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July 2013

Volume 10, No. 7

Strategies, analysis, and news for FX traders

TAKING STOCK OF THE DOLLAR/YEN CORRECTION P. 18

The dollar in the

catbird seat? p. 6

Minor currenciesand the

LIBOR kerfufe p. 26

Market turning points

and overreactions p. 1

Gauging the qualityof your

trading system p. 20

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2/362 July2013CURRENCY TRADER

CONTENTS

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

Global Markets

Dollar bull back into gear,

courtesy of the Fed .....................................6After a spring setback, the U.S. dollar appears

to have the wind at its back, thanks in large part

to one word tapering.

By Currency Trader Staff

On the Money

Overshooting the tipping points ............12

The Fed knew ending quantitative easing would

prick various market bubbles, but it seems to

have underestimated the extent and speed of

the reaction.

By Barbara Rockefeller

Spot Check

Dollar/yen.................................................. 18

History would argue favoring the short side in

the dollar/yen pair, but the recent correction

could be a pullback opportunity for longs.

By Currency Trader Staff

Trading Strategies

Measuring system quality

with Ideal R .............................................20

Calculating regressions on rolling time periods

of an equity curve provides a more accurate

understanding of a trading systems value.

ByDaniel Fernandez

Advanced ConceptsMinor currencies less affected by

great LIBOR kerfufe............................... 26

Why minor currencies were ahead

of their time and didnt know it.

By Howard L. Simons

Global Economic Calendar ........................32

Important dates for currency traders.

Events .......................................................32

Conferences, seminars, and other events.

Currency Futures Snapshot.................33

BarclayHedge Rankings........................33

Top-ranked managed money programs.

International Markets............................ 34

Numbers from the global forex, stock, and

interest-rate markets.

Looking for an

advertiser?Click on the company

name for a direct link to the

ad in this months issue.

Ablesys

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Questions or comments?Submit editorial queries or comments to

[email protected]
mailto:[email protected]:[email protected]://www.fxcm.com/ninja

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http://www.fxcm.com/ninja

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CONTRIBUTORS

4 July2013CURRENCY 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]

Classied ad sales: Mark Seger

[email protected]

Volume 10, Issue 7. Currency Traderis 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 Tradermagazine 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 frequentlyon a wide range of economic and nancial

market issues.

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

international economist with a focus on foreign exchange.She has worked as a forecaster, trader, and consultant at

Citibank and other nancial institutions, and currentlypublishes two daily reports on foreign exchange. Rockefel-

ler is the author ofTechnical Analysis for Dummies, SecondEdition (Wiley, 2011), 24/7 Trading Around the Clock, Around

the World (John Wiley & Sons, 2000), The Global Trader(John Wiley & Sons, 2001), The Foreign Exchange Matrix

(Harriman House, 2013), 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 ofdirectors of a large European hedge fund.

qDaniel Fernandezis an active trader

with a strong interest in calculus, statistics,and economics who has been focusing

on the analysis of forex trading strate-

gies, particularly algorithmic trading andthe mathematical evaluation of long-termsystem protability. For the past two years

he has published his research and opinions on his blogReviewing Everything Forex, which also includes re-

views of commercial and free trading systems and generalinterest articles on forex trading (http://mechanicalforex.

com). Fernandez is a graduate of the National Universityof Colombia, where he majored in chemistry, concentrating

in computational chemistry. He can be reached at [email protected].
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.rts-forex.com/http://mechanicalforex.com/http://mechanicalforex.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]://mechanicalforex.com/http://mechanicalforex.com/http://www.rts-forex.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]

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GLOBAL MARKETS

Despite a correction in late May and early June, the U.S.dollar (USD) was still up on the year vs. a variety of majorand emerging-market currencies at the beginning of July,and many analysts expect the overall appreciation trendto continue in the second half of 2013 (Figure 1). The dol-lar was little changed vs. the Euro (EUR), but scanninga range of global currencies shows the buck was much

more a winner than a loser in the first half of the year. Asof late June the U.S. dollar had gained nearly 13% vs. the

Japanese yen (JPY) and the Australian dollar (AUD), andmore than 5% vs. the Canadian dollar (CAD) and theBritish pound (GBP).

The U.S. Federal Reserves recent hints about the taper-ing of quantitative easing, or a reduction in the amount ofmonthly asset purchases it is currently making to stimulatethe U.S. economy, reinvigorated dollar bulls. Also, mod-

erate improvement in the U.S. economy could make thegreenback the least ugly in a currency beauty contest

among major industrialized economies.Lets first look at the immediate, and dramatic,

effects of the Federal Reserves recent commentsregarding tapering its asset-buying program.

The Fed speaks

When asked to pinpoint key U.S. dollar driversin the months to come, Alvise Marino, foreignexchange strategist at Credit Suisse, says the Fedis the main one. The Fed is turning tighter, while

other central banks are steady or turning easier,he says.

At its June 19 policy meeting, Fed officials stat-ed the downside risks to the economy had dimin-ished in recent months, and in Federal Reservechairman Ben Bernankes June 19 press confer-ence, he suggested if the current Fed economicprojections pan out, the asset purchases will con-clude by mid-2014.

The U.S. dollar rallied in the wake of the meet-ing as Fed officials indicated a cutback in theFeds current $85 billion per month of asset pur-

Dollar bull back into gear,courtesy of the Fed

After a spring setback, the U.S. dollar appears to have the wind at

its back, thanks in large part to one word tapering.

BY CURRENCY TRADER STAFF

FIGURE 1: RESURGENT DOLLAR

After a sharp May-June correction, the U.S. dollar turned higher

again on June 19 when the Fed discussed the eventual wind-down

of its quantitative easing program.

Source for all figures: TradeStation

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7/36CURRENCY TRADERJuly2013

chases could come sooner than expected. While it is by nomeans a tightening of U.S. Federal Reserve policy, sucha tapering would mark the beginning of the end for theultra-loose approach to monetary policy in recent years.

Forecasts of when tapering might begin vary widely from the July 30-31 FOMC meeting to as late as Decemberand even into 2014 if economic conditions deteriorate

again. Markets will be finely tuned to labor market andinflation data, and will likely gyrate as tapering expecta-tions shift.

In a June 19 research note, Credit Suisse analysts wrotethey had been looking for the first cutback in the monthlyasset purchase pace in September, but after the Fedsannouncement they decided the July 30-31 FOMC meetingwas now a possibility, so long as labor market data do notdeteriorate and inflation expectations hold near their new,lower levels.

Bob Lynch, head of G-10 FX strategy Americas HSBC,notes that even though the Fed might not taper until the

end of the year, that doesnt mean the markets wont reactsooner. Even just the expectation that it is coming is hav-ing an impact on our markets, he says.

Economic improvement

Another factor that could support U.S. dollar bullishnessin the second half of the year is continuing improvementin the U.S. economy a prerequisite for the U.S. FederalReserve to begin reducing its monthly asset purchases.

Even amid the twin fiscal shocks of fiscal-cliff squab-bling and sequestration, the worlds biggest economyhas been surprisingly resilient, wrote Beth Ann Bovino,

deputy chief economist at Standard & Poors in a June 21research note. In the first quarter, consumers have spentat the fastest pace in two years. Additionally, the hous-ing market continues to improve, and although businessinvestment has slowed, managers are still hiring. Sheexpects Fed tapering to begin in December.

Recent U.S. jobs data has shown a stable labor market,

but not necessarily a strongly growing one. In May, non-farm payrolls rose by 175,000, following Aprils 149,000increase. The unemployment rate stood at 7.6% in May.The Fed has pointed to a 6.5% unemployment rate as a keythreshold for raising its benchmark lending rate, the Fedfunds rate. Thats a separate issue, however, from a taper-ing of the monthly asset purchases, which is expected tobegin well before a rate hike.

Despite some stumbles, such as the downward revisionof Q1 GDP on June 26, most analysts seem to think theeconomy is growing, if not briskly.

We do think the U.S. recovery is gaining traction, says

Jeet Dutta, senior economist at Moodys Analytics. So farthis year data has surprised on the upside. We expectedsequestration to take a heavier toll, although we still thinkthe worst could be ahead when we see the [government]furloughs. Overall, Moodys Analytics forecasts 2013 U.S.GDP around 2%.

Currently, though, Dutta says the private sector is strongenough to handle these fiscal blows. If this trend can holdup for a few more months, by year-end and into next year,things will look a whole lot better, he says. Dutta addsthat sequestration represented a roughly 1.5% hit on theeconomy this year and estimates if the federal government

Analyst estimates of when the tapering

process will begin range from as soon

as the July 30-31 FOMC meeting to as

late as 2014, if economic conditions

deteriorate again.

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GLOBAL MARKETS

had kept spending steady, GDP growth for 2013 would bearound 3.5%. Moodys is forecasting 2014 U.S. GDP at 3.5%and 2015 at 4%. In the meantime, Dutta thinks consumerswill do their part to fuel the economic flames.

Overall, many of the excesses of the Great Recessionare slowly healing, he says. A lot of consumers bal-ance sheets are [improved], and they are in better shape to

spend more. There is a lot of pent-up demand, especiallyfor autos, which will keep auto purchases at a healthypace for the next year, and there are many other categorieswhere consumers simply need to replace. Finally, housingwill be more and more of a positive factor.

The Fed, Dutta argues, is more or less correct in read-ing the latest numbers and concluding the recovery is onmore steady footing. It is proving more sturdy than mostpeople thought, he says.

In contrast, Jay Bryson, global economist at Wells Fargo,weighs in on a more cautionary note. We dont think theeconomy will go back into recession, but we dont look for

a big breakout, he says. We are still forecasting 2-2.5%over the next few quarters.According to Bryson, there are some persistent uncer-

tainties with the potential to hamstring growth. There isprobably still some deleveraging that needs to occur withconsumers, he says. House prices still havent recovered people dont feel as wealthy as they once did. There arestill some uncertainties for businesses, and the [long-term]fiscal situation is not settled by any stretch of the imagina-tion.

Treasury yields

Another dollar-supportive factor is rising U.S. Treasuryyields. Ten-year T-note yields had already been climbingsteadily since early May when they received a big boostfrom the Feds June 19 announcement. After being aslow as 1.61% as recently as early May, the 10-year yieldclimbed from 2.15% to 2.65% between June 19 and June25. The change corresponded into a sharp jump in 30-yearfixed mortgage rates as well.

In general, the rising yield environment is bullish for theU.S. dollar. The higher Treasury yields are helping theU.S. dollar as it attracts some inflow into the U.S., saysCharles St-Arnaud, foreign exchange strategist at Nomura.

Many U.S. investors saw opportunity in Mexico andBrazil. Now that yields are rising in the U.S., they are redo-ing their math and realizing those countries arent as gooda bet from a currency and bond perspective.

However, the rising yield environment has other rami-fications, including a potentially negative impact on thehousing market recovery. A sudden, sharp increase inlong-term rates could potentially discourage home buy-ers, Moodys Dutta notes.

The impact of higher rates wouldnt necessarily be lim-ited to housing prices, either. Weve seen a big back-up

in yields, he Wells Fargos Bryson says. If they continueto move north, that could be a restraining factor [for theeconomy]. His firm expects the U.S. Fed to wait untilDecember to begin tapering.

Fiscal improvement

The U.S. fiscal picture has been improving, if partially bydefault via the sequestration, or automatic spendingcuts that went into place in early 2013. Rising tax revenuesfrom the expiration of the payroll tax cut and other incometax increases have also helped reduce the deficit this year.

Of course, the U.S. still has a large deficit and there

remain long-term issues regarding unsustainable SocialSecurity and Medicare spending, but in the short term,the year-to-date deficit is below that for fiscal year 2012.According to Briefing.com, through May the federal bud-get deficit stood at $626.2 billion, or $218.2 billion less thanfiscal year 2012.

The fiscal backdrop in the U.S. has turned betterbecause of the sequester, says HSBCs Lynch. We stillhave a large deficit, but we are not adding to it at the pacewe had been. To the extent that it [previously] looked asif a continued weak fiscal backdrop could lead to anotherratings downgrade or a threat to the dollars reserve cur-

The U.S. fiscal picture has been

improving, partially by default

because of sequestration.

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9/36CURRENCY TRADERJuly2013 9

rency status, that element seems less problematicfor the dollar.

So what dollar plays look most promising inthe second half of the year?

Currency action

Nomuras St-Arnaud says the dollars gains in

the first half of the year stem from a combinationof dollar-supportive factors and negative coun-try-specific stories.

The yen has new monetary and economicpolicies, which put pressure on the currency,he says. The Australian dollar has seen lowercommodity prices and a central bank that cutrates, and the Canadian dollar has seen economicunderperformance.

Kevin Chau, forex strategist at Ideaglobal,notes the dollar is currently in an enviable bull-ish position. I see the dollar being stronger in

the second half, he says. If the U.S. economyimproves, the dollar wins. If the economy doesntimprove, the dollar wins on safe-haven buying.

According to BNP Paribas forex strategistVassili Serebriakov, the commencement of taper-ing should be quite supportive of the dollar.We prefer to play it vs. other low-yieldingcurrencies, like the Japanese yen and the Swissfranc, he says. We want to be long the dollaragainst currencies with central banks that arelikely to have aggressive monetary policy (Japan)or where they are preventing their currency from

appreciating (Switzerland).Serebriakov adds that his firm likes the generalidea of North America (including the Canadiandollar and Mexican peso) outperforming the yenand Swiss franc. BNP Paribas has a fourth-quar-ter target at 108 for the dollar/yen pair (Figure 2)and $1.03 for dollar/Swiss (Figure 3).

Credit Suisse also forecasts U.S. dollar strengthand yen weakness ahead. We still have the viewthe strategy employed by the Bank of Japan willwork, Credit Suisses Marino says. They pos-sibly could turn more aggressive on the easing

FIGURE 3: DOLLAR/FRANC

The Swiss franc shackled by its central bank is another

candidate for a long-dollar play.

FIGURE 2: A YEN FOR A RALLY

Despite an already robust uptrend, some analysts expect the dollar

to continue to appreciate vs. the yen.

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GLOBAL MARKETS

side. The yen is most disadvantaged [among the majors].Credit Suisse has a 12-month target of 120 in dollar/yen.

Nonetheless, Serebriakov notes that currency marketswill be closely eyeing upcoming U.S. economic data, andthe dollar-bullish plays will need action by the FederalReserve to gain steam. The Fed does need to start taper-ing, he says. This could change if the [economic] num-bers start to change. There are certain elements of the storythat still have to play out.

The Euro

Marino says his Credit Suisse is fairly bullish on the dollaracross the board with the exception of the Euro (Figure4). The firm forecasts the Euro/dollar pair (EUR/USD) at1.3700 by year-end and 1.400 in 12 months. The Euro story,Marino notes, has more than just one theme.

Its a flow story, he says. Europe has a record currentaccount surplus. Also, the market has been very short theEuro the past three years. Now that the tail-risk isnt there

anymore, we are seeing reallocation back to theEuro there is a rebalancing occurring. We areseeing central bank reserve managers who werevery into Australia and Canada now piling backinto the Euro.

The Fed bump

For now, the U.S. dollar appears to have the windat its back, thanks to the U.S. Federal Reserve.Youve got the Fed dialing back on QE while

other central banks are taking measures that willhave the opposite impact on their currencies,HSBCs Lynch says. The Bank of Japan is easing,in May the ECB cut rates, the RBA cut rates, theReserve Bank of New Zealand is intervening tosupport the kiwi, and the Swiss National Bankhas said a floor for Euro/Swiss is still in place.We expect the dollar to do better in the secondhalf.y

The dollars gains in the first half of

the year stem from a combination of

dollar-supportive factors and negative

country-specific factors.

FIGURE 4: THE EURO EXCEPTION

Renewed flows into the long-battered Euro may make it one of the

tougher currencies for the dollar to gain against.

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Victoria Park Plaza, London

17th - 18th September 2013
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12/36

Markets overshoot at policy tipping points, and thatswhat the Fed announcement after the June 19 FOMCmeeting on turned out to be, despite the Feds insistencethat reducing quantitative easing is not a policy changebut rather just easing up on the gas pedal. The bond mar-ket doesnt buy the analogy and sees the Fed hitting thebrakes.

In the first few days after the policy meeting, the yieldon U.S. 10-year notes soared to 2.6% (more than 100 pointshigher than in early May), with yields on all sovereign

notes rising, too the UK, Germany, and peripheralEuropean countries. Stock markets fell. The ShanghaiComposite lost over 5% in a single day, with Chinese equi-ty losses compounded by a central bank-approved liquid-ity crunch. Emerging-market currencies continued to fallas previously yield-hungry carry-trade traders withdrew.The dollar index rallied strongly. Commodities tanked.Volatility in every asset class rose to abnormally high lev-els. As noted before, in times of distress, intermarket cor-relations re-emerge, even if only for a few days.

The question for the FX market is

whether this is an authentic turningpoint that will put the dollar on a sus-tainable long-term uptrend, or if itsjust a flash in the pan stemming fromtemporary insanity. We argue that itsan authentic turning point that willhave long-lasting effects on everymarket, including FX, but just becauseits a historic change doesnt necessar-ily imply anything specific about thefate of the dollar. Yes, so far the dollaris the beneficiary of rising rates, butthe rate differential is not the only dol-

lar determinant.

The Fed vs. the marketWe didnt really hear anything newfrom Federal Reserve chairman BenBernanke at his June 19 press confer-ence, but markets freaked out anyway.The response seems to have been asevere overreaction, with the 10-yearyield rising more than 100 points ina month (Figure 1) and the S&P 500breaking support to the downside in

just the first few days after the policy

On the Money


ON THE MONEY

Overshooting

the tipping pointThe Fed knew ending quantitative easing would prick various market bubbles, but

it seems to have underestimated the extent and speed of the reaction.

BY BARBARA ROCKEFELLER

FIGURE 1: 10-YEAR YIELD INDEX VS. DOLLAR INDEX

The already rising 10-year T-note yield (black) leapt higher after Fed chairman

Ben Bernankes June 19 press conference, while the dollar (green) also turned up.

Source: Chart Metastock; data Reuters and eSignal
http://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 201307


meeting (Figure 2). Its the size of the moves over such ashort period of time that makes them important.

The Fed was hoping futilely, as it turned out themarkets would accept the message in an orderly manner.After all, in May the Fed had given an early warning itwould start talking about tapering QE purchases. In thesix weeks between meetings, the markets were treated to afull analysis of the situation. In the end, the Fed deliveredwhat a plurality of analysts had expected (see The viewfrom the Fed, p. 16). It all seems reasonable and accept-able, especially if we adopt the Feds

new forecasts for the economy.Therein lies the rub. Many forecast-ers do not accept the Feds data fore-casts, claiming the Fed consistentlyoverestimates. The Fed sees growththis year at 2.3% to 2.6%, while privateforecasters have an average of 2.3%,the low end of the Fed range. Youcould argue if the Fed has overesti-mated, it wont begin tapering becauseit wont have the data to back it up,so whats the problem? The answerseems to lie in traders not trusting

the Fed to back off tapering even ifsub-forecast data starts coming in.Another problem is the Fed is will-ing to accept the participation rate,a key context for evaluating unem-ployment data, is now permanentlylower, allowing focus on the joblessrate alone. This smacks of rigging thenumbers. Finally, the Fed didnt offerany magic phrases, like green shootsor Bernankes more recent escapevelocity. The failure to create a catchyphrase at the June meeting is a short-

coming traders love magic phrases.Its hard to tell how much of the markets hysterical over-

reaction to tapering QE was inevitable because its seenas a historic event, and how much may be due to distrustof the Fed. Its never a good thing when markets broadlydemonstrate lack of trust in a central bank. The Bank forInternational Settlements (BIS), the Switzerland-based cen-tral bankers bank, issued its annual report the weekendafter the June FOMC meeting and ran to the Feds defense.The report says in no uncertain terms its time for central

Although the stock and bond markets

are throwing a tantrum and need to get

over it, central banks have no equivalent

of the parental time-out for traders.

FIGURE 2: S&P INDEX

The S&P 500 broke downside support in the first few days after the Fed June

policy meeting.

Source: Chart Metastock; data Reuters and eSignal

7/27/2019 Ctm 201307


ON THE MONEY

banks to turn off the free-money spigot. Extraordinaryaccommodation gets the blame for delaying private sectordeleveraging and for making countries vulnerable to ris-ing interest rates, which, without an equal increase in theoutput growth rate will further undermine fiscal sustain-ability. The BIS says the global economy is past the crisisand the central bank job now is to return still-sluggisheconomies to strong and sustainable growth Alas, cen-tral banks cannot do more without compounding the risks

they have already created. To offer more extraordinarystimulus now would be increasingly perilous.

Inevitable destabilizationAlthough it appears the stock and bond markets arethrowing a tantrum and need to get over it, central bankshave no equivalent of a time-out for traders as parents dofor unruly children. And in practice, there was no betterway for the Fed to communicate that QE is ending. Inother words, traders were always going to freak out andthe Fed always knew it it just failed to judge the extentand pace of the reaction.

This is because of something that has been around fordecades in economic and central bank circles, the zero-bound problem: How does a central bank manage interestrates when the single rate it sets, in this case the Fed fundsrate, is at or near zero? The zero-bound problem is notthe same thing as Keynes liquidity trap, but its a kissingcousin. It seems there are two solutions to boost householdand business activity create inflation or change the fiscallandscape. The only policy a central bank can adopt, sincelegislatures control fiscal policy, is to create inflation. Notethat when Japanese Prime Minister Shinzo Abe announcedhis three-point plan to lift Japan out of recession, the firstpoint was to raise inflation to 2%. This was Bernankes

advice to Japan long before he became Fed chief.But QE didnt actually create inflation in the U.S., andso far its unclear how the Fed plans to promote inflationwithout QE. To a certain extent, the absence of any real

discussion of inflation is fishy. After all, Bernankes viewson the zero-bound problem are well known he wroteseveral papers and a book about it. Professional econo-mists are separated into two camps over QE those whosee the justification for boosting growth (Keynesians) andthose who oppose QE (Friedmanites). Only a few havewritten about what happens when stimulus is reduced orwithdrawn. These academic papers, some of them by Fedeconomists, are surely familiar to Bernanke.

The ending-QE analysis follows a familiar coursebecause government interference in markets always resultsin a misallocation of resources due to artificial pricing.Removal of that interference is equivalent to eliminatinga subsidy it changes the supply and demand metricsin one fell swoop, and permanently, having first distortedmarkets in a big way. And everyone acknowledges QE is,in essence, government interference in the biggest marketin the world after foreign exchange. QE affected not onlyits direct target, U.S. Treasury debt (and then mortgage-backed securities), but also every other security and asseton the planet.

It was always known QE would promote bubbles. Byartificially lowering the price of bonds through large pur-chases, the government feeds demand for higher-yieldingpaper in other sectors, including corporate and foreignbonds, but also equities and commodities. And by flood-ing the market with cash, the government risks promotinginflation. So far, inflation is not occurring because at thesame time QE went into effect, lenders tightened creditstandards and the Great Recession reduced demand forcredit, due in part to bankruptcies and foreclosures. Also,QE failed to cause the dollar to depreciate, as Keynesiansalways enjoy pointing out. Its true the dollar index low of71.58 was in March 2008 and its subsequent high of 88.49

was after the first round of QE in February 2009, but QEwas not the only FX-determinative event going on at thetime there was also the European sovereign debt crisis,the U.S. fiscal crisis and ratings agency downgrade, etc. QEmay not have caused the dollar to depreciate, but it almostcertainly contributed to the index dropping like a rock onQE announcements and staying low since 2009.

Reducing QE is not the same thing as ending it, but thebond market is acting as though it is. This is exactly thesame kind of reaction that economist Rudi Dornbuschproposed caused overshooting in the FX market in 1976.Overshooting works like this: Investors expect inflationto be much higher in the future, and thus anticipate tak-

Central banks refuse to take

responsibility for the bubbles they

created by interfering in markets.

7/27/2019 Ctm 201307


ing capital losses on bond holdings, so they demandextra yield today to make up for what they expect later.Commodities follow the same storyline those expectinginflation to follow from QE sought a form of protection inhard assets like gold. But with QE ending (and no actualinflation to be seen anywhere), the cost of inflation insur-ance is going higher, hollowing out the demand for com-modities.

For the FX market, the analysis is easy. The nominal

return became very low, below 0.5% for shorter maturitieslike the two-year note and as low as 1.60% for the 10-yearnote, pushing investors into higher-yielding currencies.The capital flows to high-yielding emerging marketsbecame so big several countries, most prominently Brazil,applied various forms of capital controls and complainedabout currency wars that raised their currencies toohigh, damaging exports. QE was, from day one, a policythat would depreciate the dollar, something acknowledgedby the Fed but as an unintended consequence. Dollardepreciation, however limited, gets the blame for furthercontributing to bubbles in foreign stocks and bonds as wellas commodities. We can blame dollar depreciation for con-tributing to the commodity price bubble, not only becauseof the (so far) mythical inflation effect, but also authenticdemand because commodities are cheaper in local cur-rency terms.

Therefore, ending QE should raise the U.S. dollar, burstbubbles in the U.S. and foreign stock and bond markets,and burst the commodity bubble hardest of all. We areonly a few days into this new overshooting process, butalready some analysts are wondering whether the Fed willback down once it sees that its not only the central bank ofthe U.S., but of the world. And consider that in the absenceof inflation, falling asset prices are inherently contraction-

ary. Savers who desperately sought higher yields, includ-ing foreign yields, are going to take a big hit. In the U.S.,these savers are the very households on which the Fedis depending to pull the U.S. economy out of recession.Some institutions that specialized in this segment may fail.Maybe the financial sector will see a domino effect andmaybe the economy wont recover, after all.

In the end, QE removed or masked a proper respectfor risk, and ending QE reminds us this is how the wholething got started in the first place lack of respect formortgage credit risk. Traders used to joke about theGreenspan put, meaning former Fed chairman AlanGreenspan was attentive to stock market declines and

could be counted on to loosen policy in the face of a sharpdrop. Now we have the equivalent of a Bernanke sub-sidy that is suddenly being withdrawn. Never mind thatits not sudden and not a full withdrawal, just talk aboutwithdrawal, but investors and traders are acting like pen-sioners who just got a 40% cut in their monthly check.From their point of view, this is an accurate description oftheir wealth and income prospects.

From a broader and more political perspective, QE sup-ported banks and brokers and their clients, whether theyhave yachts or not. We normally think of government sub-sidies as supporting persons and households, or at leastworthy sectors (agriculture), not the financial elite andtheir institutions. This is not strictly accurate (consider themilitary-industrial complex), but never mind publicacknowledgement that QE was designed to save the bigshots has not gone unnoticed. Ostensibly the true targetof QE was to rebuild household demand, but with incomeinequality so high, its not clear QE resulted in sufficienttrickle down. In fact, all QE did was rescue the financialsector, or at least most of it, without fixing moral hazard atthe same time (too big to fail).

Central banks are more than reluctant to talk aboutbubbles they refuse to take responsibility for those theycreated by interfering in markets. Yes, the Fed undoubted-ly knew that ending QE would prick bubbles all over theplace, and yet it seems to have underestimated the extentand speed of the reaction.

Whats nextWeirdly, the FX market also knew from the May FOMCmeeting the Fed would announce tapering at the Junepolicy meeting, and yet by the week of June 18, FX specu-lators had already flipped from a net short Euro positionto a small net long, according to the CFTC Commitments

The longstanding pro-Euro bias is

asymmetrical a small amount

of favorable news has an outsized

effect while a big dose of bad news

is shrugged off.

7/27/2019 Ctm 201307


ON THE MONEY

of Traders Report. Speculators had a net long position of7,533 contracts, from a 20,030-contract net short positionthe week before. The largest net short Euro position (84,644contracts) since November 2012 was only a few weeks ear-lier. The CFTC releases its data every Tuesday, and the Fedpolicy meeting and announcement was the very next day,Wednesday, June 19. In other words, those newly long Euroswrongly anticipated a dovish Fed and got slammed.

Dashed dovish expectations imply some press reports maybe right the Fed doesnt really intend to end QE rightaway (September) and is just preparing the ground. Afterall, the Fed never actually named the month tapering wouldbegin.

Can this be right? Well, yes, and for several reasons. First,the data may not come in as rosy as the Fed forecasts. Also,the Fed may start to make soothing noises about postponingthe start of tapering, specifically to try to repair market insta-bility which after all, is a Fed mandate. Behind the scenes,the Fed may be hoping to see a little inflation emerge, too.This may take the form of data that is not strictly inflationdata, such as wages and import prices.

And finally, something may be brewing elsewhere, suchas the European Union plan to capitalize newly distressedbanks directly with Emergency Stability Facility funds ratherthan through the sovereign governments (and thereby impos-ing unpalatable conditions). As we continue to see, the long-standing pro-Euro bias is asymmetrical a small amount offavorable news has an outsized effect while a big dose of badnews is shrugged off.

We are left with two seemingly contradictory conclusions.The tapering of QE is an event of historic proportions, but itmay be delayed to make it seem less historic. The Fed cantbe seen as a hostage to market sentiment, especially of thetantrum variety, but it cant be insensitive to real distressin markets that could spill over into institutional failuresor other catastrophes. It would not be surprising to hear ofmoral suasion, aka arm-twisting, at the private meetingsbetween Fed and big bank officials.

In the end, the data will rule, and its data that will con -vince markets that tapering is acceptable. You have to won-der what the Fed knows about upcoming data on employ-ment and inflation that the rest of us dont. If data surprisesand tapering becomes acceptable, bond yields will fall. Andwe should assume that absent a European crisis, the dollar

will too.y

Barbara Rockefeller (www.rts-forex.com) is an international economist

with a focus on foreign exchange, and the author of the new book The

Foreign Exchange Matrix (Harriman House). For more information

on the author, see p. 4.

The view from the Fed

Key statements from the June FOMC meeting:Whentheeconomyisdemonstratingsustainablegrowth in employment, the Fed will buy lesser amountsof Treasuries and mortgage-backed securities (MBS)thanthe$85billionpermonthitstartedbuyinginSeptember 2012.TheFOMChasnotmadeapolicydecisionyet,but has come to a consensus it should start nailingdown details, including the amount by which to reduce

purchases and the date on which to begin (possiblySeptember).TheFedwillstopbuyingTreasuriesandMBSbytheend of June 2014 again, assuming the economicdata supports the tapering.IftheFediswrongaboutunemploymentfallingorother aspects of the growth scenario, it will stop taper-ing and increase purchases to higher levels. We dontknowif$85billionpermonthisacap.Reducingpurchasesisnotapolicychange.Itsthesame accommodative policy we had all along, just withless pressure on the gas pedal.Reducingpurchasesisnotraisingrates.TheFedfunds rate, the only rate actually set by the Fed, will

remainthesame(0to0.25%)until2015attheearli -est, and when the Fed does decide to raise rates, it willgive plenty of advance warning.

Federal Reserve Economic Forecasts:Inflationisstillabnormallylowbutwiththeexceptionof one dissenter on the FOMC board, rising inflationis not currently considered an issue. The PersonalConsumptionExpenditurespriceindexroseonly0.7%year-over-yearinApril,thelowestsinceOctober2009andmorethan1%underthe2%target.TheFedfore -caststhePCEindexwillriseto0.8-1.2%in2013(from1.3-1.7%forecastedinMarch)and1.4-2%in2014

(from1.5-2.0%forecastedinMarch).By2015,itwillbe1.6-2%(from1.7-2.0%forecastedinMarch).TheFedsjoblessrateforecastis7.2-7.3%thisyear(from7.3-7.5%intheMarchforecast),fallingto6.5-6.8%in2014(from6.7-7%intheMarchforecast)and5.8-6.2%bytheendof2015(from6-6.5%intheMarchforecast).U.S.GDPisnowforecasttogrow2.3-2.6%thisyear(from2.3-2.8%intheMarchforecast).Itwillgrow3-3.5%in2014(from2.9-3.4%intheMarchforecast),and2.9-3.6%in2015(from2.9-3.7%intheMarchfore -cast).

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17/36

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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 L IKELY 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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Dollar/yen

Long-term history would argue favoring the short side in the dollar/yen pair,

but the recent correction could be a pullback opportunity for longs.

BY CURRENCY TRADER STAFF

Into mid-year, the weakened Japanese yen

remained the lead story in the forex world. From

late May to mid-June the U.S. dollar/Japanese

yen (USD/JPY) made the first significant correc-tion of its approximately nine-month rally, fall-

ing from 103.73 to 93.78 (9.6%) before bouncing

back above 99.30 by the last trading day of June

(Figure 1). Still, the pair had already rallied some

35% off its mid-September 2012 low, so the pair

was still trading at relatively high levels as trad-

ing in July began.

Or was it? Figure 2 shows the current rally has

taken the dollar/yen to highs not seen since 2008

(and set the record for consecutive monthly high-

er highs, eight, through May), but its nonethelessjust one of several mostly minor counter-rallies in

the pairs generational downtrend. Its the biggest

rally since 2000-2002, but it hardly marks a sea

change in the dollar/yen relationship.

Where does that leave the pair in the days and

weeks to come? Those looking for market symme-

try will note the dollar/yens highs in April were

right around 100 the level the pair was trying

to reclaim as of June 28. Traders with a bearish

bent might see that price point as a short oppor-

tunity, although few analysts seem to believethe rally is done (see Dollar bull back into gear,

courtesy of the Fed). The Feds reminder on June

19 that quantitative easing will be downsized in

the not-too-distant future, and that it will increase

interest rates eventually (possibly in 2015), were

enough to knock the stock and bond markets for

a loop; it also gave a boost to the buck, which was

consolidating in mid-June after the correction. By

contrast, Japan has given no indication it intends

to rein in its easy-money policies.

SPOT CHECK

FIGURE 1: DAILY DOLLAR/YEN

After pulling back nearly 10%, the dollar/yen pair rebounded close

to 100 by June 28.

FIGURE 2: LONG-TERM VIEW

The dollar/yens current rally is its biggest in more than a decade,

but such moves have tended to be exceptions in a longer-term

downtrend.
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7/27/2019 Ctm 201307


The highlighted bars in Figure 3s weekly chart

are a pattern that was identified (only) 42 previous

times in the floating-rate era: four lower weeklylows (concluding the week of June 14) followed

by a week with a close in the upper 40% of the

previous weeks range (the week ending June 21).

Figure 4 shows the average and median weekly

close-to-close changes after these patterns along

with the dollar/yens average and median changes

for all one- to four-week periods. Although the

post-pattern move is notably positive at week 1,

this bullishness quickly evaporates as the pairs

long-term bearish bias reasserts itself.

In the most recent pattern instance, week 1 cor-responds to the dollar/yens position as of the

June 28 close, at which point it had gained more

than 1.5% from the June 21 close. This does not

necessarily mean the pair is likely to sag in the

coming weeks. The vast majority of the pattern

instances occurred during longer-term down-

trends; the few instances that occurred in uptrend-

ing environments were mostly followed by sus-

tained (several weeks or even months) of gains.

The pattern tail will not walk the fundamental

dog here. Unless there is a fundamental reason

for the rally to have ended at this point (the dol-

lar/yens previous rallies have run approximately

18 months to three years), the correction must be

viewed as a pullback rather than the beginning

of a new significant downtrend. Nonetheless, the

brisk rally in the second half of June may make

waiting for a pullback (especially after a re-tag of

100) for long entries a wise course of action. Easing

pressure on the stock market will stem some of the

nervous-money flows into the dollar.y

FIGURE 3: WEEKLY DOLLAR/YEN

A pattern of four weeks of lower lows and a one-week rebound

concluded on June 21.

FIGURE 4: BOUNCE AND SAG

The pair tended to bounce back in the first week after the four-week

down-move pattern, but the markets long-term bias subsequently

weighed on price.

7/27/2019 Ctm 201307

20/3620 October2010CURRENCY TRADER20 July2013CURRENCY TRADER

All traders developing mechanical

strategies are eventually faced with

the problem of determining system

quality. This is commonly done to

know if modifications can improve a

certain strategy, or to choose between

different candidate systems for live

trading.

There are many statistical measures

designed to establish system quality,

including the Ulcer Index, maximum

drawdown, profit factor, Sharpe ratio,

etc., but all of them have significant

shortcomings that make them less

than ideal solutions. For example,

a strategy with a deep, short-lived

drawdown might have the same

Ulcer Index reading as a strategy with

a long, shallow drawdown, when

both strategies are, in reality, com-

pletely different.

Because of such limitations, traders

TRADING STRATEGIESTRADING STRATEGIES

Measuring system qualitywith Ideal R

Calculating regressions on rolling time periods of an equity curve provides

a more accurate understanding of a trading systems value.

BY DANIEL FERNANDEZ

FIGURE 1: MODELING PERFECTION

The perfect non-compounding system would exhibit a perfect linear relationship

between time and account balance.

7/27/2019 Ctm 201307


usually reference multiple statistical gauges to generate

a subjective vision of system quality because the relative

importance of the different variables is not formally estab-

lished. This creates problems in terms of systematically

evaluating strategy quality.

However, its possible to develop a set of statistics to

objectively compare different trading systems. We can do

this by establishing the nature of an ideal trading strategy

and then finding ways to measure deviations from this

behavior.

The ideal trading system

The first step, defining ideal trading results, is easy. A per-

fect non-compounding trading strategy would be a system

that exhibits a perfect linear relationship between time and

account balance that is, balance and time would be per-

fectly correlated, and the balance would increase as a func-

tion of time, without any losses, along a perfectly straight

line (Figure 1).

Once we know what the perfect trading system looks

like, we can start to evaluate how a trading system devi-

ates from this behavior.

Fitting the ideal system model

The most basic way to evaluate a strategys deviation

from the ideal system model would be to calculate a linear

regression of balance vs. time and determine how much

we deviate from a perfect fit to this model. This analysis is

easily conducted in Excel or any other statistical analysis

software by calculating a simple linear regression follow-

ing the form:

balance(time) = time*slope + intercept

Where balance is a function of time

Figure 2 shows this analysis carried out for two sample

systems.

FIGURE 2: STARTING WITH LINEAR REGRESSION

A linear regression of balance vs. time shows how much a systems performance

deviates from the ideal model.
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22/36

The most important aspect of this analysis is the Pearson

correlation coefficient (R) that allows us to measure the

goodness-of-fit to the linear model. An R of 1 implies a

very high positive correlation (closer to ideal), while lower

values imply lower system quality.

Although this criterion can help us distinguish between

overly good and bad strategies, it is certainly not the bestwe can do. Note that we cannot use the commonly used

correlation coefficient (R2) because the direction of a corre-

lation matters in trading; we are interested only in positive

linear correlations.

The problem with a simple linear regression is that in

trading we are concerned not just with the general correla-

tion of balance and time, but also about how the strategy

behaves within the curve. For example its not enough for

us to have an R of 0.99 because the equation that calculates

the R can generate high values for systems with periods of

high volatility (such as spike drawdowns).

Figure 3 shows a system with a 0.99 linear regression

coefficient, but it is obvious the system is not even close

to the ideal case because of the many spikes below and

around the linear regression line. The R calculation aver-

ages these profit and loss spikes, generating a problem in

terms of measuring system quality. Using this method, itbecomes increasingly difficult to tell which system is better

as we approach R values closer to 1.

This means we need a better model to assess system

quality one that goes beyond a simple linear regression

of balance vs. time.

Beyond simple global linear regression

Our challenge here is that we need to account for even

small deviations from linear behavior (i.e., from the ideal

system) to adequately determine how close a system is to


TRADING STRATEGIES

FIGURE 3: LIMITATIONS OF SIMPLE REGRESSION

Although this system has a 0.99 linear regression coefficient (R), its equity curve

is far from the ideal case.

7/27/2019 Ctm 201307


being ideal.

The way to do this is to divide the

balance curve into equally spaced time

periods and measure individual linear

regressions for each of them. Doing

this allows us to determine how linear-

ly the system behaved during shorter

time periods, which helps us avoid theR-value error-averaging problem in a

simple regression of the entire balance

curve. We can then calculate the aver-

age of the R values from all the smaller

periods to get a better statistical mea-

surement of system quality. We will

call this new statistic the average of

all sub-period R values the Ideal

R (IR).

Figure 4 shows the curves for two

systems that have been divided intoone-year periods, each of which have

been fitted with their own linear

regressions (blue lines). The simple lin-

ear regression analysis generated R val-

uesof 0.99 (System A) and 0.95 (System

B) for these two strategies, meaning

that both exhibit a large degree of cor-

relation between balance and time.

However we know these two strategies

look nothing like the ideal system in

FIGURE 4: R VS. IR

System A, which had an R value of 0.99, is revealed to have an IR value of only

0.47, while System B went from an R of 0.95 to an IR of 0.25.

7/27/2019 Ctm 201307

24/3624 October2010CURRENCY TRADER

TRADING STATEGIES

Figure 1 (the ideal system has no volatility whatsoever), soa more accurate system quality statistic should yield much

smaller values.

The IR values for the systems in Figure 4 provide a

much more realistic picture of their quality. The system

with an R value of 0.99 had an IR value of 0.47, while the

system with an R of 0.95 had an IR of 0.25. Not only have

we been able to get a much clearer picture of both systems

performance relative to the ideal (both are further away

from 1 than previously indicated), but weve also discov-

ered a much bigger quality difference between them. Now

we know System A (IR of 0.47) is much better than System

B (IR of 0.25), because it exhibits a much more positive lin-

ear behavior over smaller trading periods. Figure 5 shows

the variation of R along all the linear regressions carried

out across the different time intervals for both systems .

Limitations

Despite its apparent advantages, this technique is not

appropriate for all systems.

A system with a very low trading frequency will not

benefit from it (because its results will not be statistically

significant), while strategies with very high trading fre-quencies might require a much shorter divisions to deter-

mine the IR statistic and avoid the previously described

averaging pitfalls.

Linear regression, a very powerful tool

With the IR statistic you now have a very powerful tool

to measure system quality, which evaluates in a very clear

way how much your strategy deviates from purely ideal

behavior. Systems with higher IR values will be closer to

the ideal, perfectly linear growth model. Remember to use

non-compounding money management when evaluat-

ing this statistic and also make sure your strategy has a

large enough number of trades (at least 20 for each one of

the regression periods). An Igor Pro procedure script

including a function to calculate IR is also available for

download.yDaniel Fernandez is an active trader focusing on forex strategy

analysis, particularly algorithmic trading and the mathematical

evaluation of long-term system protability. For more information on

the author, see p. 4.

FIGURE 5: PERIOD-BY-PERIOD R VARIATION

R Values for the different periods are consistently better for the system with the highest IR.

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25/36CURRENCY TRADEROctober2010 25
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7/27/2019 Ctm 201307


TRADING STRATEGIESADVANCED CONCEPTS

Does last months conclusion (see

Major currencies and the great

LIBOR kerfuffle) apply to a set

of minor currencies? The conclu-

sion of that article was:

No one knows when the era of zero

interest rates will end, how it will

end, and what the eventual market

structure will look like when it does.

What will remain constant, though,

is the inability of generalized and

simplified rules about what drives

currencies over time. Perhaps we

should be grateful: Just as a messy

election is the sign of a functioning

democracy, a messy market is one

people want to trade.

Minor currencies less affectedby great LIBOR kerfuffle

Why minor currencies were ahead of their time and didnt know it.

BY HOWARD L. SIMONS

The post-March 2008 period has some fairly distinct lines, which look as if they are

conveying signal and not noise.

FIGURE 1: MONEY-MARKET YIELD CURVESBEFORE AND AFTER BEAR STEARNS

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

ForwardRateRatios,Six-NineMonths

USD

CAD

EUR

GBP

AUD

SEK

CHF

JPY

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The approach taken for the majors was simple andstraightforward (or at least what passes for straightfor-

ward in these precincts). As purchasing power parity and

trade flows have proven well-nigh useless in assessing

currency movements over time, only two market-derived

variables hold out any hope for position traders: rela-

tive asset returns and expected interest rate differentials.

The total return for a countrys stock market relative to

the U.S. market, all expressed in USD terms, serves as a

proxy for relative asset returns. The difference in money-

market yield curves as measured by the difference inforward-rate ratios between six and nine months (FRR6,9)

between the non-USD currency and the USD is the dif-

ference in expected interest rates.

As before, the comparison will be split in time into the

periods before and after the Federal Reserve-orchestrated

rescue of Bear Stearns by J.P. Morgan Chase in March

2008. That preceded a story in The Wall Street Journal

one month later about reporting irregularities in LIBOR.

A cynic might note those irregularities were conducted

with the direct approval not only of the reporting banks

With the possible exception of the Taiwan dollar (TWD), these FRR6,9 lines suggest

we should lower our expectations that expected interest-rate differentials drive these

markets.

FIGURE 2: MONEY-MARKET YIELD CURVESBEFORE AND AFTER BEAR STEARNS

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

ForwardRateRatios,Six-NineMonths

USD

ILS

INR

ZAR

TRY

THB

MXN

TWD

FIGURE 3: THREE-MONTH-AHEAD SPOT CURRENCYRETURNS, ISRAELI SHEKEL (ILS)

Pre-Bear Stearns takeover

Post-Bear Stearns takeover

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28/36

ON THE MONEY


ADVANCED CONCEPTS

in the British Bankers Association but of the regulatory

bodies involved: After all, no one wanted to report the

truth about the banks parlous state of finances and their

unwillingness to lend to each other.

Churchill said, In wartime, truth is so precious that

she should always be attended by a bodyguard of lies.

Of course, he was talking about matters of life, death, and

national survival, not of anything as crushingly important

as the basis for mortgage derivatives.

Messy markets

The messy markets referred to here and in last months

article have the advantage of producing neat charts

something more valued by the nations financial writers

than commonly admitted. Lets take, for comparison, the

map of FRR6,9 differentials for the major currencies shown

in Figure 1. The post-March 2008 period has some fairly

distinct lines and they look as if they are conveying signal

and not noise.

Now lets take the same construct for the set of minor

currencies to be examined (Figure 2). These are, with the

possible exception of the TWD, a random mess. It was dif-

ficult to select a set of currencies, as so many of the minor

currencies either lack sufficient length in their histories or

do not have nine-month interest markets. The very shape

and noisiness of the FRR6,9 lines in Figure 2 tell us we

should lower our expectations for expected interest-rate

differentials driving these markets.

As a reminder, we should expect a country whose

FRR6,9 starts steepening relative to the USD FRR6,9 to see

its currency rise relative to the USD, unless the non-USD

FRR6,9 is steepening bearishly and the prospect of higher

FIGURE 4: THREE-MONTH-AHEAD SPOT CURRENCYRETURNS, INDIAN RUPEE (INR)



FIGURE 5: THREE-MONTH-AHEAD SPOT CURRENCYRETURNS, SOUTH AFRICAN RAND (ZAR)



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short-term interest rates is leading a capital outflow out of

the country. Often, the currency already associated with

an already relatively steep FRR6,9 starts to weaken as the

short-term interest rates begin to roll down the curve as

nine-month rates become six-month rates, etc.

Another important point to consider is because most

investors are trend-followers and chase performance,

higher stock market returns relative to U.S. stock market

returns tend to lead capital inflows and push the currency

higher unless those inflows are forestalled by runaway

money-printing. As we saw in the Swiss case last month,

money-printing is a way of life in the modern world.

With these two preambles in mind, lets map three

month-ahead spot currency returns for the set of minor

currencies as a function of [FRR6,9Foreign - FRR6,9

USD] and

of the trailing relative stock market returns as measured

by the MSCI index return in USD terms between the non-

U.S. and U.S. markets. The maps for the Jan

Documents

Ctm 201307