A Bit of Theory to Explain Why Currency Trading Can Be Very Profitable Over Time….

Quotable

“History is strewn with the wrecks of nations which have gained a little progressiveness at the cost of a great deal of hard manliness.”

Walter Bagehot

Commentary & Analysis
A bit of theory to explain why currency trading can be very profitable over time….

Oh joy, today is Fed day. Analysts across this fair land and across the globe are now pondering and prognosticating what the Federal Open Market Committee’s (FOMC) notorious Dot-Plot will portray later today, as Janet parses the data and her words with extreme caution in order to maintain the proper cryptic tone we’ve come to hate so much. It is all so exciting, yet all so banal, yet all so important for markets, at least over the near-term. Thus, we all seem to pay attention. So, I thought instead of joining in on the fun of forecasting said dots, I would share a little theory (my word) I try to keep in mind when considering currencies.

As you know, or should know, currency trading is not an easy game. Currencies are driven by many variables. And even when a trader can identify the variables, it’s not always clear which is the most important at any particular point in time.

There is an old adage that says: In forecasting you try to be right, but in trading you try to do right. There is no other asset class where this adage better applies than to currency trading. It’s nice to forecast what will happen to an the economy or stock market or interest rates, but the fact is, even if these forecasts are right, they may have no bearing on the direction that the currency will take. That is why analysis of currency markets is different from other types of analysis.

Is it interest yield, inflation, economic growth, international capital flow, trade deficits, monetary policy, fiscal policy or political risk…what is the key driver of the dollar now?

I admit it, it can be extremely confusing at times—and I believe we are in one of those times where most people have become confused as to what is driving currency trading today. Before I get into what I believe are the key drivers behind the movement of the dollar, first let me present you with a simple model that I use to help clear the scales from my eyes.

Know your reason and your time frame…

As you know, many of my currency forecasts are based on events that I expect to play out over the longer term—these are views based more on fundamental analysis than technical analysis. But they too have a technical analysis component. And as much as we (guilty as charged) like to make short-term trades based on fundamental analysis, short-term currency trades should include more of a technical component. This doesn’t mean one can’t have a market view, I think you should, but dealers and short-term traders are trading daily with lots of leverage and looking for levels driven soley on their technical analysis. Things like Fibonacci retracements and extensions, Pivot Points, moving average crosses, moment indicators, etc.

Because of this short- and longer term trading dichotomy, it may make sense to trade currencies as two pools of funds—short-term and long-term.

The Model…

A model, maybe a framework, is a better word, is important to have in mind when doing currency analysis over the intermediate-time frame—several months to a year. One I keep in mind is something I have borrowed a lot from legendary speculator George Soros, which was shared in his excellent book, Alchemy of Finance.

Please note, I talking about Soros the trader, not Soros the political activist. And if you remember, it was Soros who broke the back of the Bank of England in 1992 that effectively led to the British pound’s exit from Europe’s monetary union—and in hindsight, probably did them a big favor keep them out of the euro.

Granted the model below is a bit esoteric, but stay with me, because ultimately it will be simplified to something we can use. Something we can use is a framework that boils down the currency trading decision to a simple yes or no question.

e nominal exchange rate (number of foreign currency units for one domestic currency unit; ↑e = strengthening)

i nominal interest rate

p domestic versus foreign price level (↑p = increase in domestic prices faster than in foreign prices and vice versa)

v level of economic activity

N nonspeculative capital flow ↑ = increased outflow

S speculative capital flow ↓ = increased inflow

T trade balance ↑ = surplus

B government budget ↓ = deficit

Whenever you think about the variables that impact currency prices, keep in mind that the relationship is often circular. What I mean is that the variables tend to serve as both cause and effect in relation to other variables…a rising currency can improve the economic fundamentals and improving economic fundamentals tend to improve the outlook for the underlying currency. It leads to the mind numbing question: “What leads and what follows?”

But, luckily we can simplify our equation further. Thank goodness, because it is probably not very useful for traders in the real world, like us, when 7 or 8 variables need to be evaluated simultaneously.

Trading is about taking all the available information you have and simplifying it to a simple yes or no question: Should we make a trade now?

Because ultimately currency movement is a function of supply and demand, we can derive a simple model from the seven or eight variables we defined above:

↓ T + ↑ N + ↑ S → ↑e

↓ T – Trade Surplus

↑ N – Nonspeculative Capital Inflow

↑ S – Speculative Capital Inflow

↓ e – Exchange Rate

Since the T (Trade) and N (Nonspeculative Flow, such as foreign direct investment) don’t change much over our time frame for making the currency decision, the important part of the equation boils down to the S (Speculative Capital Flow).

This gets to the meat and potatoes of the issue, the essence of my currency framework. Currency movement over the short- to intermediate-term time frame is driven by funds flow at the margin—and it is this flow is driven by market sentiment or expectations of the players in the market that take positions with real money.

Speculative capital is driven by expected total return.

↑Expected Total Return = ↑Interest Yield + ↓Inflation + ↑Future Exchange Rate

Higher real yields and rising exchange rates attracts speculative capital flow.

But we are back to our earlier point that the relationship tends to be circular: Do rising real yields cause the exchange rates to rise or is it a rising exchange rate, impacting the fundamentals, which force interest rates to rise? What leads and what follows? That question goes to the way interest rate changes play out against expectations and whether or not those changes in rates are the result of domestic or international pressures.

As Soros says, “Expectations relate to expectations and the prevailing bias can validate itself almost indefinitely.”

There are fundamental drivers of expectations or underlying rationales for currency movement, these expectations are not created out of a vacuum; the major ones are the key seven or eight variables that we first identified.

But, regardless of the drivers, we have seen time and again when the trend begins it becomes self-feeding and the feedback information from rising prices leads more players to jump on the trend.

It is why we see these large multi-year trends in the dollar.

[Note: Looks easy with the gift of hindsight; but lots of head fakes (multi-year trend changes) included within the long-term trend.]

But sooner or later, the self-feeding aspect of the trend leads to an overshoot, which leads to an over or undervaluation of the currency over the many time frames that we, as traders, can exploit.

That doesn’t mean that we will always be looking for turning points, at times we do our best to ride the trend with the crowd when we think it has longer to go.

Conclusion

If we accept the notion that currencies can be driven in the short- and intermediate-term by flows of money at the margin…we have to believe that the increment at the margin is made up almost completely by speculative capital flows. This I believe can be exploited over time and make currency trading profitable for many.

Thus back to where this missive started: We will be watching the FOMC today for clues about the “at the margin” stuff. Stay tuned.

  • Harry

    excellent article! thank you!