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Changing the monetary regime

currencies

A recent article on Zero Hedge talked about how the folks Switzerland are considering eliminating fractional reserve lending. The piece starts off by sharing the results of a recent vote in which a referendum requiring the Swiss National Bank (SNB) to increase it’s proportion of reserves in gold up to 20%. It called that a failure to move toward more “sound money”.

Any time someone talks about money backed by something – gold, silver, whatever – being “sound” I can’t help but shake my head.

Having currency backed by something doesn’t make it sound by itself. The issue is fractional reserve lending. That’s the process by which banks lend out some multiple of the amount of money they actually have on-hand. For example, banks in the US are only required to have 10% of the money they lend out on-hand in the form of reserves.

If you have a currency backed by gold and still allow fractional reserve lending, you don’t have sound money. As long as financial institutions can lend more than they have on-hand, then the same problems exist as in a non-backed currency situation. Banks can create money. If you ascribe to the idea that inflation is caused by too much money chasing too few goods, then here you have a contributing factor.

Essentially, if Switzerland were to eliminate fractional reserve lending it would mean banks could no longer create money. That would be paradigm shifting in modern finance.

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Reader Questions Answered

Investing in forex

I’ve been working on a short article that will likely end up on a Reuters blog at some point in the not too distant future. The subject matter is investing in the foreign exchange market. It took my a while to kind of wrap my head around how best to address the subject, but I think I finally have done. I’ll post a link when it goes up.

In the meantime, though, I wanted to hear what you thought about the idea “investing in forex”. What does that term mean to you?

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Reader Questions Answered

Working Out Position Size in Forex Trading

I got this (slightly edited) private message inquiry from a Trade2Win member yesterday. It gives me a chance to reiterate something which has new forex traders minds spinning regularly for nothing.

… wondered if you could assist me in working out my position sizing for different currency pairs? Be great if you could as im a bit stumped…

Say i have an account of £10,000

I want to risk 1% which = £100

I’d like to buy usd/chf @ 10500, with a stop of 20 pips @ 10480.

How do i go about working this out if i have leverage of 100:1?

Dealing with USD/CHF pip values isn’t quite as clean and easy as dealing with those of EUR/USD where they are fixed (in dollar terms), but it certainly can be done. The math isn’t all that hard.

To get the pip value for a pair where the USD is the base currency (quoted first) you are effictively determining what a pip represents in % terms relative to the market price. In this case we’re looking at USD/CHF with a starting value of 1.05, thus

Pip % value = .0001/1.05 = 0.00952%

So if we’re trading a full standard lot ($100,000) then the pip value will be $9.52, which is $100,000 x 0.0000952.

Now the question is how to determine position size based on a 20 pip stop loss for a given risk exposure. The first step there is to figure out the 20 pip % value. That’s 0.0020/1.05, or 0.19048%. From there you have to do some algebra to figure out the size of the position based on how much you are risking. You’re using this base formula.

R = PPV x S

Where R is risk amount in $, PPV is the pip % value for the number of pips you’re risking, and S is the position size in $. Flipping that around to solve for S you get:

S = R/PPV

Using our example, we have a £100 risk. If the GBP/USD exchange rate is 1.50, that’s a $150 value for R. Plugging in that into the formula above and we get:

S = $150/0.19048 = $78,750

Rounding down that gives us either 78 micro lots or 7 mini lots.

We can put all of the above into one formula.

S = R/(Pf/Pr)

Where Pf is the pip fraction (decimal difference between entry and exit) and Pr is the current market rate for the pair in question. Using our example numbers we have:

S = £100/(.0020/1.0500)

Using the GBP/USD value of 1.5 that becomes

S = $150/(.0020/1.0500) = $78,750

Now here’s where the 100: 1 leverage question comes in. Ready? It’s very simple. You just have to ask this question:

Based on my permissible leverage, can I take a position this size?

In this example where a £10,000 account is being used, so long as a major chunk of those funds aren’t already being used for margin on other positions, the answer is yes.

To put it another way, the leverage question plays absolutely no part in determining the size of the position you take when you are working out that size from how much risk you want to take other than to set the upper end limit of how big that could be.

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Trading Tips

A Peak Inside Professional Level Market Analysis

I want to share something with you that I recieved today in my email from one of my co-workers. He actually works on the rates side of things, focusing particularly on the US Treasury market. The content of the email, though, has clear forex market implications. I offer it up as an example of the sorts of things that market professionals look at and talk about that the vast majority of retail traders would never even think about.

The ECB’s money market operations have effectively delivered a significant tightening of monetary policy especially when compared to the effective easing of policy that has occurred in most other economies over the last month.

The result has been a substantial rise in the EUR yield advantage that the market has not been able to ignore.

The ECB policy of shifting the slide-rule on their 1% rate from 12mth to 3mth terms has lifted the overall money market yield curve. The 1% benchmark rate level now means more to where short term money market rates trade.

With less term funding, this has put upward pressure on all yields across the front end of curves. 2yr bund and swap rates rose a further 7.5bp today. Over the course of the last month, the USTr-Bund 2yr yield spread has moved in favour of the EUR by over 30bp to +5bp. The 2yr swap rate spread has moved up by 35bp to +44b in favour of the EUR. In a global environment of falling yields over the last month, EUR’s yields have risen against virtually all comers. The chart below shows the EUR/USD compared to the 2yr yield spread.

There are some complex elements to the commentary above, but the bottom line is that the recent technical moves on the funding side of things by the ECB has created a rate crunch on the short-end, and when short rates go up it tends to make a currency more attractive. Looked at a chart of EUR/USD lately?

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Reader Questions Answered

Understanding Currency Moves Requires Looking Deeper

Reader Rod is a good one for sending me questions, and generally interesting ones at that. Here’s his lastest inquiry.

Dear John,

What was the source of Yen strength from April to December 2009?

The carry trade was back, so “unwinding of the carry trade” doesn’t seem right.

“Safe haven currency” would be odd as well, as there was a global “risk on” investment theme during the year.

Their trade surplus was contracting, and so was economic activity. Budget deficits as a % of GDP the highest in the industrialized world.

Expectations of an Inflation differential (and interest rate differential) were not biased to the upside.

“Potential for capital appreciation” (stock market expectations), not really.

Thank you.

Rod

Unfortunately for Rod, I’m going to have to give him some stick here – in a nice way, of course. 🙂

First, let’s look at a USD/JPY chart of the timeframe in question. The line is a linear regression to highlight the general trend of that period, not that it really needs much highlighting.

Now let’s take a look at a chart of the Dollar Index for the same period.

Notice the same downtrend pattern. In other words, USD/JPY was falling on dollar weakness rather than yen strength.

Just to reinforce that view, here’s EUR/JPY for the same timeframe.

As the regression line shows, if anything there was a slight upside bias to the cross, meaning a weaker yen, though I’d call it basically neutral.

The moral of the story is that in the forex market (and others as well) one needs to look beyond just one pair to get the real story. After all, a pair represents only the relationship between two currencies. It may or may not be reflective of general strength or weakness in one of the components.

Had Rod looked beyond USD/JPY to determine the real position of the yen he would not have realized that it really didn’t rally during the April to December timeframe, putting his mind at rest. 🙂

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Trading Book Reviews

Book Review: Making Sense of the Dollar

[easyazon-link asin=”1576603210″][/easyazon-link]I’ve just finished reading [easyazon-link asin=”1576603210″]Making Sense of the Dollar: Exposing Dangerous Myths about Trade and Foreign Exchange[/easyazon-link] by Marc Chandler. You may be familiar with Chandler from appearances on CNBC. He is currently the Chief Foreign Exchange Strategist at Brown Brothers Harriman, having prior held a similar post with HSBC. He’s written a number of magazine and online articles, and teaches at NYU as well.

What Chandler looks to do with Making Sense of the Dollar is to dispute many of the commonly held views about the US currency, international trade, and related economic and political considerations. He does this by presenting ten myths and criticisms of them. Those myths are:

  1. The Trade Deficit Reflects US Competitiveness
  2. The Current Account Deficit Drives the Dollar
  3. You Can’t Have too Much Money
  4. Labor Market Flexibility is the Key to US Economic Prowess
  5. There is One Type of Capitalism
  6. The Dollar’s Privileged Place in the World is Lost
  7. Globalization Destroyed American Industry
  8. US Capitalist Development Prevents Socialism
  9. The Weak US Dollar Boost Exports and Drives Stock Markets
  10. The Foreign Exchange Market is Strange and Speculative

I went into the book looking to view it from the perspective of a forex trader (and in my own case, analyst as well). With that in mind, while the amount of repetition was at times annoying, and in some places the author could have presented more evidence to support his assertions, the book certainly contains a lot of thought-provoking material.

The myth sections I found most interesting in regards to gaining insight into the workings of the dollar are 1, 2, 6, and 9. Not that the others aren’t interesting. It’s just that these four really, for me, get to the major critical issues which a lot of market watchers point at in terms of why the dollar has lost or can be expected to lose its position as the premier world currency.

I can tell you that the trade and current account deficits are things my professional colleagues often point to as unsustainable issues which eventually will have to correct – to the detriment of the dollar. Chandler says both are flawed measures based on outdated methodologies which do not properly account for modern trade and capital flow.

In terms of Myth 6 about the dollar losing its place, the author brings up a number of defenses for the greenback. One of them is the view that I myself have expressed on several occasions that one of the reasons that the dollar is the top reserve currency is the breadth and depth of the US financial markets. No other country or region can come close to matching them, making the US the place where excess savings looking for a safe place to sit comes, as witnessed by the dollar’s gains during risk aversion.

As to the idea that the lowering dollar’s exchange rate will boost exports and reduce imports, Chandler indicates that there’s no real evidence to support that notion. For example, he notes that in the early 90s a pair of Congressmen suggested that the dollar was 20% overvalued and that it needed to come down to close the trade gap. The dollar trended down for most of the decade, losing about 20% of its value in that span, but the trade deficit actually expanded. The author also points out that much of the cost of import goods to US citizens is actually added on to them once they reach our shores, so that the value of the dollar isn’t really a major influence on the prices we see. And of course he also points out that the largest portion of our imports comes in the form of oil and related products, the demand for which is relatively inelastic over the short- to intermediate-term.

New forex traders can often be heard to ask questions about what fundamental factors drive exchange rates, and with good reason. It can be a very confusing market in that regard as things which are clear drivers in one direction one week can be drivers in the other direction later. Chandler does a really good job in the space of a couple of pages in the 10th myth chapter of addressing the primary factors impacting the forex market and the concept of currency valuation. That’s really the only place “trading” of currencies is discussed. The rest of the book is more focused on looking at the big macro dollar picture.

As much as Chandler makes some interesting points about Capitalism vs. Socialism, in my view he spends too much time on the subject. One could even ask whether he needed to address it at all, but I was fine with it overall. He just got a bit repetitive on the subject.

The bottom line as far as Chandler is concerned is that the dollar is just fine the way it is and that attempts to focus on imports and exports and weaken the dollar to influence them could produce serious negative consequences. I definitely recommend [easyazon-link asin=”1576603210″]Making Sense of the Dollar[/easyazon-link] to anyone interested in the macro view of the dollar and global currency markets.

Make sure to check out my other trading book reviews.

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Trading Tips

Taking the Piss Out of Goldman

My British and Aussie/New Zealand readers will understand the above headline, as will those who have spent any time (as I have) with friends or colleagues from there. The rest of you will figure it out quickly enough as you read on. No, it isn’t about urine! 🙂

Actually, I’m not talking about the whole of Goldman Sachs here. It’s just one analyst based in London (I believe), but does demonstrate that not everyone who works for the company is brilliant.

A colleague of mine sent along this story

Goldman’s Currie Says Oil Drives Dollar Down, Not Vice Versa

2009-11-04 11:19:12.989 GMT
 By Juan Pablo Spinetto and Alexander Kwiatkowski

     Nov. 4 (Bloomberg) — Crude oil, which has risen 80 percent this year, is causing the U.S. dollar to weaken, driving metals and other commodities higher, according to Jeffrey Currie, head of commodity research at Goldman Sachs Group Inc.
     While oil has risen, the U.S. currency has weakened, leading to speculation that the dollar’s depreciation is driving investors to buy oil as an inflation hedge, thereby pushing up the price of crude.
     “I would argue the other way,” Currie said in an interview yesterday in London. “I would argue that higher oil prices drive the dollar down and then the weaker dollar drives the metals and soft commodities up.”
     The U.S. currency dropped to the lowest in more than a year against the euro on Oct. 26, while the dollar index, an indication of the international value of the currency, has lost 6.4 percent this year. Gold for immediate delivery has climbed 24 percent to a record this year while sugar is up 70 percent.
     “Oil represents 40 to 50 percent of the U.S. current account deficit, so a higher oil price represents an outflow of dollars that pushes the currency lower,” Currie said in the interview, after attending a Chatham House conference on food security.
     Goldman Sachs estimates that oil will reach $85 a barrel by the end of the year on Chinese demand for diesel, and $95 within 12 months time. Crude oil for December delivery traded at $80.35 a barrel, up 0.9 percent, on the New York Mercantile Exchange at 10:48 a.m. London time.

The immediate thing that jumped out at me was the “Oil represents 40 to 50 percent of the U.S. current account deficit…” bit. This is a really poor statistical analysis. I hesitate to even given it that much credit. You can say oil is X% of the total outflows. That would be fine. You cannot, however, state that one thing or another is X% of a deficit. A deficit comes about because outflows in total exceed inflows. It doesn’t mean some components are placed in the part of the equation that balances while others are placed in the deficit portion.

Be careful what kind of stats you accept – even from the so-called experts (and especially from politicians!) – as sometimes folks just don’t look at things the right way and in other cases they only present the information which supports their position (intentionally or otherwise). And watch out for making the same errors in your own analysis. They are insidious little buggers that can do real damage.

The said thing is this guy probably makes a lot more money than me. Maybe I should put in for a job at Goldman. 🙂

OK. Got that rant out of my system.

Here’s the real issue with what this Currie bloke is claiming in regards to the Dollar/Oil relationship. Oil prices can change without there being any change in currency exchange rates. It just becomes more or less expensive in all currency terms. This is what you would expect if prices are being driven mainly by supply/demand considerations. In other words, a rise in oil prices does not have to result in a decline in the exchange rate of the dollar.

On the flip side, though, a broad change in the value of the dollar against the other world currencies MUST result in a change in the dollar price of oil, holding the previously noted oil market supply/demand element equal.

Take a look of this chart of the correlation between EUR/USD and Oil prices.

Rolling 1-Month Oil vs EUR/USD Correlation

The chart above shows the rolling 1-month correlation between the EUR/USD exchange rate and Oil prices. That means each point on the chart shows the correlation between the two markets for the prior roughly 22 trading days. It shows that while most of the time the two have moved in the same direction (oil up, dollar down), there have been times when there’s been either little or no link, and at one point it the relationship was quite inverted. If oil was the main driving force in the dollar’s moves we would expect to see a more sustained positive correlation (though not necessarily always near 100%), not one that’s all over the place.