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March 2013

Volume 10, No. 3

Strategies, analysis, and news for FX traders

GAUGING A EURO REBOUND P. 31

U.S. dollar new-high pattern analysis p. 18

Canadian dollar: Loonie comes back to earth p. 6

Foreign exchange rules of engagement p. 10

The price of currency union p. 20

Perspective on currency war p. 12

7/27/2019 Ctm 201303

2/312 March2013CURRENCY TRADER

CONTENTS

Contributors................................................. 4

Global Markets

Has the loonie lost its luster? ....................6

Sluggish economic data and looming resistance

could put a cap on a major dollar/Canada rally.

By Currency Trader Staff

On the Money

Rules of FX engagement .........................10

There might be new rules of engagement in

foreign exchange, but that hardly means a cur-

rency war is inevitable.

By Marc Chandler

Straight talk about currency wars ..........12

Perspective is needed when addressing the

overheated currency war topic.

By Barbara Rockefeller

Spot Check

Dollar dance .............................................18

A markets phase will dictate the performance

of a price pattern. What mode is the dollar

currently in?

By Currency Trader Staff

Advanced Concepts

The interest rate price

of a currency union..................................20

Until it abandons its separate national histories

andadoptsacommonscalpolicy,the

Eurozone will suffer the consequences of its

fundamental contradiction.

By Howard L. Simons

Global Economic Calendar ........................26

Important dates for currency traders.

Currency Futures Snapshot.................27

BarclayHedge Rankings........................27

Top-ranked managed money programs

International Markets............................ 28

Numbers from the global forex, stock, and

interest-rate markets.

Forex Journal ........................................... 31

Dollar analysis prompts Euro trade.

Looking for an

advertiser?

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name for a direct link to the

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CONTRIBUTORS

4 March2013CURRENCY TRADER

Editor-in-chief: Mark Etzkorn

[email protected]

Managing editor: Molly Goad

[email protected]

Contributing editor:

Howard Simons

Contributing writers:

Barbara Rockefeller,

Marc Chandler, Chris Peters

Editorial assistant and

webmaster: Kesha Green

[email protected]

President: Phil Dorman

[email protected]

Publisher, ad sales:

Bob Dorman

[email protected]

Classifed ad sales: Mark Seger

[email protected]

Volume 10, Issue 3. Currency Trader is published monthly by TechInfo,Inc., PO Box 487, Lake Zurich, Illinois 60047. Copyright 2013 TechInfo,Inc. All rights reserved. Information in this publication may not be stored orreproduced in any form without written permission from the publisher.

The information in Currency Trader magazine is intended for educationalpurposes only. It is not meant to recommend, promote or in any way implythe effectiveness of any trading sys tem, strategy or approach. Traders areadvised to do their own research and testing to determine the validity of atrading idea. Trading and investing carry a high level of risk. Past perfor-mance does not guarantee future results.

For all subscriber services:www.currencytradermag.com

A publication of Active Trader

CONTRIBUTORS

qHoward Simons is president of Rose-

wood Trading Inc. and a strategist for Bianco

Research. He writes and speaks frequently

on a wide range of economic and nancial

market issues.

qBarbara Rockefeller(www.rts-forex.com) is an interna-

tional economist with a focus on foreign exchange. She has

worked as a forecaster, trader, and consultant at Citibank

and other nancial institutions, and currently publishes two

daily reports on foreign exchange. Rockefeller is the author

ofTechnical Analysis for Dummies, Second Edition (Wiley,

2011), 24/7 Trading Around the Clock, Around the World (John

Wiley & Sons, 2000), The Global Trader (John Wiley & Sons,

2001), and How to Invest Internationally, published in Japan

in 1999. A book tentatively titled How to Trade FX is in the

works. Rockefeller is on the board of directors of a large

European hedge fund.

q Marc Chandler([email protected]) is

the head of global foreign exchange strate-

gies at Brown Brothers Harriman and an

associate professor at New York Universitys

School of Continuing and Professional Stud-

ies. Chandler has spent more than 20 years

analyzing, writing, and speaking about

global capital markets. He is the author ofMaking Sense ofthe Dollar: Exposing Dangerous Myths about Trade and Foreign

Exchange (Bloomberg Press, 2009).
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.rts-forex.com/http://www.rts-forex.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]

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http://clk.atdmt.com/FXM/go/438305665/direct/01/

7/27/2019 Ctm 201303


GLOBAL MARKETS

The Canadian dollar started 2013 with a thud, falling near-

ly 5% vs. the U.S. dollar from mid-January to late February.

Once a pillar of economic envy, Canada is running into

some trouble in that area, and is expected to experience a

modest slowdown in growth this year from 2012 levels.

During and after the global financial crisis, Canadas

economy held up relatively well and its recession was

shallow, mild, and accompanied by little job loss. Also,

Canadas banking sector was a strength rather than aweakness. Overall, stringent and conservative banking

practices had been seen in Canada, which limited the type

of balance sheet rebuilding that had to occur in the U.S.

However, it appears Canadian consumers may have fall-

en prey to a temptation that helped sink the U.S. economy.

Driven by low interest rates, a housing boom has unfolded

in Canada, with house prices soaring and consumers bor-

rowing against their climbing home equity. Now, with eco-

nomic conditions slowing amid a weak export picture and

a bottleneck in Canadian oil supplies, debt-ridden consum-

ers are no longer able to step in and drive the economy

forward with more spending.Also, a spate of recent economic data out of Canada

has disappointed, pressuring the Canadian dollar to the

downside. Since the start of the year, the dollar/Canada

pair (USD/CAD) has climbed (reflecting Canadian dollar

weakness) from .9815 to 1.0300 a relatively big move in

a short time for a currency that has a reputation for stabil-

ity (Figure 1).

Lets take a look at the underlying economic fundamen-

tals for Canada, how monetary policy might unfold, and

the implications for the Canadian loonie in the coming

months.

Economy: A shaky housing market

After generating gross domestic product (GDP) growth

at an approximately 1.9%-2% pace in 2012, economists

expected Canadas economy to slow down this year.

Nomura and BNP Paribas both forecast contraction to a

1.5% pace, and while Moodys Analytics currently fore-

casts a 1.9%-2% rate for 2013, one economist there admits

the risks associated with this outlook are to the downside.

BNP Paribas economist Bricklan Dwyer points to two

key factors weighing on Canadas economic outlook: hous-

Has the loonie lost its luster?Sluggish economic data and looming resistance could put a cap on a major dollar/Canada rally.

BY CURRENCY TRADER STAFF

FIGURE 1: EARLY 2013 SURGE

The USD/CAD pair gained more than 5% between early

January and mid-February, and more than 7% since mid-

September 2012.

7/27/2019 Ctm 201303

7/31CURRENCY TRADERMarch2013

ing and household debt. They have an economy

that has been consumer driven and benefit-

ted from fast acceleration in house prices, he

says. Consumers have borrowed against their

homes.

According to Dwyer, Canadian home prices

have gained 125% since December 1999. Its a

huge concern, he says. There is a real question

about when or if the housing market has topped

out if the froth is just going to be removedand the economy will keep chugging, or if it will

face a more substantial correction.

The parallels are striking to the housing boom

and bust that unfolded in the U.S. However,

while in recent years U.S. consumers have worked to

improve their balance sheets, the Canadians have been

going in the opposite direction. Dwyer notes that house-

hold debt as a percentage of disposable income is 155.5%

in Canada, compared to 139.4% in the U.S. But now

Canadian consumers are beginning to pull back on spend-

ing, which is removing one of the props from the economy.Is Canada set up for a U.S.-style housing collapse and

recession? Dwyer says no, at least for now. Our base case

is that we see a 15% price correction to take some of the

froth out of housing, he says.

The U.S. connection and exports

In addition to its uncertain housing market, Canadas

economic picture is further clouded by declining exports

to the U.S. About three-quarters of Canadian exports go

to the U.S., and the U.S. is still not back to full employ-

ment, says Mark Hopkins, senior economist at MoodysAnalytics. The Canadian economy has been running on

ginned-up consumption spending to help replace the miss-

ing export growth.

Comparing some numbers before and after the global

financial crisis reveals how Canada has suffered on the

export front. Canadian merchandise exports in 2012 totaled

$462 billion, a 5.2% decline from the 2008 figure of $487

billion, according to Hopkins. Exports to the U.S. in 2012

stood at $338 billion, down 8.4% from $369 billion in 2008.

That trend isnt likely to reverse soon. The U.S. economy

continues to face fiscal challenges that still have the poten-

tial to trigger government spending cuts, which in turn

could slow the U.S. economy. Canada has the blessing and

the curse to have the close ties to U.S. economic growth,

and its fortunes will rise and fall accordingly.

Depending on how things go with sequestration, the

Canadian [growth] forecast could come down, Hopkins

says. A rule of thumb I use is that exports to the U.S. areabout three-quarters of all exports of goods and services,

which in turn are about a third of GDP. Thus, roughly one-

quarter of Canadian GDP is sold to the U.S. market. So, for

every 1% drop in U.S. demand, we could expect roughly a

quarter-point reduction in Canadian GDP. This is a direct

impact.

However, Hopkins also notes there is potential for

growth in the Pacific Rim. The biggest market [in the

Pacific Rim], not surprisingly, is China, he says. In addi-

tion to having the largest economy, China has had a vora-

cious demand for resources, which it has sought to acquirenot simply through Canadian exports, but also through

offers to purchase large Canadian resource companies.

There are a wide range of commodities in question, mostly

ores and minerals, such as nickel and copper, but also

wood products.

Hopkins adds that the biggest potential growth area for

exports to Asia is energy coal, oil, and liquefied natural

gas. For the moment, exports of these products almost

all go to the U.S. because Canada lacks the transporta-

tion infrastructure to get these resources onto ships in the

Pacific, he says. Plans to build a pipeline from Alberta

7/27/2019 Ctm 201303


GLOBAL MARKETS

through British Columbia to the coast are in development.

Although by no means certain, this would greatly improve

the ability of Canada to ship its vast energy resources to

Asian markets, where oil and gas sell for a much higher

price than in North America.

Ironically, a supply bottleneck currently skews Canadas

oil picture. There is too much supply and they cant get it

out, Dwyer says.

Although Canada is an oil producer, there are no pipe-

lines linking production in Alberta in the west to consump-

tion in Ontario or Quebec in the east. Because there is

no pipeline, Canada still has to import roughly 40% of all

the oil it consumes, explains Charles St-Arnaud, foreign

exchange strategist at Nomura.Currently, Western Canada Select (WCS) oil from Alberta

flows to the U.S. Midwest and Cushing, Okla., the main

U.S. oil storage hub, and is ultimately land-locked. But

because of increased U.S. oil production, Canadian oil is

in oversupply. The Western Canada Select has been sell-

ing at a $50 discount to Brent [crude oil] since October,

St-Arnaud says. This, in turn, has weighed on Canadian

oil company profits and, ultimately, on government tax

revenues. Oil producers are receiving less money for their

oil exports and the lost revenues for the economy is $2.5

billion per month, he says.

Central bank policy

The expected slowdown in 2013 growth has the Bank of

Canada (BOC) backpedaling on its interest-rate tightening

bias. The current BOC interest rate is 1%.

In late February, analysts seemed to think the BOCs

changing outlook would be reflected in its March 6 meet-

ing. I think they will shift their rhetoric, Dwyer says.

Inflation is now below their target band. They are more

likely to cut than raise rates in 2013 if things deteriorate

more quickly. Since the beginning of 2012, the BOC hasbeen suggesting rate hikes could be in the works.

The banks inflation target is 2% with a +/- 1% band,

and right now numbers are nowhere near that level. In

January, headline inflation was 0.5% year over year, reflect-

ing weak demand and weaker energy and food prices,

Dwyer says.

The BOCs softer tone at its January meeting was a major

factor behind the Canadian dollars decline since the start

of the year. Traders had already begun to price in expecta-

tions for a rate hike, but now a lot of investors are looking

for the BOC to turn even more dovish at the March meet-

ing, according to Vassili Serebriakov, FX strategist at BNP

Paribas.

Also, the USD has been independently stronger. The

U.S. dollar has been doing a little better against a number

of currencies, including the Canadian dollar, in part due

to the more open debate on how much more Fed easing

will be seen, says Bob Lynch, head of G-10 FX strategy

Americas at HSBC. If the market needs to scale back onFed expectations, risk currencies might suffer.

Dollar/Canada near resistance?

However, despite the recent weakness, several forex strate-

gists believe the loonie could be ready to level out. In June

2012 the USD/CAD pair hit its high for the year around

$1.0445; its high the previous year was 1.0657 (Figure 2).

Last year it poked briefly above $1.04, Lynch says. As

you get up toward those levels it might be more difficult to

extend, barring new [Canada-] bearish developments.

Serebriakov agrees the recent Canadian dollar weaknessmight be about to run its course. I dont think this is the

beginning of a substantial weakness in the Canadian dol-

lar, he says. I think its a readjustment to the economic

news. I dont think its the next yen or the next pound. I

dont see what would sustain this sell-off very strongly.

St-Arnaud sees the potential for additional short-term

Canadian dollar weakness, but expects a ceiling around

$1.05 in the dollar/Canada pair. Over the next few weeks

dollar/Canada could continue to go higher if we see con-

tinuing weakness in the economic data, he says. We

know the first quarter could be relatively weak.y

FIGURE 2: NEARING RESISTANCE

A longer-term picture shows the dollar/Canada pair

approaching the resistance of its 2012 high.

7/27/2019 Ctm 201303

9/31

ESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PER-

RMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-ORER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSOBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS ORSSES SIMILAR TO THESE BEING SHOWN. THE TESTIMONIAL MAY NOT BE REPRESENTATIVE OF THE EXPERIENCE OF OTHER CLIENTS AND THE TESTIMONIAL IS NO GUARANTEE OF FUTURERFORMANCE OR SUCCESS. TECHNICAL ANALYSIS OF STOCKS & COMMODITIES LOGO AND AWARD ARE TRADEMARKS OF TECHNICAL ANALYSIS, INC.

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7/27/2019 Ctm 201303

10/3110 October2010CURRENCY TRADER

Traditionally, the international arena has been the realm

within which nation-states pursue their national interests.

The forex market is a subset of this international stage.

This state of affairs held true before, during, and after the

1944 Bretton Woods conference, but a new understanding

has emerged over the past couple of decades that is pro-

ducing new rules of engagement, as it were.

The Group of Seven (G7) industrialized nations often

reiterates the current rules of engagement in its vari-ous statements. There are essentially four rules. First,

exchange-rate prices are best set by the market. Second,

officials should avoid making foreign exchange prices an

object of policy. Third, excessive volatility should be avoid-

ed. Fourth, in the rare case where official action is needed,

coordination is vital.

Beggar-thy-neighbor policies

When Brazils Finance Minister Guido Mantega first

coined the term currency war in 2010, it seemed primar-

ily directed at the U.S. The implication was the U.S. waspursuing unorthodox monetary policy to offset household

and government deleveraging and reflate the worlds larg-

est economy.

More recently, the new Japanese government was

criticized for resorting to beggar-thy-neighbor policies.

Officials in the government, led by Prime Minister Shinzo

Abe, had been quoted in the press providing bilateral

exchange targets for the dollar/yen rate. Since the election

in the mid-November 2012, the yen has declined about

13.5% against the U.S. dollar. The yen has easily been the

weakest of both major emerging-market currencies (out-

side of the Venezuelan bolivar, which had been devalued

by 32%).

In the weeks leading up to the recent G20 meeting in

mid-February 2013, there was much consternation and

official push-back at what appeared to be official efforts to

manage a depreciation of the yen. The statements issued

by the G7 and G20 essentially reiterated the rules of

engagement, but did not single out Japan or any other

country for that matter.

Softening stance

Indeed, even in the days before the G20 meeting, Japanese

officials had begun tempering their comments and had

ceased to cite specific yen targets. Instead, they empha-

sized the extremely accommodative monetary and fiscal

policies they were pursuing.

The criticism levied against the Japanese officials has

other policy implications. Shortly after the G20 meeting,

senior Japanese officials backed away from a public-

private fund to buy foreign bonds, which probably wouldhave seemed too much like intervention. In addition,

despite earlier threats, senior officials downplayed the

need to change the Bank of Japan charter. The suggestion

had appeared to be too much of a threat to the central

banks nominal independence.

Arbitrary nature of rules

The rules of engagement recognize the right of countries

to pursue monetary and fiscal policies that promote stable

prices and sustainable growth. This means the long-term

asset purchases of the U.S., Japan and, maybe soon, the

Rules of FX engagement

There might be new rules of engagement in foreign exchange,

but that hardly means a currency war is inevitable.

BY MARC CHANDLER

ON THE MONEY


7/27/2019 Ctm 201303

11/31CURRENCY TRADERMarch2013 11

UK (again) are not in violation of the rules.

Many observers are troubled by this prospect. They

dont see the difference between a currency that falls

because officials prod the market and a currency that

declines because of eased monetary policy.

But every game or institution has rules the uninitiated

find arbitrary. Its difficult for some people to understandwhy the Americans call a game they play with their hands

football. In basketball, you must dribble the ball as you

walk. However, youre allowed to take a step and a half to

shoot the ball. In baseball, if you catch a fly ball, the bat-

ter is out. But if there are fewer than two outs and runners

on second and third base, a pop-up ball in the infield is an

automatic out. Fielders need not even catch the ball.

Essentially, pursuing domestic policies for domestic

goals is sanctioned by the rules of international conduct,

even if a currency declines as a consequence. It is not prop-

er, though, to specifically target or manage an exchangerate. Its as if the temptations and dangers of beggar-thy-

neighbor competitive devaluations are so great that, under

the rules of engagement that have evolved since the late

1980s, high-income countries have generally forsworn their

use.

The fear is that competitive devaluations can lead to

trade wars, and then shooting wars. Of course, the clear

reference is to the 1920s and 1930s. However, this fear is

just as much a case of Godwins Law of Nazi Analogies. In

1990 Mike Godwin postulated: As an online discussion

grows longer, the probability of a comparison involvingNazis or Hitler approaches 1. (Meme, Counter-meme,

Wired magazine, 1994). Although Godwin was referring

to online discussions, we can broaden it to include discus-

sions of all kinds.

Easing market tensions

There are several compelling reasons tensions in the cur-

rency market will not lead to a trade war or a shooting

war. First, the main participants, the U.S., Europe, Japan,

China, and the International Monetary Fund do not view

current behavior as an act of war. Second, there are circuit

breakers and a trade-conflict-resolution mechanism under

the auspices of the World Trade Organization. Third, as

noted above, Japanese officials have ceased their offensive

behavior.

Currency war was, arguably, a useful metaphor to illus-

trate the tensions, but it took on a life of its own. There are

numerous reasons investment capital has flowed into some

emerging markets and, as a rule, those flows have slowed

during the last couple of years even as several high-income

countries pursue unorthodox monetary policies. These

include stronger macro fundamentals, such as stronger

growth and higher interest rates. Some investors are also

attracted to countries where the currency is perceived to be

deeply under-valued.

In the final analysis, numerous factors drive exchange

rates. Official talk may have short-run impact but, ulti-

mately, foreign-exchange prices are driven by interest

rates, the larger investment climate, and other macro-eco-

nomic variables. Typically, central banks prefer currency

movement that is consistent with the thrust of their mon-

etary policy.

The synchronized economic downturn prompted a cor-

responding policy response, and led to increased tensions

in the foreign exchange market. Look for such consterna-

tion to ease in the months ahead.y

Marc Chandler is head of global foreign exchange strategies atBrown Brothers Harriman. His blog is called Marc to Market(www.marctomarket.com). For more information on the author,see p. 4.

Ultimately, foreign-exchange

prices are driven by interest

rates, the larger investment

climate, and other macro-

economic variables.
http://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.marctomarket.com/http://www.marctomarket.com/http://www.wired.com/wired/archive/2.10/godwin.if.htmlhttp://www.wired.com/wired/archive/2.10/godwin.if.html

7/27/2019 Ctm 201303

12/31

Are we in the midst of a currency war, as the financialpress is pushing us to worry about? Yes. But its not whatthe press wants us to think. In fact, much of the talk aboutcurrency wars is pure nonsense. As Winston Churchill saidin 1949, There is no sphere of human thought in which itis easier to show superficial cleverness and the appearanceof superior wisdom than in discussing questions of cur-rency and exchange.

A currency war is deliberate devaluation to promoteexports that triggers retaliation by other countries. Theresevidence several countries including Japan, Australia,

New Zealand, and many developing countries (SouthKorea, Philippines, et al) are doing just that.

But the U.S. and Europe are not using currency warrhetoric on the contrary, they have plans to improvetrade relations with one another in the form of a free-tradepact. Together, the U.S. and Europe account for almosthalf the worlds output, and a free-trade deal benefits notonly both parties, but also improves competitiveness withChina, the one country that really has been waging a tradewar. Currency war rhetoric is only the first step in a tradewar, and so far no country except China has taken the hardactions tariffs, quotas, subsidies that spell trade war.

If two of the top three currency issuers are not engagedand, indeed, speak out against currency war, is it really awar?

A currency war is really the first shot fired in a tradewar. Historically, trade wars result in lower trade volumesfor everyone and, we can safely assume, a lowering ofhousehold well-being everywhere, too, since export-orient-ed jobs may be saved but the cost of imported goods goesup.

In the days before floating exchange rates, the mecha-nism for implementing a competitive devaluation policywas simple just declare it. Such a case of devaluation by

fiat occurred on Feb. 14, 2013 when Venezuelan PresidentHugo Chavez, speaking from Cuba, devalued the bolivarby 32% (from 4.3 to the dollar to 6.3). Venezuela had deval-ued five times since 2003, most recently in January 2010.Because oil is about 95% of Venezuelas exports and oil isdollar-denominated, Venezuela gets no export advantagefrom devaluation, but it does get more bolivars per dollarto pay domestic expenses, such as Chavezs costly re-elec-tion campaign. Devaluation also inhibits imports and thusinflation, which was running above 22% in January. To theextent imports are essential and cannot be cut, in the lon-

ger run devaluation raises inflation.Much of todays currency war talk assumes countries

can simply announce devaluation, when this is true onlyfor fixed currencies. For example, in an op-ed article in theWall Street Journal a former hedge fund manager wrote theFed should halt quantitative easing right away and, at thesame time, incoming Treasury Secretary Jack Lew shouldimplement a strong-dollar policy. What would that entail,exactly? Aside from interfering with trade or some othertax or subsidy measure, historically, you get a stronger cur-rency by raising interest rates. The Treasury doesnt do that the Fed does. Currency policy resides at the Treasury,

but the only entity with the tool to execute policy is theFederal Reserve.

Therefore, in speaking of currency wars, we have to keepthe facts consistent with the structure of the FX markettoday, not in centuries past. Countries with fixed exchangerates can engage in currency wars directly. A president,central bank governor, or finance minister can stand up infront of a TV camera and simply command devaluation,and financial parties like banks need to obey or they losetheir license to operate.

In contrast, countries with floating exchange rates can-not declare devaluation. To do so they would have to

On the Money


ON THE MONEY

Straight talk

about currency warsPerspective is needed when addressing the overheated currency war topic.

BY BARBARA ROCKEFELLER
http://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Concepts

7/27/2019 Ctm 201303


make changes elsewhere in the economy that have thesecondary effect of causing currency devaluation. Inthe floating-rate era, only one instance of a countrychanging interest rates specifically to influence a cur-rency comes to mind: Japan, which raised rates afterthe Plaza Accord in 1985 at the request of the U.S.specifically to drive down the dollar against the yen.Germany and the rest of the Europe declined to par-ticipate.

Is it fair to accuse a country of currency war if it imple-ments a policy targeting a certain economic condition that

has the secondary effect of causing devaluation? Saneand reasonable people say no. If the Federal Reserve isengaging in quantitative easing to nurture an ailing finan-cial system and to stimulate the economy, can it be blamedwhen the dollar falls? No, since the Feds mandate is tokeep inflation in check (no more than 2%), unemploymentat an acceptable level (most recently defined as 6.5%), andthe financial system stable. The Feds job is not to manageequity or currency prices. As Fed Chairman Ben Bernankehas said, changes in the dollar that arise from Fed policiestargeting the domestic U.S. economy are unintended.

In fact, Bernanke said at the October 2012 annual IMF

meeting in Tokyo that perception of the currency warconcept is one-sided by the emerging-market countriesthat feel aggrieved. Remember, it was Brazilian FinanceMinister Guido Mantega who revived the term currencywar at the G20 meeting in Seoul in November 2010.Bernankes rebuttal is more than a simple denial. He saidcapital inflows to higher-yielding emerging markets area function of many more factors than interest rate differ-entials. Relative higher growth is one factor, and besides,the correlation of flows with interest rate differentials hastended to diminish over time; it takes a bigger differentialto get a lesser flow.

Moreover, Bernanke continued, emerging markets arenot helpless. They have tools, including taxes and outrightcapital controls, to tame hot-money inflows. But perhapsthey should reconsider the capital-control form of currency

market intervention after all, a stronger currency allowsa lower cost of capital imports, like machinery, that eventu-ally leads to a stronger economy. Finally, emerging marketsshouldnt complain about the U.S. and other countrieshaving an easy-money policy, because its keeping alivethe source of demand for developing-country exports. Nocountry benefits if the U.S. economy remains mired in theGreat Recession.

Bottom line, the Fed and other super-accommodativedeveloped-country central banks are not out to swindleand harm emerging markets. Bernanke, tactfully, didnot add the Fed doesnt work for the Brazilian voter and

Brazilian business it works for the U.S. economy. Hecould have noted total U.S. exports of goods and servicesare only 14% of GDP, whereas the percentage is 32% in theUK, 50% in Germany, and 107% in Ireland. In Brazil, thegreat complainer, exports of goods and services are lessthan in the U.S., only 12%, according to World Bank datafor 2011 (Table 1). Meanwhile, total merchandise trade(exports plus imports), is 25% of U.S. GDP and 19.9% ofBrazils GDP. According to this table, among developedcountries Germany and Ireland, not to mention Canadaand the UK, should want a devalued currency.

In addition, Bernanke could have pointed out that dollar

TABLE 1: TRADE AS PERCENTAGE OF GDP 2011

Country

Exports of goods and

services as % of GDP

Total merchandise

trade as % of GDP

Bolivia 44% 66.8%

Brazil 12% 19.9%

Canada 31% 52.7%

China 31% 49.8%

France 27% 47.3%

Germany 50% 75.8%

Ireland 107% 88.9%

UK 32% 45.4%

US 14% 25%

The data suggests Germany and Ireland, and perhaps Canada

and the UK, should want devalued currencies.

Source: http://data.worldbank.org/indicator/TG.VAL.TOTL.GD.ZS

7/27/2019 Ctm 201303


ON THE MONEY

devaluation harms incoming capital flows. Foreign directinvestment (FDI) in the U.S. fell from about $94 billion inthe first half of 2011 to $57 billion in the first half of 2012.Even China had a drop in FDI, from $62 billion to $59 bil-lion. Brazils drop was smaller, $30 billion from $33 billion.The World Bank reports that over a longer period, Brazilgot $50.7 billion in FDI in 2008, rising to $71.5 billion in2011, while the U.S. showed a drop from $332.7 billion in2008 to $275.5 billion in 2011. These are absolute dollaramounts, and really should be expressed as a percentage ofGDP. In the U.S., FDI is only 1.5% of GDP (1.6% in China),but in Brazil, its 2.7%.

Then theres investment in equity markets. The TreasuryInternational Capital System (TICS) report shows globalequity investors seem to respond far more to changesin equity index levels than to changes in the dollar.

Meanwhile, inflows to Brazilian equities are robust andonly sometimes correlated to the real again, as Bernankesaid, a function of high growth and expectations of a posi-tive growth differential (Figure 1). From December 2011 toJune 2012, as the real was weakening, so was the Bovespastock index. Elsewhere the relationship is wobbly. In themost recent period, as shown by the linear regression lines,the real is falling while the Bovespa is rising. Net-net, aconsistent cause-and-effect relationship cant be deduced.If foreign investors consider the currency a factor in decid-ing to invest in Brazilian equities, its not the top-most fac-tor.

Where it is a top-most factor is Japan. In fact, the onlylongstanding and consistent stock market-currency rela-tionship is between the Nikkei and the yen, a tribute tothe export orientation of the big Japanese companies.Generally, the direction of causality is from the yen toequity prices; the Nikkei rises in lockstep with the dol-lar/yen rate (Figure 2). Now heres a chart showing thatpolicymakers have a logical reason to consider the levelof their currency as having a direct effect on the wealth oftheir citizens.

Denials

One reason the currency war story fizzled after MantegasG20 comments in 2010 was cooler heads prevailed. Butthen Japan held an election in December 2012, and incom-ing Prime Minister Shinzo Abe made it clear from the very

beginning the linchpin of all policy would be aggressivestimulus using quantitative easing and deficit spending.In the early days of Abes regime, his political allies andnewly appointed officials told the press the goal was toweaken the yen and get the Nikkei to 13,000 (from about10,000). Abe threatened the independence of the Bank ofJapan, which, in a rare joint statement, dutifully agreed todouble its inflation target. The governor agreed to resignearly, too.

As Figure 2 shows, anticipation of the Abe electoral vic-tory and nearly daily comments from Tokyo about the yenwas very effective in creating and maintaining the dollar

FIGURE 1: BRAZILIAN REAL (BLACK, INVERTED) VS. BOVESPA STOCK

From December 2011 to June 2012 Brazils Bovespa stock index was weakening

along with the real, but elsewhere the relationship between the two is weak.

Source: Chart Metastock; data Reuters and eSignal

2010 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2012 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2013 Feb M

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uptrend/yen downtrend, about 13% from mid-Novemberto mid-February. The Japanese yen depreciated to 94.46 perdollar on Feb. 11, the weakest level in almost three years

By the time of the G20 meeting in Moscow in mid-February, complaints were becoming more raucous thatJapan was starting a currency war. In an unprecedentedmove, the G7 issued a statement two days before the G20meeting that was interpreted as meaning the G7 was satis-fied Japans policy actions were not directed specificallyat devaluation, and therefore Japan was not to blamefor starting a currency war: We, the G7 Ministers andGovernors, reaffirm our longstanding commitment to mar-ket-determined exchange rates and to consult closely inregard to actions in foreign exchange markets. We reaffirmthat our fiscal and monetary policies have been and willremain oriented towards meeting our respective domestic

objectives using domestic instruments, and that we willnot target exchange rates. We are agreed that excessivevolatility and disorderly movements in exchange ratescan have adverse implications for economic and financialstability. We will continue to consult closely on exchangemarkets and cooperate as appropriate.

The G7 statement was a warning to the G20 not to singleout Japan, or even use the phrase currency war, andindeed thats exactly what the G20 did.

There is a certain amount of sympathy for Japans eco-nomic plight more than two decades of deflationaryrecession, punctuated by the occasional short-lived recov-

ery. The trade surplus has gone to a deficit, too. The IMFreports Japanese growth from 1994 to 2003 averaged amere 0.9%, or about one-third the growth rate of advancedcountries and that includes occasional bouts of yenweakness of more than 10% in 1996-1997 and 2000-2001.One analyst estimates a 10% drop in the yen will producea 0.6% gain in GDP if it can be sustained.

Economists admit they dont have any policy prescrip-tion other than QE and stimulus spending. If it devaluesthe currency, so be it. One idea still floating around withinthe Japanese government is that it buy foreign bondsas well as its own JGBs. Surely buying foreign govern-ment bonds would violate the G7 commitment to seekingdomestic objectives using domestic instruments andmay yet cause some fireworks.

Japan dodged the bullet this time but no one has any

doubt if sentiment were to come down on the side of QEand stimulus failing (as it has done before), this time theyen will be restrained from returning to too-strong levels,presumably by outright intervention. After all, theres alimit to how much words can achieve alone, isnt there?

Words count

Floating currency countries cannot arbitrarily decreedevaluation, but words count. A phrase may not be anactual command, but it can still have the same effect. TheFX market responds instantly to comments like the onefrom Japanese Finance Minister Akira Amari that, golly,

FIGURE 2: USD/JPY (BLACK) VS. THE NIKKEI STOCK INDEX

The stock market-currency relationship between the Nikkei and the Japanese

yen is a tribute to the export orientation of big Japanese companies. Generally,

the Nikkei rises in step with the dollar/yen rate.

2011 Apr May Jun Jul Aug Sep Oct Nov Dec 2012 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2013 Feb M

4.04.55.05.56.0

6.57.07.58.08.59.09.50.00.51.01.52.02.53.03.54.04.55.05.56.06.57.07.58.08.59.09.50.00.51.01.52.02.53.03.54.04.55.05.56.0

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7/27/2019 Ctm 201303


ON THE MONEY

he hadnt expected the yen to move so far, so fast. Yenshorts covered, only to restore the position the next daywhen a different comment was published. The CFTCCommitments of Traders Report shows speculativeaccounts had a net yen short position of 65,891 contracts asof Feb. 19, from 61,306 contracts the week before. Tradershad a bigger short position on the Dec. 11 report, 94,401contracts. This was the biggest number since 188,077 con-tracts on June 26, 2007. The implication is there are plentyof fence-sitters waiting to short the yen if this move turnsout to be more than a flash in the pan.

Japan is not the only country to speak out about cur-rency levels. Bank of England Governor Mervyn Kingrecently said real recovery would be much aided by aweaker pound. French Finance Minister Pierre Moscovicicalled for an ECB exchange rate policy, and President

Francois Hollande, evidently jealous of Japans success,demanded coordinated action to push the Euro lower so itbetter represented fundamental values. Bundesbank chiefJens Weidmann shot back within hours that exchange-rate policy to specifically weaken the Euro would lead tohigher inflation in the end. He also said the ECB wouldnot consider a rising Euro alone in considering a rate cut.Besides, calling for exchange rate system changes simplydiverts attention from the need to make their economiesmore competitive. Only governments can solve theseproblems, the central banks cannot. In this respect, thediscussion about a supposed overvaluation of the Euros

exchange rate simply deviates from the real challenges.Austrian Finance Minister Maria Fekter agrees with

Weidmann. Eurogroup chief Jean-Claude Juncker saidEurope must not be nave on currencies. Even thepresident of the Swiss National Bank which set a capfor the Swiss franc in the Euro-Swiss cross and intervenedto get it, denies a currency war, saying central banksmonetary policies are internal programs. And ECB chiefMario Draghi denounced chatter about currency warsas either inappropriate or fruitless, in all cases self-defeat-ing. Effective exchange rates are near their long-termaverages and besides, Draghi says, The exchange rate isnot a policy target but important for growth and price sta-bility.

Draghi seemingly used a little currency war rhetorichimself when he added the ECB would still have to assess

the economic impact of the Euros strength, and he is con-cerned a stronger Euro will be a drag on growth and maycause inflation to drop too far, i.e., deflation. The Euro fell120 points in under an hour. The charitable interpretationof Draghis drag remark is that he couldnt resist beingan economist. At the time, the remark made him appeartwo-faced and, at a guess, he wont do it again.

The Australian dollar gyrated up and down in a widerange (1.0222 to 1.0375) during February on commentsalmost every day about whether the Reserve Bank will cutrates to tame the AUD (Figure 3). Reserve Bank GovernorGlenn Stevens said the Australian dollar remains stronger

FIGURE 3: AUD/USD WIDE RANGE, HIGH VOLATILITY

The Australian dollar swung in a wide range in February on virtually daily

comments about whether the Reserve Bank will cut rates to tame the

currency.

013

7 14 21 28 4

February

11 18 25 4

March

11.011.01.01.0

1.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.01.0

1.01.01.01.01.01.01.01.01.0

7/27/2019 Ctm 201303


than expected and a relevant factor in setting interest rates:As we have noted repeatedly, the exchange rate remainssomewhat higher than one might have expected given thedecline in export prices so far observed. This has been arelevant factor in the setting of interest rates. A cut in therate would not be aimed at achieving a particular responsein the exchange rate, but rates are being set with a recog-nition of the exchange rates effect on the economy.

Also, New Zealand central bank Governor Graeme

Wheeler said, The kiwi is not a one-way bet. Speakingto a conference, he said he was prepared to intervene toinfluence the kiwi. The NZD fell 1% in response. Othercountries are making grumbling noises, too SouthKorea, Taiwan, even Norway, which maychooseto cutinterest rates to counter the krones strength. Centralbankers in the Philippines and Indonesia have spoken outabout policy changes to address currency levels.

The Japanese are now refraining from mentioning theyen in the same breath as comments about stimulatingthe economy, but other countries are blatantly referenc-ing their currencies when they speak of interest ratepolicy. Australia and New Zealand are the latest cases, butSwitzerland and Norway deserve mention, too. This is afar cry from the G7 statement and G20s acquiescence. In anutshell, plenty of countries are, indeed, engaging in influ-encing currency markets.

Newcomers to the FX market may not know it, but thisis an unwelcome return to conditions during the 1970s and1980s when comments from officials and summits were themain fodder for traders to choose positions. For example,after Black Monday in 1987, the G7 issued a communiquon Dec. 23 (called the Christmas Communiqu), sayinga further decline in the dollar would be counterproductive.As usual, the G7 was a day late and a dollar short. (Black

Monday was Oct. 19 so the Christmas Communiqu wasabout two months late.) To read the early history of theFX market, replete with hundreds of interventions andmarket-moving comments and communiqus, check outVolcker and Gyohten, Changing Fortunes, 1992.

We dont know when, exactly, keeping quiet about FXbecame the norm. We think it was Treasury SecretaryRubin during the Clinton Administration, circa 1995,who declined to say anything other than the now-famousRubin mantra a strong dollar is in the U.S. best interests.Whoever started it, we do know who put the final nail inthe coffin of officials making FX comments it was the

first ECB chief Wim Duisenberg, who misspoke so oftenduring the first year after the Euro launch (1999) thatsilence on FX matters became the preferred stance.

Increasing numbers of comments about currency levelsfrom top officials seem to back up the idea that govern-ments are deliberately trying to manipulate currencieswith rhetoric and the occasional interest rate change. Butnot a single country has proposed an actual trade war inthe form of the hard actions tariffs, quotas, and sub-

sidies. The real trade war participant, China, is actuallyrelaxing its measures.So far the currency war is just hot air. Moreover, G7 and

G20 are blowing smoke, too. Their communiqus donteven mention trade and focus instead on the intent ofinterest rate policy as directed solely to the domestic econ-omy. This is a feint. G7 and G20 seem to be hoping that bydefending a sovereigns right to manage its own economy,nobody will notice the real implications of currency war that its really trade war.

The Fed and the ECB are not part of the currency wargang, but with so many other countries engaged in curren-cy war talk, this is going unnoticed. But we should notice;it implies that unless someone escalates to real trade warmeasures, this currency war talk will fizzle just like it didin 2011. The odd part is that no country ever depreciatedits way to prosperity and we all know that. Small advan-tages from higher exports get dissipated and even over-whelmed by other effects, such as imported inflation orglobal investors fleeing your equity market.

The current spate of comments from finance ministersand central bankers is a symptom of lack of disciplineamong top officials and an absence of leadership fromthe U.S. or the G7. We need somebody important to standup and call a halt to it, whereupon we can all go back to

second-guessing central bank intentions. The obvious can-didate is new Treasury Secretary Jack Lew, but he is a bud-get expert rather than an international markets guy, and helacks the stature Rubin brought to the job on day one.

Who will save us from currency war officials? We pro-pose Bernanke and Draghi have tea and issue an ultima-tum.y

Barbara Rockefeller (www.rts-forex.com) is an internationaleconomist with a focus on foreign exchange, and the author of thenew book The Foreign Exchange Matrix (Harriman House).For more information on the author, see p. 4.

7/27/2019 Ctm 201303

18/3118 October2010CURRENCY TRADER18 March2013CURRENCY TRADER

The U.S. dollar index (DXY) rallied around 4.5% between

the first day of February and the first day of March, post-

ing four consecutive weeks of higher highs and closes.

The run-up swept the short-side implications of the

20-day low breakdown analysis featured in last months

Spot Check out the window. (The article also included

analysis of DXYs behavior after new 20-week lows; the

market failed to trade below its September 2012 low and

trigger that signal, however.)

Feb. 1, in fact, turned out to be the low of the early-

2013 down swing, marking just two days of downside

follow-through after making a new 20-day low on Jan.

30. By Feb. 18, DXY had swung far enough to the upside

to establish a 20-day high, and two days later on Feb. 20

it made a new 63-day (three-month) high the first of

several over the next couple of weeks.

Figure 1 highlights the 12 most recent instances offour-week runs of higher highs and higher closes, the last

one occurring the week ending March 1. The examples

date back to 2005; there have been a total of 55 four-week

(or longer) runs since March 1973. Of the 11 previous

instances in Figure 1, all were followed by a lower close

the following week, seven were followed immediately by

two- to four-week down moves, a couple were followed

by declines two or three weeks later, and only a couple

others (the most notable occurring in Q3 2009) were fol-

lowed by significant upswings.

SPOT CHECK

Dollar danceA markets phase will dictate the performance of a price

pattern. What mode is the dollar currently in?

BY CURRENCY TRADER STAFF

FIGURE 1: DXY FOUR-WEEK RUNS, 2005-MARCH 2013

Most of the instances of four consecutive weeks of higher

highs and closes during this period were followed by bearish

price action.

FIGURE 2: WEEKLY PATTERN PERFORMANCE,2005-MARCH 2013

Performance after the four-week runs was a little more

bearish than the market benchmark in the first three weeks.

7/27/2019 Ctm 201303


Ignoring for a moment the fact there were only 11

examples in the past eight years, Figure 2 shows the

performance after these four-week higher-high, higher-

close (HH/HC). The blue lines represent the average andmedian moves from the close of the final week of the pat-

tern to the closes of the subsequent 12 weeks; the red lines

represent the average and median performance for all one-

to 12-week moves during the analysis period, and reveal

DXYs downside bias during this period. The performance

after four-week runs was a little more bearish than the

market benchmark in the first three weeks, peaked (some-

times above the benchmark) into week 7, and then turned

back down.

Overall and especially given the performance after

the most recent examples in Figure 1, and the fact thatall examples were followed by a lower close the follow-

ing week a trader might be tempted to look for selling

opportunities after four-week runs of higher highs and

higher closes. However, Figure 3 shows the performance

after all 54 previous examples dating back to 1973. Even

though it incorporates the marginally bearish data from

Figure 2, here the post-pattern performance is unambigu-

ously bullish, with positive average and median returns at

all intervals.

The big difference between the two data sets is that DXY

has been dominated by a general downtrend and consoli-

dation (with some sharp counter-rallies in 2008 and 2010)

since 2002. The preceding period included the dollars

monster rally from 1980 to 1985 and the somewhat smaller

uptrend from 1995 to 2002 periods during which four

weeks of consecutive higher highs and higher closes were

more often than not followed by additional up weeks.

Faced only with this conflicting information a long-

term history that implies upside follow-through and the

most recent data suggesting the possibility of weakness

what would a trader do?

The daily time frame: Three-month highsFigure 4 shows DXYs performance from March 1973 to

March 2013 in the 12 days after making new 63-day highs.

The dollar index made a new 63-day high 772 times during

this period, prior to the six most recent instances shown in

Figure 5.

Figure 4 suggests, other factors notwithstanding, expect-

ing DXY to continue to rally after making a new 63-day

high was a good bet. The percentage of higher closes was

lowest (at around 53%) at day 2 and climbed to 58-59% at

FIGURE 3: WEEKLY PATTERN PERFORMANCE,1973-2013

The price action after all 54 examples of the pattern is clearly

bullish, with positive average and median returns at all

intervals.

FIGURE 4: AFTER 63-DAY HIGHS, 1973-2013

Overall, DXY continued to rally after making a new 63-day

high.

FIGURE 5: RECENT 63-DAY HIGHS

The upside follow through after the initial 63-day highs

shown here is in keeping with the signals statistics over the

past 40 years.continued on p. 25
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TRADING STRATEGIESADVANCED CONCEPTS

Certain acts define desperation. These include cubicle-

dwellers self-identifying as contrarian, paying tuition for

a course on entrepreneurship, subscribing to any diet plan

and, of course, repeating any management buzz-phrase

such as thinking outside of the box. When you hear the

latter term, replace it with thinking with a childs natural

curiosity and be done with it.

Lets take the subject of a currency union, please. Having

witnessed the construction of the Berlin

Wall and its toppling a mere 28 years

later, I wonder if the Euro will endure for

longer than that tribute to human oppres-sion. You can conceive of the Euro as a

single entity or you can think of it as a

set of fixed exchange rates between all

of its members. As there are 17 members

of the Eurozone in early March 2013, the

Euro actually converts 136 currency pairs

[(172 17)/2] into a set of 17 national cur-

rencies trading at fixed rates to each other

and at a floating rate to the rest of the

world. This type of network economics

is why centralized nodes, including stockand commodity exchanges, have such cost

efficiency in sharing information.

Two asides are in order: While the

United Nations, an organization never

known as a bastion of efficiency in any-

thing, settled on a small set of official

languages (just six at last count), the

European Union insists on simultaneous

translations into all member languages

during its proceedings; this may strike

notoriously mono-lingual Americans who

The interest rate price of acurrency union

Until it abandons its separate national histories and adopts a common fiscal policy,

the Eurozone will suffer the consequences of its fundamental contradiction.

BY HOWARD L. SIMONS

Portugal, Spain, and Italy have the flattest yield curves, while stronger credits

such as Germany, Finland, and the Netherlands have the steepest.

FIGURE 1: GLOBAL CURRENCY SWAP EXPANSION STEEPENEDYIELD CURVES

Nov-11

Dec-11

Jan-12

Feb-12

Mar-12

Apr-12

May-12

Jun-12

Jul-12

Aug-12

Sep-12

Oct-12

Portugal

Italy

Spain

Belgium

France

Austria

Netherlands

Finland

Germany

0.90

0.93

0.95

0.98

1.00

1.03

1.05

1.08

1.10

1.13

1.15

1.18

1.20

1.23

1.25

1.28

ForwardRateRatio,

2-10Years

7/27/2019 Ctm 201303


are impressed with Europeans multilin-

gual skills as unnecessary, and it certainly

is cumbersome. The second is the move

to the Euro was devastating to the large

population of oddball currency tradersat European banks and money-changers:

Some people actually made their living

trading the Finnish markka against the

Portuguese escudo, or some-such, regard-

less of its general flouting of the principles

of economic utility.

But there is a significant downside to

fixing currency rates, and that is a country

can fix its short-term interest rates or it

can fix its currency exchange rates, but it

cannot fix both simultaneously. Thus, ifGreece, just to take the prime example of

the whole 2009-2012 European sovereign-

debt mess, has a de facto fixed exchange

rate against Germany, all macroeco-

nomic adjustments have to be achieved

through higher short-term interest rates as

opposed to a combination of higher short-

term interest rates and a weaker currency.

Consequences of the fix

Accordingly, we should expect the weakercredits within the Eurozone to have

higher short-term interest rates and flatter

yield curves than they would have other-

wise, and the stronger credits within the

Eurozone to have lower short-term inter-

est rates and a steeper yield curve than

they would have otherwise.

A second consequence is the interest

rate distortion makes the common cur-

rency weaker than it would be otherwise

for the stronger credits and stronger than

Here, and in Figures 4-8, the FRR2,10tends to lead two-year zero-coupon

implied volatility by 13 weeks. These charts show how the one variable

allowed to operate in a currency union, short-term interest rates, drives

volatility and the cost of insuring financial risk.

FIGURE 3: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: PORTUGAL

60%

65%

70%

75%

80%

85%

90%

95%

100%

105%

110%

115%

120%

125%

130%

0.80

0.82

0.84

0.86

0.88

0.90

0.92

0.94

0.96

0.98

1.00

1.02

1.04

1.06

1.08

1.10

1.12

1.14

May-10

Jul-10

Sep-10

Nov-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13

Two-YearZero-CouponVolatilityLed13Weeks

Forwar

dRateRatio,

2-10Years

Yield Curve

Volatility

The flood of money into the short-term paper of the higher-quality credits, such

as Germany, drove volatility higher.

FIGURE 2: TWO-YEAR ZERO-COUPON IMPLIED VOLATILITY SINCENOV. 30, 2011

Ireland

Portugal

Belgium

Austria

Netherlands

Germany

10%

100%

Nov-11

Dec-11

Jan-12

Feb-12

Mar-12

Apr-12

May-12

Jun-12

Jul-12

Aug-12

Sep-12

Oct-12

ImpliedVolatility

7/27/2019 Ctm 201303

22/31

ON THE MONEY


ADVANCED CONCEPTS

it would be otherwise for the weaker

credits.

The third consequence is a bit stranger.The implied volatility of any short-term

interest rate viewed as artificially low and

at the anchor end of a yield curve steeper

than it would be otherwise rises. The

reason is devilishly simple: The market

knows once the suppression of short-term

interest rates ends, those yields will snap

higher and flatten the yield curve in con-

sequence.

If we sum these effects, we see lose-lose

propositions all the way around: Weakercredits have to struggle with higher

short-term interest rates and a stronger

currency, while stronger credits have to

deal with higher implied volatility and a

steeper yield curve. As improperly val-

ued currencies affect all segments of an

economy, and as interest rates equilibrate

current and future consumption, the

mechanics of a currency bloc create a large

and differing number and distribution of

winners and losers in its member states asthe price of avoiding those extra trading

pairs.

Two measures over time

Lets illustrate the distortions of the

Eurozone currency bloc across two dimen-

sions. The first is the sovereign yield

curve as measured by the forward rate

ratio between two and 10 years (FRR2,10).

This is the rate at which borrowing can

be locked in for eight years starting two

FIGURE 5: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: ITALY

39%

45%

51%

57%

63%

69%

75%

81%

87%

93%

0.98

0.99

1.00

1.01

1.02

1.03

1.04

1.05

1.06

1.07

1.08

1.09

1.10

1.11

1.12

1.13

1.14

1.15

1.16

1.17

May-10

Jul-10

Sep-10

Nov-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13

Two-YearZe

ro-CouponVolatilityLed13Weeks

ForwardRateRatio,

2-10

Years

Yield Curve

Volatility

FIGURE 4: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: SPAIN

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

1.02

1.03

1.04

1.05

1.06

1.07

1.08

1.09

1.10

1.11

1.12

1.13

1.14

1.15

May-10

Jul-10

Sep-10

Nov-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13


ForwardRateRatio,

2-10Years

Yield Curve

Volatility
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7/27/2019 Ctm 201303


years from now, divided by the 10-year

rate itself. The more this ratio exceeds

1.00, the steeper the yield curve is. (As an

aside, neither the Greek FRR2,10, nor theIrish FRR2,10 are shown. Greece defaulted

in March 2012 and restructured; Ireland

similarly stopped issuing 10-year notes.

Both yield curves had moved into and out

of inversion. The second dimension is the

implied volatility of two-year zero-coupon

sovereign debt.)

How have these measures traded since

the expansion of currency swaps into the

Eurozone at the end of November 2011?

First, the weakest remaining member ofthe former PIIGS quintet, Portugal, was

the last country to have an inverted yield

curve (Figure 1). However, Portugal,

Spain, and Italy have the flattest yield

curves, while stronger credits such as

Germany, Finland, and the Netherlands

have the steepest yield curves.

Next, the picture for two-year zero-

coupon implied volatility is as expected

as well (Figure 2). The weaker credits

(Greece after its March 2012 restructur-ing excepted) have the lowest volatility

for the counterintuitive reason the market

does not consider them accidents waiting

to happen. The flood of money into the

short-term paper of the higher-quality

credits, such as Germany, drove volatility

higher, with deleterious consequences for

insuring against interest rate volatility.

National histories

Now lets step back and look at the select-

FIGURE 7: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: NETHERLANDS

FIGURE 6: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: GERMANY

60%

110%

160%

210%

260%

310%

360%

410%

460%

510%

560%

610%

660%

710%

1.10

1.11

1.12

1.13

1.14

1.15

1.16

1.17

1.18

1.19

1.20

1.21

1.22

1.23

1.24

1.25

1.26

1.27

1.28

May-10

Jul-10

Sep-10

Nov-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13


ForwardRateRatio,

2-10Years

Yield Curve

Volatility

50%

75%

100%

125%

150%

175%

200%

225%

250%

275%

300%

325%

350%

375%

1.115

1.125

1.135

1.145

1.155

1.165

1.175

1.185

1.195

1.205

1.215

1.225

1.235

1.245

1.255

1.265

May-10

Jul-10

Sep-10

Nov-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13

Two-YearZer

o-CouponVolatilityLed13Weeks

ForwardRateRatio,

2-10

Years

Yield Curve

Volatility

7/27/2019 Ctm 201303

24/31

ON THE MONEY


ADVANCED CONCEPTS

ed paths of various strong

and weak credits. TheFRR2,10 tends to lead two-

year zero-coupon implied

volatility across a number

of markets by 13 weeks,

or one calendar quarter.

This is consistent with the

quarterly expiration and

debt issuance cycles in

many countries. These are

presented in Figures 3-8

without further commentas they show us how the one variable allowed to operate

in a currency union short-term interest rates drives

volatility and the cost of insuring financial risk.

Kick that bloc

As Keynes noted famously, The ideas of economists

and political philosophers, both when they are right and

when they are wrong, are more powerful than is com-

monly understood. Indeed the world is ruled by little else.

Practical men, who believe themselves to be quite exempt

from any intellectual influence, are usually the slaves of

some defunct economist.

The world of currencytrading has been driven by

the ideas of several Nobel

laureates, including Milton

Friedman, who espoused

floating exchange rates as a

way of getting to self-correct-

ing current account balances,

and Robert Mundell, the real

architect of the Euro.

Both floating exchange

rates and the Euro weredesigned to replace existing regimes found wanting and

in perpetual crisis mode, and both went on to create their

own rolling and somewhat quasi-permanent crises. Until

the Eurozone both abandons its separate national histories

and adopts a common fiscal policy, it will suffer at the

interest rate cost defined by its internally fixed exchange

rates. That is quite simply a given.y

Howard Simons is president of Rosewood Trading Inc. and astrategist for Bianco Research.For more information on theauthor, see p. 4.

FIGURE 8: EUROZONE COUPON YIELD CURVE AND TWO-YEARSOVEREIGN VOLATILITY: FINLAND

40%

80%

120%

160%

200%

240%

280%

320%

360%

400%

440%

1.115

1.125

1.135

1.145

1.155

1.165

1.175

1.185

1.195

1.205

1.215

1.225

1.235

1.245

1.255

1.265

May-10

Jul-10

Sep-10

Nov-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13

Two-YearZero-CouponVolatility

Led13Weeks

ForwardRateRatio,

2-10Years

Yield Curve

Volatility

A country can fix itsshort-term interest rates or

it can fix its currency

exchange rates, but it cannot

fix both simultaneously.

7/27/2019 Ctm 201303


days 10-12.

Figure 6, however, shows the DXYs performance

after the 349 instances of 63-day highs that took place

the most recent 20 years, March 1993 to Feb. 19, 2013

(again, prior to the examples shown in Figure 5). Now

the post-pattern performance looks more bearish,

although until day 10 it was mostly a more volatile

version of the DXYs downside bias; it was only at day

11 that the post-pattern performance was clearly more

negative than the benchmark performance.

The same phenomenon apparent in the weeklyanalysis is evident here: The patterns performance is

notably determined by the markets mode or trend at

the time. When DXY is trending higher, a four-week

run of higher highs and higher closes or a new 63-day

high presages additional buying; when DXY is in a

downtrend, these patterns both tend to be signs of

exhaustion.

Figures 7 and 8 provide some final perspective on

this dichotomy: The former shows the 1985 to March

1993 performance after 63-day highs that closed within

0.06 of the days high (as was the case on March 1,2013), while the latter shows this patterns perfor-

mance from March 1993 to March 2013. The difference

between the two is more extreme than in previous

examples: The bullish trajectory in Figure 7 is strong

than that in Figure 4, while Figure 8 is more clearly

bearish than Figure 6.

Right here, right now

As of March 4, the dollar index had rallied to nearly

82.50 and was poised to challenge the resistance of

its 2012 high around 84 (refer to Figure 1). The ques-tion is, does the recent run mean the dollar is in a new

uptrend, or is the prevailing environment still side-

ways/down, which would imply selling into strength

will offer a chance to profit on a pullback? DXY cer-

tainly rallied smartly off the support zone defined in

the final four months of last year, which was discussed

at length last month. But on a longer-term basis, the

DXY has been trendless for the better part of four

years.

The Forex Trade Journaldetails a trade based par-

tially on this analysis.y

SPOT CHECK

FIGURE 6: AFTER 63-DAY HIGHS, 1993-2013

Instances of 63-day highs that took place between March

1993 and Feb. 19, 2013 were followed by much more

bearish action than that shown in Figure 4.

FIGURE 7: 63-DAY HIGHS W/ HIGH CLOSE, 1985-1993

After 63-day highs that closed strongly (within 0.06 of the

days high), the DXY tended to rally.

FIGURE 8: 63-DAY HIGHS W/ HIGH CLOSE, 1993-2013

Over the past 20 years, strongly closing 63-day highs were

followed by more selling than buying.

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CPI: Consumer price index

ECB: European Central Bank

FDD(rstdeliveryday):Therst

day on which delivery of a com-modityinfulllmentofafutures

contract can take place.

FND(rstnoticeday):Also

knownasrstintentday,thisis

therstdayonwhichaclear-nghouse can give notice to abuyer of a futures contract that itntends to deliver a commodity infulllmentofafuturescontract.

The clearinghouse also informsthe seller.

FOMC: Federal Open MarketCommittee

GDP: Gross domestic product

ISM: Institute for supplymanagement

LTD(lasttradingday):Thenal

day trading can take place in a

futures or options contract.

PMI: Purchasing managers index

PPI: Producer price index

Economic Releaserelease(U.S.) time(ET)

GDP 8:30 a.m.

CPI 8:30 a.m.

ECI 8:30 a.m.

PPI 8:30 a.m.

SM 10:00 a.m.

Unemployment 8:30 a.m.

Personal income 8:30 a.m.

Durable goods 8:30 a.m.Retail sales 8:30 a.m.

Trade balance 8:30 a.m.

Leading indicators 10:00 a.m.

GLOBAL ECONOMIC CALENDAR

March

1

U.S.: February ISM manufacturingreportBrazil: Q4 GDPCanada: Q4 GDPJapan: January employment reportand CPI

23

4

5

6

U.S.: Fed beige bookAustralia: Q4 GDPBrazil: February PPICanada: Bank of Canada interest-rate announcement

7

U.S.: January trade balanceFrance: Q4 employment report

Japan: Bank of Japan interest-rateannouncementMexico: February PPI and Feb. 28CPIUK: Bank of England interest-rateannouncementECB: Governing council interest-rateannouncement

8

U.S.: February employment reportBrazil: February CPICanada: February employmentreportLTD:

March forex options; MarchU.S.dollarindexoptions(ICE)

9

10

11

12Germany: February CPIJapan: February PPI

13U.S.: February retail salesFrance: February CPI

14

U.S.: February PPIAustralia: February employmentreportHong Kong: Q4 PPIIndia: February PPI

15 U.S.: February CPI

16

17

18Hong Kong: December-Februaryemployment reportLTD: March forex futures

19

U.S.:

Documents

Ctm 201303