraq, which is not likely to go away but much depends on how oil trades as that will affect the global economy. Forex markets seem to trade best when there is a crisis but the trend over the past year and a half has been that potential crises have not seen the typical reactions and for the most part have been ignored. Geopolitical risks appear to have replaced China's growth and Fed policy as the main investor concerns but so far with only limited fallout.
The forex market also trades best when there are divergent economies and/or monetary policies but so far cautious central banks in the race to the top and cautious central banks in the race to the bottom (e.g. no QE from the ECB, no further stimulus from the BoJ) have contributed to the lack of volatility and contained ranges seen so far this year. I do not like to use the word HOPE when it comes to trading but the hope is that volatility will pick if markets start to force the hand of reluctant central banks. In this regard, recent U.S. data has seen a downgrade to growth forecasts for the 2nd quarter rebound from a dismal first quarter so the current low volatility market may continue for longer than anticipated. In this regard, watch U.S. economic data and whether it surprises to the upside or the downside. In the meantime, we may be in for a summer range market.
Jay Meisler, founder
Global Traders Association
Forex Trading Outlook for July
Our role as the advocate for the global traders is to inform and provide trading insights. This is why our motto is knowledge is power. This is also why I enjoy writing our monthly newsletter as it gives us an opportunity to comment directly on the market and hopefully add some fresh insights. In this regard, I have added my trading outlook video for the month ahead to the July newsletter:
Jay Meisler, founder
Global Traders Association
