FOREX

The Role of Inflation

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:52:00 +0000

Inflation is in many ways the elusive enemy of central banks throughout the world.
Much progress has been made over the decades. In the period of 1973 through 1987,
inflation levels in industrialized countries were near the 7.5 percent range. A decade
later, in 1989, inflation levels ranged at the much lower level of 3 percent. Today, all
you have to do is read the central banks’ public documents to realize that their major
mission is to contain inflation. Many central banks, in fact, announce inflation targets. In
fact, Bernard Bernanke, the successor to Alan Greenspan, has favored formal inflation
targeting for the U.S. Federal Reserve, and this is a significant change from Greenspan’s
famous verbal ambiguity in his communications strategy.
Central banks around the world monitor inflation and raise interest rates to try to
slow down inflation. Central banks often include in their statements accompanying interest
rate decisions that they will be vigilant over potential risks of inflation. This is
commonly known as being an inflation “hawk.” Whenever inflation is feared to be lingering
in the economy, traders interpret this fear as raising the probability that interest rates
will increase.
A fear of lingering inflation tends to generate in the market the anticipation of
higher rates, and therefore works to support the buying of a currency. That is also why
strong retail prices tend to undermine bond prices. Bondholders fear increased rates
because they reduce the attractiveness of the bonds they hold, and the market lowers
the prices of the bonds in order to equalize the yield of the old bonds with the new
interest rates.
Inflation is the ever-present yet stealthy ghost that spooks the forex market and challenges
central banks. It is particularly difficult to track. There is ongoing controversyeven among the best economists on how to measure and detect inflation, and as a result
there are many data sets relating to inflation. Central banks all over the world are trying
to get an accurate answer to the question of what is true core inflation?
This level of complexity in measuring inflation sets up the forex market for surprises
when data comes along that inflation has not been contained. If central banks can’t be
accurate in measuring inflation, why should an individual trader? Surprises can be expected.
For example, in December 2006, when inflation data rose the highest in 30 years,
it provided a boost in the dollar value as more traders were betting that the Fed would
not decrease rates, or might even increase rates.
Speaking of the challenge in interpreting monthly inflation numbers during his tenure
on the Federal Reserve Board, former vice chairman Alan Blinder said, “The name of
the game then was distinguishing the signal from the noise, which was often difficult.
The key question on my mind was typically: What part of each month’s observation on
inflation is durable and what part is fleeting?” (Commentary on “Measuring Short-Run
Inflation for Central Bankers,” Federal Reserve Bank of St. Louis Review, May/June
1997).
The challenge to getting a true measure of inflation has also been a focus of recent
activity in Britain. The Office of National Statistics is introducing a new inflation calculator
that allows persons to calculate their own inflation measure! In other words, the
other measures [such as the Retail Price Index (RPI), the Retail Price Index excluding
Mortgage Payments (RPIX), and the Harmonized Index of Consumer Prices (HCIP)] are
still in force, but there is recognition that inflation needs more measures for an accurate
assessment. This confusion and debate over how to detect inflation in Great Britain underscores
the issue is an international one. The Monetary Policy Committee of the Bank
of England (www.parliament.the-stationery-office.co.uk/pa/ld199899/ldselect/ldmon/96/
9615.htm) offers more details on this subject.
The good news is that the forex trader doesn’t have to become a Ph.D in economics
to follow inflation data. There are many key measures of inflation that are tracked. But
you have to check the central bank web sites.
A S

HOUSING DATA AND GREAT BRITAIN

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:51:00 +0000

As discussed earlier, housing provides a strong indicator regarding interest rates
throughout the world. For example, as 2006 ended, the situation in Great Britain regarding
housing indicated a very strong housing market and therefore supported sentiment
of interest rate increases by the Bank of England. In 2006, housing prices inflated
by nearly 10 percent in Great Britain. Economist Diana Choyleva believed prices
could rise by as much as 15 percent in 2007. But she warned that if the Bank of England
did not prevent people’s taking on excessive debt by raising interest rates, it risked
laying the foundations of another major collapse. In January 2007, she said, “The Bank
could risk finally spawning a house price bubble in 2008” (Edmund Conway, economics
editor, “House Prices at Their Most Overvalued for 15 Years,” Telegraph, January 2,
2007).
In other words, expectations of an interest rate cut in Britain would require evidence
of a slowdown in housing price increases. The trader trading the British pound should
watch British housing data very carefully and gain an edge in shaping trading strategy. A
useful web site for staying on top of British housing data is www.hometrack.co.uk/.

ALSO WATCH HOUSING EQUITY SECTOR STOCKS

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:43:00 +0000

Another way for the forex trader to get a grip on housing data is to watch equities that are
housing related. For example, Lennar Homes is a leading home builder. Its stock price
and earning forecasts offer good clues regarding the direction of the housing market and
by inference interest rate policies (Figure 1.3). In April 2006, Lennar homes broke down
below its support at $55 per share. Lennar Homes’ weakness was an omen about the
end of interest rate increases. Interestingly, when the forex market begins to conjecture
whether the Federal Reserve will raise rates in the future, the trader following Lennar
Homes’s stock price or another housing equity leader will be helpful in shaping an opinion
about the likelihood of an interest rate increase.

Here is what the Lennar chief executive officer (CEO) said as 2007 started (Wall
Street Journal, March 1, 2007):
Lennar Corp. (LEN) Chief Executive Stuart Miller is seeing no signs that the deteriorating
home-building market has bottomed, and Lennar expects to take landrelated
write downs of between $400 million and $500 million in its fiscal fourth
quarter to reflect the weak conditions.
“Market conditions continued to weaken throughout the fourth quarter, and
we have not yet seen tangible evidence of a market recovery,” said Miller, in a
statement.

HOUSING SENTIMENT INDICATORS

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:39:00 +0000

One can argue that economic data on housing activity is lagging and that a trader needs to
find indicators that are more coincident with activity or even leading. A valuable source
for assessing housing activity in the United States is the survey releases of the National
Association of Housing Builders (NAHB). According to the NAHB, “The Housing Market
Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse
of the housing industry, especially the single-family industry. The survey asks respondents
to rate general economic and housing market conditions.”
By looking at the HMI data for 2005 and 2006 we can discern an increasing pessimism
on the health of the housing market (see Tables 1.2 and 1.3). The survey results
in the summer of 2005 were at a peak on all HMI component measures. The Federal
Reserve stopped increasing rates in August 2006, reflecting their judgment that the economy
didn’t require more rate increases. Using the HMI index, the forex trader saw asignificant weakening in the housing market, which was an omen that increases in rates
were increasingly not likely. At the end of 2006, the HMI survey shows that the previous
rate of decline in housing starts was slowing down. This can be interpreted as possible
bottoming out of the housing market. Using this data, those traders expecting an interest
rate decrease would have to reconsider their confidence in a rate cut.
The importance of housing data as an indicator for traders is reflected in the fact that
new sources of data on housing are being developed for investors. One of the more recent
sources is the Standard & Poor’s (S&P)/Case-Shiller home price index. It is a benchmark
measure for housing prices. It tracks the value of single-family homes in the United
States. Twenty metropolitan areas are tracked, and the index is measured monthly. Thelast Tuesday of each month at 9 A.M. is the release time of the announcement. Traders
looking for leading indicators of a housing recovery will likely see it in increases in housing
prices tracked by this monthly index, posted at www.indices.standardandpoors.com.
Detailed housing data can also be found at www.macromarkets.com.

HOUSING DATA AS A LEADING INDICATOR

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:39:00 +0000

What is important to realize about fundamental analysis of housing sector data is that the
trader can identify pending changes in trends and direction of the economy. Of course, it
is true that forex prices move all the time in reaction to news and the like, but economies
don’t change direction overnight. By understanding housing data, one can develop a fundamental
viewpoint that leads to trading strategies before technical price patterns reflect
the change.
For example, in Table 1.1 we see data on U.S. new housing starts. The year 2005 was
a year of a high level of housing starts peaking in February at 2.2 million units and then
testing that peak in January 2006 (see Figure 1.2). After January 2006, the data showed
a decline, and by August 2006, the decline in housing starts reached levels of 2003. The
forex trader may not have picked the start of the slump by looking at this kind of data, but
clearly would have seen that right after the start of 2006 new home starts were in a period
of weakening. When housing starts reached a peak and then started declining, it was
difficult to be pro-dollar. Although housing data showed a slump, the Federal Reserve
didn’t stop the increase in rates until August 2006. In this case the new housing start data
was a very reliable leading indicator that interest rates would not increase.

THE ROLE OF HOUSING IN FOREX PRICE MOVEMENTS

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:25:00 +0000

Fundamentally, however, one of the most important categories of economic data around
the world, which is sensitive to interest rate changes, is housing data. The housing sector
in the United States, as well as other nations, provides a major share of wealth, consumer
spending, and job creation. Recent years have seen an international housing boom, with
prices growing at more than 10 percent per year in many countries. For example, Ireland
grew at 15 percent in 2006; Spain’s growth actually slowed down to 13 percent. Canada,
Norway, and Sweden shared more than 10 percent growth. The United States, in the face
of a slowdown, saw prices up 7 percent. This means that the value of homes around the
world has doubled in the past 10 years, and as a result the increased wealth has fueled
economic growth and consumer purchase.
Closely watched are data releases that relate to housing activity. Some of the main
data releases track:
The level of unsold homes
Mortgage loan applications
New and existing home sales
Single-family housing permits
Housing prices
Forex traders’ expectations of the future direction of interest rates are significantly
affected by housing data because, for example, weak housing leads to expectations of a
slowdown on consumption. The economic reasoning is that consumers start seeing a decline
in housing values and restrain their consumer spending. One of the most important
factors related to housing market strength in recent years has been mortgage equity withdrawals
(MEWs). As home prices have increased around the world, consumers take out
loans against their mortgages, which stimulates consumption. During periods of housing
booms, MEWs rise. MEWs have been, in fact, calculated to contribute to the growth
of gross domestic product (GDP). Figure 1.2 shows that MEWs have reached nearly 6
percent of U.S. GDP. However, if MEWs slow down, this can portend a decline in consumption
and a slowdown in the economy. If and when a slowdown in MEWs occurs,
central bankers view it as lessening the likelihood of an interest rate increase. Damon
Darlin wrote in the New York Times (“YOUR MONEY; Mortgage Lesson No. 1: Home Is
Not a Piggy Bank,” November 4, 2006):
Economists argue over what effect the access to money, which mortgage equity
withdrawals allow, has had on consumer spending. Homeowners cash out to pay
off more expensive credit card debt, remodel the house to build more equity, or just

have fun. They may very well have used it to buy another house or not spent it at
all, but added it to savings. Economists really are not certain.
“I guess it is one of those mysteries,” said Christopher D. Carroll, an economics
professor at Johns Hopkins University. “I don’t think anyone knows what
the answer is.”
Nevertheless, mortgage equity withdrawal is closely watched as an indicator
of the general economy because, Mr. Carroll said, “there is a lot of concern
that a cooling housing market could result in a sharp fallback in consumer
spending.”
A recent paper that Mr. Carroll helped write contends that for every $1,000
change in housing wealth there is an immediate propensity to consume about $20
more. The wealth effect, as the phenomenon is called, is twice as high for housing
wealth as it is for stock wealth, Mr. Carroll and his associates said.
At the end of 2006, the data on MEWs showed a large decline from the year before
in the United States. This was an early indicator of a slowdown in the U.S. economy
because it is estimated that two-thirds of the money from MEWs goes for consumption.
So the forex trader seeing signs of an MEW slowdown can get ready for its effect to take
place months in advance.
The importance of housing data as a factor in shaping currency moves has been
highlighted further by the events relating to subprime mortgages in the United States.
These mortgages were issued during the housing boom/bubble, without the traditional
credit requirements. Economic forces ultimately worked to create mortgage delinquencies
and a collapse in this market. For the forex trader it is a clear case where fundamentals
affect the dollar. More housing weakness translates to weaker consumer demand
and that translates to lowering the probability of interest rate increases. It’s difficult
to be bullish on the dollar in this environment. However, if the housing market startshave fun. They may very well have used it to buy another house or not spent it at
all, but added it to savings. Economists really are not certain.
“I guess it is one of those mysteries,” said Christopher D. Carroll, an economics
professor at Johns Hopkins University. “I don’t think anyone knows what
the answer is.”
Nevertheless, mortgage equity withdrawal is closely watched as an indicator
of the general economy because, Mr. Carroll said, “there is a lot of concern
that a cooling housing market could result in a sharp fallback in consumer
spending.”
A recent paper that Mr. Carroll helped write contends that for every $1,000
change in housing wealth there is an immediate propensity to consume about $20
more. The wealth effect, as the phenomenon is called, is twice as high for housing
wealth as it is for stock wealth, Mr. Carroll and his associates said.
At the end of 2006, the data on MEWs showed a large decline from the year before
in the United States. This was an early indicator of a slowdown in the U.S. economy
because it is estimated that two-thirds of the money from MEWs goes for consumption.
So the forex trader seeing signs of an MEW slowdown can get ready for its effect to take
place months in advance.
The importance of housing data as a factor in shaping currency moves has been
highlighted further by the events relating to subprime mortgages in the United States.
These mortgages were issued during the housing boom/bubble, without the traditional
credit requirements. Economic forces ultimately worked to create mortgage delinquencies
and a collapse in this market. For the forex trader it is a clear case where fundamentals
affect the dollar. More housing weakness translates to weaker consumer demand
and that translates to lowering the probability of interest rate increases. It’s difficult
to be bullish on the dollar in this environment. However, if the housing market starts recovering, the pressures to increase interest rates (or not decrease them) will help attract
dollar buyers.

THE MAIN INGREDIENT: INTEREST RATES AND INTEREST RATE DIFFERENTIALS

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:20:00 +0000

Interest rates are the “dough” of the fundamental forex pie. They are one of the most important factors that affect forex prices, as interest rates are the modern tool that central banks use as a throttle on their economies. The central banks of the world do not hesitate to use this important tool. In recent years almost all of the central banks increased interest rates. The European Central Bank raised interest rates eight times from December 6, 2005, to June 13, 2007, to a level of 4.0 percent to guide a booming European economy to slow down and avoid too high inflation. The United States’ central bank—the Federal Reserve—increased interest rates 17 times between June 30, 2004, and August 2006, and then paused when it decided the economy no longer needed the brake of interest rate increases. Interest rate increases do much more than slow down an economy; they also act as a magnet to attract capital to bonds and other interest-bearing instruments. This has been called an “appetite for yield,” and when applied globally the flow of capital in and out of a country can be substantially affected by the difference in interest rates between one country and another. In recent years the outflow of capital from Japan to New Zealand, Australia, and Great Britain has reflected money chasing more yield and has been a major multibillion-dollar feature called the “carry trade.” The carry trade was driven by the interest rate differential that has existed, for example, between Japan (0.50) and New Zealand (8.0), causing low-cost borrowing in yen to invest in higher-yielding kiwis. There can be no doubt of the critical role interest rates play in forex price movements. Some forex traders learned this lesson when the U.S. stock market sold off on February 27, 2007. It was precipitated by traders getting out of their carry trade positions. Since billions of dollars were sold to be converted back into yen, equity markets were also affected because equity positions had to be sold to buy back the yen positions. In Figure 1.1 we see how the Dow Jones Industrial Index correlated directly with the U.S. dollar–Japanese yen (USDJPY) pair that day.

The Fundamentals of Forex

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:15:00 +0000

We begin in this chapter with an exploration of the forces that move the prices:
the fundamentals. The reader will learn why fundamentals are important to foreign
exchange (forex) traders as well as what kind of economic activity are
most important in affecting price movements. These include interest rates, interest rate
differentials, economic growth, and sentiment regarding the U.S. dollar.
WHY FUNDAMENTALS ARE IMPORTANT
In many ways, forex trading is similar to playing a game. You have an opponent (the
market). In game of chance the key feature is that everyone faces the same odds
and therefore the same level of information. In these games, no player can change
the odds.
Playing forex, however, is not a game of odds. Participants in forex trading do not
share the same amount of information. In forex, this asymmetry of information results in
advantages and disadvantages to trades. Some players have more information than the
others. In forex, information about fundamental aspects of economies does not arrive
simultaneously to all participants. The real important question is what kind of knowledge
and information can improve trading performance. The search for an edge starts with a
fundamental understanding of the nature of the forex market. Having a foundation of
knowledge in fundamentals is a first step in evolving into a winning trader.
In getting acquainted with the forex market, most people start by looking only at
price charts and price patterns. This is called technical analysis. But the study of whatmoves those charts is called fundamental analysis. The goal of Part I is to identify the
components of fundamental analysis in regard to forex and then provide a recipe for
developing your own fundamental analysis of a currency pair.
Why take time to look at forex fundamentals? Why should fundamentals matter if a
trade is done off a short-term time interval such as the 5-minute chart? The short answer
is that one cannot separate the fundamentals from the technical analysis without exposing
oneself to great distortions in understanding the forex market. Foreign exchange is
by its nature both fundamental and technical and reflect the increased globalization of
the world economy.
It is worthwhile to note the comments of the late, great Milton Friedman in a 2005
conversation with Dallas Fed president Richard Fisher:
The really remarkable thing about the world is how people cooperate together.
How somebody in China makes a little bit of your television set. Or somebody
in Malaysia produces some rubber. And that rubber is used by somebody in the
United States to put on the tip of a pencil, or in some other way. What has
happened has been an enormous expansion in the opportunities for cooperation.
(http://dallasfed.org/research/swe/2006/swe0606e.html)
Consider the following: every transaction in the world settles in a currency. Whether
it is a consumer purchase, an imported or exported item, an investment in an equity,
or even cash under the mattress, the world’s economic activity is essentially a
flow of money. What makes forex fascinating as a market and as a trading vehicle is
the fact that currencies provide an intimate linkage to the world economy. The currency
trader by putting on a currency trade becomes a participant the world economy.
The trader is participating as a speculator looking for a very short-term profit. The forex
trader is riding on a global wave. Some will surf the waves, jumping on and off; others
will stay in much longer and face the volatility. Forex trading becomes possible
because the world is constantly assessing and reassessing the value of one currency
against another. The forex currency trader is looking to tap into this stream of changing
values.
The challenge is to find the right combination of tools that can assist the trader in
finding high-probability profitable trades. In meeting this challenge, the first step is understanding
what moves currencies over time. In putting together a recipe for successful
forex trading, knowing the fundamental chemistry of forex is highly recommended. Anyone
who doubts this should simply look at daily headlines that evoke names and places
that are part of the daily consciousness of a trader. These names should be familiar to
all traders: Bernanke, Fukui, Trichet, Xiaochuan. The words and decisions of these central
bankers of the United States, the Bank of Japan, the European Central Bank, andthe Bank of China alert the trader to interest rate policy and news that affect sentiment
about the direction of the dollar. Mention the capitals Pyongdong, Baghdad, Tehran, and
they evoke emotions of fear and crises. Detect news about retail giant Wal-Mart’s sales,
and one starts anticipating a potential reaction in the currency markets. These and other
factors mix together and form the chemistry of forex, which results in shifts of sentiment
regarding the U.S. dollar. These shifts in sentiment cause price reactions and shift
the balance between buyers and sellers. Let’s look in more detail at these fundamental
factors.

What Drives the Forex Market?

noreply@blogger.com (http://feeds2.feedburner.com/blogspot/CxrG) — Sun, 07 Jun 2009 17:14:00 +0000

Part I of this book offers a look at the “big picture” in foreign exchange (forex)
trading, that is, what forces influence currency price movements. These forces are
accepted by economists around the world as responsible for changes in the value
of currencies. The person learning to trade forex or trying to improve his or her trading
will benefit from a gain of knowledge of these fundamentals. In fact, as you will see,
fundamental forces act as leading indicators of currency movement.
U.S. and global interest rates, economic growth, and market sentiment toward the
dollar are the key ingredients that shape trading opportunities. Part I provides basic
knowledge on how these factors impact forex prices and how they can be used in selecting
trading opportunities.