Chart View: A look at some charts we follow which may be of interest…

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Quotable

What is our life? A play of passion,
Our mirth the music of division,
Our mother's wombs the tiring-houses be,
Where we are dressed for this short comedy.
Heaven the judicious sharp spectator is,
That sits and marks still who doth act amiss.
Our graves that hide us from the setting sun
Are like drawn curtains when the play is done.
Thus march we, playing, to our latest rest,
Only we die in earnest, that's no jest.

 --Sir Walter Raleigh, Life

Commentary & Analysis

Chart View: A look at some charts we follow which may be of interest…

Page 2: Commodities/Stock Ratio

Page 3: Inflation in stocks versus commodities

Page 4: Japanese stocks versus the yen

Page 5: Copper as a bell whether?

Page 6: Silver looking good  

Page 7: GBP/USD Weekly

Page 8: UK gaping current account deficit

 

 

 

Stocks/Commodities Ratio:  We shared this chart many moons ago in Currency Currents.  Just checking in; nothing profound to add here other than to suggest how interesting the symmetry of this pattern.  From left to right viewing the chart below, we saw a 10-year bear market move in the ratio (i.e. commodities outperformed stocks); and now we are in 8-years bull market move in the ratio, i.e. stocks have outperformed commodities).  Obviously we don’t need to see a big bull move in commodities for this ratio to work lower; we only need to see stocks underperform. 

 

 Inflation?  You bet.  Not in real goods (yet) but definitely in stock prices (financial assets—money has to go somewhere).  This is why the 1% are happy with the status quo.  This is why those with professional jobs with access to capital are happy and asking: What recession?  So all you brainiac’s who read The New York Times, The Wall Street Journal, or The Washington Post and actually believe the pap printed, and can’t quite figure out why all those stupid hicks in the hinterlands (I am happy to be among them) are voting the way they do—take a look.  Real economy in the toilet.  The financial economy for those educated in the right places, and those who believe they are but are simply lucky, is doing very well. 

 

Japanese Stocks versus the Japanese yen: Gosh the yen looks expensive and overdone.  The Bank of Japan policy backfired relative to the needs of Japan when NIRP (Negative Interest Rate Policy) was announced.  We want to load up long on $/yen, but this chart gives us pause.  It shows Japanese stocks, measured by the Nikkei 225 Index (black line), and USD/JPY currency pair (red line).  Visually, a pretty tight correlation—weak stocks and strong yen.  It is interesting because the Japanese government already owns a huge amount of major listed stocks—what will it take to drive the Nikkei 225 higher?  We aren’t sure, but when we see it I think we should get long USD/JPY.  Note: A fresh swing low in USD/JPY, but not yet for the Nikkei.  Maybe a non-confirmation setting up?  Stay tuned.

Copper, the big question.  Real demand or Chinese speculation accounting for the recent “rally”?  If global growth is indeed on the wane yet again, and the IMF is so warning, as data across the board isn’t encouraging, we would expect copper to tumble again.  Maybe it isn’t over till we see a round trip in the metal (labeled at Alt 2).  This may very well be the bell whether for the rest of the commodities pack.  Worth watching even if you don’t care to play.  Note the retracement down to yet another key level—78.6% (1.9665)--before turning higher.  Obviously hindsight makes all of us geniuses, but it is interesting how often these key levels are respected.

Silver looking good.  We got a trend break higher in silver back on February 2nd, 2016 and we got some confirmation on a move above 15.90 [a la Victor Sperandeo trend line technique].  Now looking for at least 21.53 if this move is for real.  Resistance becomes support, so a close back below 15.90 concerns.

GBP/USD Weekly:  We shared this chart with our subscribers yesterday, in support of our short position in the pound.  I won’t belabor the Brexit issue, you all know the status and the propaganda so associated.  I do wish to add: Why the Brits would ever listen to anything President Obama says regarding Brexit is beyond my comprehension—Mr. Meddler he was on his latest trip to Europe.  You’ve got enough of your own problems here at home Mr. President, in case you haven’t noticed.  And now that you are playing the role of Hillary Clinton’s full-time mouthpiece and hit man, just open up a can of STHU when it comes to Brexit and let the Brits decide for themselves what they care to do.  And on that score, it seems, based on the latest data, the UK economy is slowing.  Whether Brexit related or not, no matter.  The pound seems to be losing yield coverage as growth fades; and as you can see in the chart below, there seems a pretty good correlation with the direction of the UK 10-year benchmark yield (green dotted line) and GBP/USD.  The chart on the next page is the UK current account. It shows massive red ink. Not sure it this matters.  But if it does start to matter, it likely won’t be good for British pound sentiment. 

UK Currency Account Quarterly:  Ugly to uglier!

Happy Friday.  Now the really tough question: Gin and tonic (Beefeater 24), or single malt (Glenmorangie 10 year)?   

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

 

 

Comment

Will The Reserve Bank of Australia Cut Rates Tomorrow?

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Quotable

“The key to being a good manager is keeping the people who hate me away from those who are still undecided.

 --Casey Stengel

Commentary & Analysis

Will The Reserve Bank of Australia Cut Rates Tomorrow? 

 This would be a good place for the Aussie to take a rest. 

AUD/USD Weekly: Resistance at 0.7857 swing and retracement level; momentum fading…

Two headlines today:

 1)      “Australia's No.3 lender Westpac Banking Corp missed forecasts with a 3 percent rise in first-half cash profit as bad debt charges soared to a six-year high while stricter capital rules pinched shareholder returns, sending its shares skidding.” (Reuters)

2)     China’s banking regulator is cracking down on financial engineering that Chinese banks have used to disguise trillions of dollars in risky loans as investment products.

 But…

 [Sent to Black Swan subscribers today]

 According to Reuters, “The Reserve Bank of Australia (RBA) is expected to keep its cash rate unchanged at a record low of 2.0 percent at a policy review on May 3, though a growing number of economists expect a cut, an updated Reuters poll released on Monday showed.

Thirty-three out of 51 economists polled expect the RBA to keep its policy rate on hold this week, while 18 see a 25 basis point (bps) reduction following surprisingly low inflation figures for the first quarter.

Last week's poll had 11 economists out of 50 forecasting a move.

Reserve Bank of Australia Cash Rate: Now at 2.0%...

It is hotly debated whether or not we see a cut tomorrow in rates (release is due out at 12:30 a.m. ET).  Here some rationales to suggest a bit of surprise, i.e. a cut:

1)     The currency seems too high relative to the deteriorating trade account:

Australia Month Trade Balance – This would suggest the RBA would be happy with a lower currency value.

2)    Real Interest Rates are high given the latest price data:

Latest monthly data showed deflation, with a -0.2% decline in prices

2-year Australian dollar yields are near 2%; if we add back in the latest negative data that makes real yield grow to 2.2%, which towers over the G-7 countries. 

Interestingly, the 2-year Australia – United States yield spread is falling in front of tomorrow’s meeting.  Are expectations for a cut rising in real time?

3)     The currency is being bid up along with commodities prices, which makes sense; but it is heading into technical resistance at swing and retracement levels which come in at 0.7848 and 0.7877, respectively:

AUD/USD (0.7628) vs. Iron Ore Futures vs. Crude Oil Futures Daily:

4)     Sentiment is increasingly bullish, as speculative open interest show Aussie bulls versus bears 69% vs. 31%, based on the latest Commitment of Traders Report dated 4/26/16:

Commercials are heavily short at 86% bearish based on open interest data.

Does any of this matter in what the market is increasingly perceiving as a Fed weak dollar policy that could have some legs?  Maybe not; but oil is turning over a bit today. Stay tuned.

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

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Comment

Hodgepodge – US Dollar Index & Dow Theory Non-Confirmation

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Quotable

“Our knowledge can only be finite, while our ignorance must necessarily be infinite.”

            Karl Popper

Commentary & Analysis

Hodgepodge – US Dollar Index & Dow Theory Non-Confirmation

 US Dollar Index – Two Views

Some of the best pieces of advice traders can find come from an unlikely place—poetry.  In these two lines from T.S. Eliot’s brilliant poem, “Ash Wednesday,” he effectively summarizes two key tenets needed to be successful in trading:

Teach us to care and not to care

Teach us to sit still.

Put another way, this means to me: 1) trade your edge and only that; don’t get all wrapped up in being “right;” don’t believe too much in your own story because Nemeses—the spirit of divine retribution against those who succumb to hubris—will soon be paying you a visit; and 2) know your time frame; a good idea based on a multi-week view can be a very bad idea if you trade it using hourly time frames for levels.

When it comes to playing the direction of the US dollar over the past few weeks, I have been able to make both mistakes in a big way proven again that knowing and doing are two very different things.  So, let’s take a fresh look at the dollar index and consider two scenarios. 

The US dollar, based on the US dollar index, has been in a range for last 13 months. I have been working off the view we are simply in a correction lower with another bull market leg due to take the US dollar index to new cycle highs.  But as much as I do expect yet another leg up in the dollar, there is another plausible scenario.

Scenario #1: Correcting in Wave 4 as seen in the chart below:

Key points supporting the correction scenario:

·   Yield matters.  Despite the fact the US dollar has fallen about 6.5% from its high back in Feb 2016, the yield spread (measured here by the difference between the 2-yr benchmark United States versus Eurozone) will matter.  Despite relative tepidness of the Fed Reserve Bank, it is the only major central bank likely to raise interest rates during 2016, suggesting the relative yield will go even higher in favor of the US dollar. Thus, we should expect the dollar to rally once again in Wave 5, i.e. this bull market isn’t over. Correction support areas come in at 92.20 (38% retracement of Wave 3); then 89.60 (50%) retracement of Wave 3.  [Alternative bull resumption view: The dollar gets a major risk bid on another credit crunch like crisis selloff in global stock markets.]

Scenario #2: The dollar bull market is over—the top is in place.

Key points supporting the dollar bull market over view:

·  Yield matters and the dollar will lose the relative yield support which sustained the bull market rally to date.  Why?  Because the US Fed will soon signal it will not hike rates during 2016; plus indicate the FOMC is seriously considering following down the monetary path blazed by Europe and Japan into negative rate territory.  This in turn will intensify the now budding recovery in commodities and the US dollar will play the mirror image roll again, i.e. commodities up and dollar down, as was the case during those pre-credit crunch “boom” years.  

I am still in the dollar bull market to resume camp.  But I am no longer in love with the story.

Dow Theory Non-Confirmation

I shared this with our Key Market Strategist (KMS) subscribers yesterday.  We changed our view on stocks Monday at the close and told our KMS subscribers to get short.  So far so good. 

Dow Theory Non-Confirmation Weekly View:  According to Dow Theory, any new swing high or swing low in one index, must be confirmed by similar price action in the other index.  I am no Dow Theory expert, to say the least, but the chart below appears to be a non-confirmation signal.  The Dow Jones Industrial Average made a fresh swing high (black line), but it was not confirmed by a similar new swing high in the Transports (red line). It suggests a deeper move lower could be in the cards, beyond a standard correction to the bull trend.

Happy Friday. 

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

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Comment

Reaction to the Bank of Japan Decision to “do nothing”…

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Quotable

“If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn't. And contrary wise, what is, it wouldn't be. And what it wouldn't be, it would. You see?” 

--Lewis Carroll, Alice’s Adventures in Wonderland & Through the Looking Glass

Commentary & Analysis

Reaction to the Bank of Japan Decision to “do nothing”…

 Mr. Carroll, I think we have entered the world of nonsense; it seems pervasive, but as it applies to monetary and fiscal policy nonsense is the word.  For the down the rabbit hole we have gone.  How else can one explain the fact central banks have completely lost their rudders yet markets turn on every utterance of useless gibberish?  

It seems clear to me our central bank “leaders” are making this stuff up on the fly.  I would suggest these new market master manipulators request a refund from whichever illustrious institution charged them for earning a Ph.D. in economics.  To torture this further, it reminds me of the movie “Good Will Hunting.”  It starred Matt Damon playing the role of the local “uneducated” South Boston toughie/genius.  In the movie he confronted a crowd of cocky Harvard elites in a bar showing everyone how smart they were.  Damon chopped them down to their proper intellectual size and showed them they weren’t quite as smart as they pretended.  He then told them if they would have spent $2 on a library card, and used it, they could have saved their parents tens of thousands of dollars on their vaunted Harvard education.  A perfect analogy I believe for our central bank Ph.Ds.

Had our CB masters shunned Ph.Ds. and the econometric nonsense so associated and instead concentrated solely on Ludwig von Mises magnum opus, “Human Action,” they would not only have saved their parents big money, but saved us from the ongoing shit-show they call monetary policy.   

But it seems traders and investors are enjoying the show and playing their roles nicely—hanging on every central bank utterance as if its mana from heaven.  How can it be other than a world of nonsense considering the reaction to the Bank of Japan’s decision to do nothing?   

Empirical evidence suggests what the BOJ has been doing isn’t working.   So, when the BOJ stops doing something that isn’t working and finally shows some degree of what we might define as rationality, what does Mr. Market (which I define as a group of highly irrational people) do—it violently reacts as if “something” should have been done.  If that isn’t nonsense I am not sure what is. 

But of course, today, in retrospect, there is likely some pundit, somewhere, explaining the reaction to the poor decision by the BOJ as completely “rational” based on his knowledge of monetary policy and its proper application for maximum efficiency in transmission of all that is good for the real economy, etc. etc. etc.  Barf!

Said pundit likely has two things to fall back on to help justify his analysis: 1) an advanced degree of some kind from an Ivy League institution; and 2) never traded his own money in highly leveraged markets.

It’s not a stretch to suggest short USD/JPY (long JPY/USD) is a very crowded trade now.  And if so, just maybe we are getting close to the end of this move.  Next key support at 106.60; then the swing low at 105.18…will the oscillator pattern repeat as seen in the weekly USD/JPY chart below?  Stay tuned. 

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

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Comment

GBP/USD Daily: A Brexit Anxiety Breakdown?

Brexit talk is everywhere.  Even President Obama can't help himself from meddling into UK politics on the issue. Despite the scary talk from the Bank of England, it doesn't seem to have hurt the pound.  Will that change soon?  Here is our primary technical view on the pound--it's bearish. Seems a good risk/reward setup.   

  Jack Crooks Black Swan Capital LLC www.blackswntrading.com 

 

Jack Crooks

Black Swan Capital LLC

www.blackswntrading.com 

Comment

USD/JPY Daily: At a critical juncture?

Is the bottom in place for USD/JPY?  Testing key downtrend line resistance and swing resistance in what so far has been a minor three wave move from the 107.61 low.  News flow suggesting Bank of Japan going to negative rates on loans as the driver.  On the radar screen again...

Interested there are a lot of yen bulls expecting the yen to continue to appreciate, as measured by the CFTC Commitment of Traders report on CME open interest, dated 4/12/16:  

Bullish Open Interest:  100,120 = 75%
Bearish Open Interest: 33,930 = 25%

Plenty of power to drive the yen lower, i.e. USD/JPY higher, on a sentiment swing here...

Jack Crooks

Black Swan Capital LLC

www.blackswantrading.com 

Comment

The “Three Calm C’s” suggest the dollar likely ranges for a while still

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Quotable

“Every parting gives a foretaste of death, every reunion a hint of the resurrection.”

     --Arthur Schopenhauer

Commentary & Analysis

The “Three Calm C’s” suggest the dollar likely ranges for a while still

If you’re a longer term trend follower, and you trade the US dollar index using an exchange traded fund, or the listed futures contract, you may not be a happy camper.  The dollar index peaked at 99.21 back on the 13th of March 2015, just over a year ago.  Since then, the index has been ensconced in a maddening range.   From a wave perspective, it appears price action is tracing out some type of corrective wedge pattern.  Once completed, it will set the stage for another trend move.  My guess is the bull move will resume once this wedge is complete …

…but this maddening range could be with us for a while. 

Why? Because of the “Three Calm C’s” so well described by Joachim Fels, global strategist for PIMCO, and for many years prior toiled away at Morgan Stanley.  I always liked him.  He seems grounded in reality; and has an excellent grasp of global macro IMHO.

[Note: Though Mr. Fels is better positioned than I am to make such a determination, I disagree with his contention there was some implicit agreement at the G-20 to stabilize the US dollar.  As I said to our subscribers in a recent note—the G-20 can’t even agree on the type of wine and cheese they want on the hors d'oeuvre menu.]

Mr. Fels “Three Calm C’s” make a lot of sense to me; maybe because it dovetails nicely on my current intermediate-term outlook, much of which I have been sharing here lately. The three C’s are:

  1. China
  2. Commodities
  3. Central banks

Unlike some other commentators who seem to believe China crisis is inevitable, I don’t.  For the reasons enumerated in Currency Currents on March 13th;  Lurching from nirvana to crisis; our dogma is barking?  So, if crisis is avoided at least for a while, then it’s unlikely we will see a major risk-bid into the US dollar (which will likely at some point be one of the drivers for the next trend move once this maddening range is complete).

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I have been expecting a playable multi-week or -month move thanks to China stabilizing and prices lurching deep into “oversold” territory, as indicated on our blog post, Commodities Turning? The negative correlation between commodities and dollar remains intact; not anything like it was during those the old “risk on” and “risk off” environment, but still. 

I have shared our $50 oil forecast.  And interestingly the oil-US dollar index 21-day correlation has risen sharply and is now at 87%--that is tight.  So as oil stages a pull-back, in what we expect is a minor correction on the way to $50, we see the dollar strengthening, i.e. moving higher in minor wave D as labeled in the chart above.  So, if oil rallies again, we expect it to coincide with another pull-back in the dollar—tracing out what we have labeled Wave E in the dollar index chart above; it will be a good time to start playing the commodity currencies from the long side once again.  

And of course the last C is central banks.  What more can be said about our illustrious monetary mavens.  I would only add this: I agree we are now off into monetary policy never-never land and the opportunity for unintended consequences abound, but the juice the banks are providing continues to support financial assets.  And though I’m extremely skeptical, it is possible negative interest rate policy may force more money where it is needed, into the real economy. In addition, with global central banks pushing rates deeper into negative territory seeming by the day, it will be hard for the US Fed to be overly aggressive given they signaled their role as defacto world central banker trumps its US role. 

Thus, if financial assets and real estate remain afloat, a panic move into the dollar will be delayed.  Given my bent toward the Austrian School, it’s difficult to watch this monetary madness playing out without thinking the end is near.  But it is quite amazing how long governments and their central bank allies can keep the balls in the air. So far, a lot longer than most concerned citizens expected. And the juggling act is still in session.

Keep in mind, just because the dollar index is ranging doesn’t mean we aren’t seeing excellent short-term trading opportunities in FX—we actually are, evidenced by a very good month for our forex service. But for longer term US dollar index trend followers, the ebb and flow of angst seems likely to continue for a bit.

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

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 For just $89 per year, our new service will help you anticipate trends in US stocks, emerging market stocks, US long bonds, gold, oil, and the US dollar…

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Comment

Directional views you can act on; not platitudes ... Stocks,Bonds, Gold, Oil, and the Dollar

Below are the views we shared in our most recent issue of Key Market Strategies about the major markets with our subscribers.  If you find this information useful, as a directional trader whether short- or intermediate-term, we would be happy to have you as a subscriber--we believe our directional views, based on our Elliott Wave and other pattern analysis are helpful and a real bargain for only $89 per year

Mon 21 March 2016

Comments: Near-term looking for stocks to stage a correction lower; commodities to follow; bonds to edge higher; and the dollar to work higher again in the wedge pattern.

Stocks--SPY Daily [last 204.67]: Key juncture. Stocks rallied to bang on the 78.6% resistance level at 205.23 we have been watching and have back off slightly.  This would be a natural place for a correction lower in Wave 4 targeting down to 200; with the next target being the swing low at 197.38.  If stocks turn down here, we would be watching for a three wave decline because that would strongly suggest the rally phase is not over and we have only seen Wave 3 of 5.  In the chart below we have drawn a stylized three-wave corrective decline, i.e. Wave 4.  Intermediate-term players may want to sit through a corrective move lower; however the risk to that strategy is the possibility the impulse move from the low is complete, i.e. alternatively we have seen Wave 5 high as labeled in red.   But our primary view is the next move is likely corrective.  For some more perspective, drilling down to the 4-hour chart, see page 2.

Stocks--SPY 4-hour View:  Note the divergence in momentum relative to the price high (Stochastic indicator at the bottom pane of the chart).  This adds some credence to the view at least a near-term top is in place. 

Emerging Markets--EEM Daily [last 34.10]:  We have seen a standard 38.2% retracement in EEM, reaching our initial target of 33.90; ultimately we expect to see at least 35.86—minor Wave 5 where it hits swing high resistance at 50% retracement before the rally is complete.  Given the tight ongoing 21-day correlation between EEM and SPY at a whopping 96.5%, we would expect a correction here in line with analysis as described in SPY above.  We suspect any Wave 4 correction lower should hold the above the down-trend line (in red); if not we will have to reassess this outlook.

Long Bonds--TLT Daily [last 128.07]: We haven’t got much more clarity here.  I am neutral-plus (if that makes sense), i.e. expecting a rally near-term in Wave B as labeled to 132-134 level—longer term it appears an intermediate-term high is in at 135.24 and a new three-wave corrective downtrend may be underway—still primary view by a small margin and I have shown that stylized path in the chart below as an A-B-C correction in blue.  But the alternative view is the move from the 135.24 high through the recent swing low made on 3/11/16 at 127.21 is major Wave 4 (labeled Alt 4); setting the stage for a new rally high. 

Gold--GLG Daily [last 118.96]: Now expecting a correction lower in minor Wave (b) to be deeper than initially thought last week—targeting down to 116.13 (a=c). Note the divergence in momentum (RSI) as GLD made a rally high. We expect a three-wave rally (a)-(b)-(c), with cope in Wave (c) to carry to first resistance comes at the swing high 125.34; with extension targets all the way to 139.82.  

Crude Oil--USO Daily [last 10.59]: We are viewing the rally from the low (7.67 on 2/10/16) as the first wave, labeled (a), of a three wave rally to carry to around 13.  My primary view is we are due for a correction here (which would coincide nicely with a decline in stocks as there is a 21-day correlation between SPY and USO of 92.6%).  USO is testing key 38.2% retracement resistance at 10.92, i.e. minor Wave 5 of A. I am expecting a pull-back to 9.5-level in Wave (b); then a resumption of the rally. I still suggest intermediate-term players consider staying long with a 13 target holding through corrections.  That being said, critical support comes in at 9.07…a break of that level changes the view here and sets up another drive for new lows.

US Dollar--UUP Daily [last 24.70]:  There is evidence to suggest a move back to 23.72 (on a break of the 24.72 near-term swing support).   However, given the price action the individual pairs and the relative correlations with other asset classes, there is still reason to believe we see yet another move higher in a maddening wedge pattern, if so then UUP looks to work higher again.  I am not buying into the idea that some implicit deal to lower the value of the dollar was secretly negotiated at the last G-20 meeting as is now be rumored in the financial press. The G-20 crowd seems a hapless bunch who likely has trouble on agreeing wine and cheese selections to put on the menu.  After this maddening wedge (labeled as Wave 4) is completed, I am expect the UUP to make a new rally high.

Jack Crooks

Black Swan Capital

www.blackswantrading.com

Comment

Dotty confusi-nomics and the dollar.

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Quotable

“There are designations, like ‘economist,’ ‘prostitute,’ or ‘consultant,’ for which additional characterization doesn’t add information.”

--Nassim Taleb

Commentary & Analysis

Dotty confusi-nomics and the dollar.

I watched America’s lead economist—Fed Chairman Janet Yellen—talking about the economy yesterday; and after she was done I was more confused than when she started—but was happy with the outcome as our subscribers and I were long the British pound.   

This is what I heard from Chair Yellen: The US economy is doing well; but not that well.  Inflation isn’t a concern, but we should be concerned as its ticking higher.  Global economic turbulence is dragging down our dots, but a strong US labor market should allow us to hike soon. 

So, the dotty takeaway—two hikes instead of four. 

So, the US Federal Reserve Bank will only hike twice during 2016.  This compares with an expectation of zero hikes, and possibly more cuts, from both the Bank of Japan and the European Central Bank this year.  It means the US dollar yield premium is likely to rise sharply against the yen and euro as the year progresses.  Knowing that, what should one do?  Well, the answer is obvious:  Sell the living bejesus out of the dollar, of course. 

The dollar was creamed on the news.  And continues to get hammered one day after Janet’s lesson in confusi-nomics…but is this an opportunity for those who believe the real economy matters?  Maybe so! 

There a simple framework I keep in mind when watching the news and thinking about the currency market.  It is called The Dollar Smile. I first saw this in a research note writing by Stephen Jen, when he was with Morgan Stanley—a firm that does great currency research IMHO.  The Dollar Smile looks like this:

Three scenarios gleaned from the dollar smile:

 1)      Left side of the smile reflects an appreciating dollar as global risk comes back into the financial system.  Despite the ongoing problems facing the US economy and the much talked about structural problems that are supposed to hurt the dollar, e.g. budget deficit, trade deficit, etc. the dollar could rally significantly if there’s a shakeup to the global financial system and risk increases outside the United States, as money flows back to the center to hide in US deep capital markets—think about that $3 trillion or more in emerging market debt flowing in on contagion.  Well, I thought Janet & Company told us there was a lot of concern about global markets?

2)      The middle of the smile reflects dollar depreciation against the major currencies as the US economy muddles through soft spots.  Implicit in this view is ongoing weakness in the US economy led by a consumer that capitulates to falling housing prices, rising energy prices and too much debt, etc., etc., rising possibility of a pending US recession or downward growth surprise.  This would shift the expectation among currency players for a Federal Reserve Bank “on hold” to a Federal Reserve Bank in “cut mode” going forward. But I thought I heard Janet & Company say the US economy was doing well relative and the labor market was still improving nicely?   

3)      The right side of the smile reflects an appreciation in the dollar on the back of strong US growth.  This is the rising yield differential stuff that pulls in hot money and a greater share of foreign direct investments as the US economy grows faster than key competitors and the Fed is planning to hike—which is self-reinforcing.  Well, if I am not mistaken, even though the dots have fallen, they are expected to get up—leading to two more hikes this year, as said above, which means strongly rising relative yield differential given the BOJ and ECB will most likely not be hiking again in our lifetime.

So, based on the framework of the Dollar Smile, it adds to my confusion as to why many have jumped back onto the dollar bull market is over bandwagon.  I don’t think it is over.  But I do believe in self-reinforcing price-driven trends that can run further than fundamentals would suggest.  And given my expectation of a rally in commodities (oil and gold)—which I shared with you a couple of weeks ago—I think this has more to do with dollar weakness than anything we can actually glean from the country’s top economist. 

So here is my best guess on a downside target for the US dollar index if this commodities move remains intact:

A 38.2% retracement of what I have labeled as Wave 3 rally means the dollar index falls another 2.5% from here—92.21.  Obviously, there is plenty of scope for more.  And that fact has the dollar perma-bears and the gold perma-bulls pretty excited right now.  Stay tuned.

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

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

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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.  

[You can learn more about our currency services—Forex & Currency Options—by visiting our website at www.blackswantrading.com ]

Jack Crooks

President, Black Swan Capital

info@blackswantrading.com

www.blackswantrading.com

Black Swan Capital New Service Announcement

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Note: If you would like to see a sample issue before subscribing, please send us an email and we will be happy to share it with you…email us at info@blackswantrading.com  

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