Reader Questions Answered

Is the Japanese Yen a Safe-Haven Currency?

Frequent trading question-asker Rod is back with another one. He sounds worried that he’s asking a foolish question, but it’s hard to get better and more knowledgeable if you’re afraid to ask when something confuses you. Fortunately for me, his question isn’t too hard to answer. 🙂

Hi John,

I know, you will slap me for this, but I have to ask: I don’t get it, why is the Japanese Yen still a safe-haven currency? To put it similarly, why is the market still in love with Japanese Government Bonds?

Is there no credit risk in JGBs? With 200% Public Debt-GDP?

As always, thank you.


This question is clearly motivated by the big gains the Yen experienced Thursday as the stock and other markets were coming unglued and a serious risk aversion/flight to quality move was afoot.

What Rod has done, however, is forgotten something important – the carry trade. A considerable amount of yen has been borrowed and exchanged for other currencies (the Aussie being a favorite given the exchange rate differential) to be invested there. What Rod has viewed as a flight to quality to the yen is in fact a reversal of the carry trade.

The carry trade gets done when one currency can be had for very cheap (like the JPY) and the markets feel comfortable with the level of volatility and prospects for positive returns. As investors and traders get more relaxed and complacent about things they continue accumulating carry positions, forgetting about the risk side of things – rather link traders who stop thinking about how much they could lose and focus too much on how much they can make. When something happens to snap them back to reality, they start cutting back their exposure. This could be either from them worrying about the returns on their invested funds or concerns about the impact on their positions of a turn in currency exchange rates.

At this point the carry traders are nervous about their investments and are reducing risk. That means selling stuff they are holding, moving out of the currency they have switched into and back into the one they borrowed. That means selling stocks and other instruments and converting their AUD and other currencies back into JPY. When it happens en masse, as it has been of late, the JPY pairs get hit hard because of all the yen buying.

This is not a flight to quality run into the Japanese currency. It is simply traders and investors paying back yen-denominated loans. This is a get flat move, not one positioning market participants long the yen. The flight to quality was actually into the dollar and US Treasuries.

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Taxes, Budget Deficits and Inflation

A couple of things have come out from different politicians the last couple days which have me shaking my head. File this under big picture macro fundamental anlysis, I suppose. I don’t normally offer up market analysis here, but it’s worth indicating the way one can approach market analysis.

Tax Hikes Leading to Inflation
The first is a statement yesterday by the governor of the Mexican central bank. In talking about forecasts for the year to come he expressed the view that tax hikes instituted in the latest budget could add 50bps (0.50%) to the annual inflation rate in 2010. I can only pressume that he means said tax cuts will somehow filter through into higher consumer prices as a pass on effect.

Now I don’t know the specifics of the tax hikes in question, so I can’t speak directly to the type of pass-along effect there might be and from what directions. I seriously doubt it would ever be a 100% pass through from producers to consumers, and some of the hikes may directly hit comsumers, which wouldn’t be involved in price levels at all. In other words, I have lots of questions about how much pass-along there is likely to be.

On top of that, there are two other elements to the inflation equation. To the extend that pass-along taxes increase prices and/or taxes directly impact consumer it will lower demand. That would tend to put downside pressure on prices. Furthermore, when the government increases taxes it pulls more money out of the system, reducing money supply. If inflation is at least partly a function of money supply, then taxes tend to be a depressive factor rather than an expansionary one.

Government Budget Deficitis of 3%
US Treasury Secretary Geithner was on CNBC this morning talking about the plan to get the US budget deficit down to 3% of GDP with the work on getting it down there starting in 2011. The EU finance ministers set similar targets for several members to reach by 2012-2015. So in other words, the world’s major economies will still be running budget deficits for quite a few more years to come.

Why is this important? Because one of two things have to happen. Either more sovereign debt (Treasuries, Gilts, Bunds, JGBs, etc) have to be issued or the monetary base will expand by the amount of those unborrowed deficits. In the latter case you get inflationary pressures. In the former you get lots more supply of debt instruments. Both tend to equate to higher interest rates over time.

Now if all countries are running deficits and not issuing debt to offset then everyone will see inflationary pressure, but it will tend to be cancelled out in the forex exchange rates. Things like commodities (think gold and oil), however, would tend to see price appreciation.

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A Sample of Professional Market Analysis

I received an email a short while ago outlining the three reasons an analyst at CIBC World Markets has for buying EUR/USD right now.

1) Diverging perceptions of interest rate policy. Fed’s Bullard talks about extending asset purchases beyond the March cut off time while the ECB appears to be taking the 1st step in a exit strategy, tightening ABS standards. Nothing creates a better trend than diverging interest rate policy.

2) EU positive M&A interest (Reliance’s EUR 10 bln bid for LyondellBasil) should put an underlying floor under the market.

3) IMM spec longs were cut in half, taking over $2 bln out of EUR positioning. Spec’s are now as flat as they have been since the 1st week of Sept, leaving plenty of room for positions to be rebuilt. EUR/USD is running higher on the broader risk outlook but this will likely only further pressure fast money to get back involved.

Target the 1.5300/50 area for now, using the 55-day MA (1.4790) as a risk point for now.

I’m not in any way presenting this as a recommendation, nor do I make any judgement on the validity of his analysis. I only show it to you to give you an idea of the sorts of things market professionals look at in their work.

This is a real mix of methods. The first reason is fundamental. The second one is focused on flows. The last reason comes from positioning data (Commitment of Traders). The target and “risk point” are derived from technical analysis.

This sort of analysis is not atypical. Market analysts use an array of tools and techniques. They also write to an audience which themselves uses different methods, which means they have to frame their arguments in a way which is going to resonate with their readers. That means speaking to the types of things those readers are looking at and thinking about.

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Understanding the Talking Heads

Talking heads abound in the markets. There are corporate CEOs and other high-level officers. There are central bank members. There are treasury and ministry of finance officials. There are heads of state. There are prominent money managers, economists, and other professionals. Opinions and philsophy and ideas come at us constantly. Personally, I mostly ignore those offering opinion. Generally speaking, those folks aren’t the type of decision-makers who will actually drive prices.

The government and central banks speakers, however, are a different story. As I noted to someone in an exchange a short while ago, they may not generally be price makers, but they are definitely price influencers. And I’m not just talking about what they say. What they do is even more important. That’s what I want to speak to here.

I’m going to pick on the US Treasury Secretary – not specifically the current one, but pretty much the whole string of them. How many times have you heard some version of “we want a strong dollar” coming out of that office? It’s like a mantra, isn’t it. They say it all the time. They might even actually believe it most of the time.

Here’s the thing, though, things have priorities. The goverment might actually want the currency to be strong, but that may or may not be high on the priority list. In fact, most of the time there are things the politicians rate more important. That’s why you get the dollar falling when the Treasury Secretary making strong dollar comments.

It all comes down to what they are actually doing. Things like running big government deficits is generally something that will weigh on a currency. Relatively low interest rates will tend to do the same. Changes is taxes or regulation or trade policy can also impact the relative attractiveness of one currency against others.

I think we all know intuitively that more attention should be paid to actions than words, but sometimes that can get forgotten in the heat of the moment when the market is reacting (or not reacting) to news. If there seems to be a disconnect between what some talking head is saying and what’s being done, always go with the latter.

Then too there’s the fun times when there are conflicting comments. That has been the case with the UK in second half of this year. Members of the Bank of England made some pretty clear comments over the summer about the attractiveness of a lower pound. They were in the middle of their quantitative easing program, which was a natural drag on the currency’s value. A couple of months ago, though, several voices from within the government tried to counter “weak sterling” comments saying the BoE really wasn’t looking to weaken the currency. At no point, however, did anyone from the central bank actually say that. As a result, and lift sterling got from the “positive” government comments was quickly erased.

All of this falls under the category of good fundamental analysis. It’s not just looking at numbers. It’s also about understanding what the policy makers are doing, or intending to do, as they are big influencers on trends.

Trading Book Reviews

Book Review: Reading Minds and Markets

[easyazon-link asin=”0132354977″][/easyazon-link]I’ve recently been reading a book titled [easyazon-link asin=”0132354977″]Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace[/easyazon-link] by Jack Ablin. Ablin is a long-time money manager with experience in both the fixed income and equity markets. While at first glance I think a lot of folks would probably say this book isn’t really something traders would be interested in, I think there are some nuggets to be had for those with a fundamental approach to the market and those who like to have a big picture view of things.

I don’t know how well the title actually sets up the book. Clearly it was crafted to hit the hot button concepts. The book is primarily about asset allocation – picking the best place(s) to put money to work.  Ablin provides what he considers the five ways one can look a the markets (speaking mainly of stocks and bonds here, but thinking on a global scale) to evaluate areas of potential opportunity. For each of those ways he provides some ideas for metrics which can be used to provide the necessary relative analysis.

The discussion of different potential metrics I found quite useful. It stimulated some ideas for me in the things that I do, and I’m sure it would do the same for other readers as well. These are, of course, more macro measures looking at broader themes, but that’s the basic point. Ablin pounds the table quite frequently about the value of looking at things top-down.

High level portfolio allocation type books can sometimes be very dry and boring. This one is actually quite approachable. The author includes quite a few personal anecdotes from his experience managing funds, showing both his triumphs and the short-falls which motivated him to improve is knowledge and methods. My one gripe was that the book was written to a bit too low a level of reader. Obviously, that makes it accessible to a wider audience, but I personally found some of the written annoyingly basic.

That drawback aside, for those who are interested in top level asset allocation type decisions, or who want a set a tools they can use for macro level analysis, I think this is a book which can offer up a lot of useful tips and ideas.

Reader Questions Answered Trading Tips

Technical/Fundamental analysis a child’s game

A reader named nikesh posted a comment to yesterday’s Improving the Win Rate of Trend System With Oscillators entry. It brings up some things about my own approach to trading and the markets that I think could do with a bit of clarification.

i don’t want to do any effort to spill out your trading system public; but it seems that you don’t follow any MA, donchian channel sort of things (buying the strength and selling the weak), oscillitors or any thing which is so called a technical analysis. And I am almost sure that you are not trading on fundamental basis…

When you answer all these questions it seems that you have a system which is above all other things and other technical/ fundamental analysis seems a child’s game for you…

I said that i don’t want to do any effort … but still can you please give the readers some clue what exactly a successful trader like you is doing the market and making a good amount of money??????

First of all, I would refer nikesh to Can a Shared Trading Edge Still be Profitable?, which I posted the other day. That addresses my feeling on the “spill out your trading system” subject.

Don’t equate my writing to my trading
As for my not using technical analysis or fundamental analysis, nikesh has drawn an erroneous conclusion from what he’s read of my writings. When I write on this blog and otherwise discuss market analysis methods, styles of trading, etc. I intentionally try to take a neutral stance. I have things which work for me. They may or may not work for others. At the same time, things which work for others don’t particularly suit me. Unlike some commentators, I do not belittle methods I don’t particularly find useful because I realize that there is no one right way to trade or methodology to employ. I try to provide readers with the information they need to make decisions for themselves.

The reason technical and fundamental analysis may seem like “a child’s game” to me is because I’ve been at this for more than 20 years. I couldn’t even guess how much system research and testing I have put in over the years. I’ve done more analysis and trade strategizing – either for my own part or on behalf of readers of the professional products on which I’ve worked – than I care to think about. I’ve read loads of books and articles – some good, some not so much. In other words, through educating myself and application of what I’ve learned I have accumulated a lot of knowledge and experience. On top of that, teaching others creates a whole new level of awareness you can’t get in other ways. And I don’t plan on stopping any of that any time soon.

What I use in my trading
I most definitely use technical analysis in my trading. In some cases I also use fundamentals as well (primarily in my stock trading). One of the methodologies I like to employ, especially in shorter-term trading,  can be found in the Following the Quest for Value course I put together a while back. From a technical analysis perspective I could be put in the “price action” category in as much as I do not use indicators. I do keep an eye on volatility readings such as the width of the Bollinger Bands and Average True Range, but I do not use either specifically in my trading to pick trade points or stops or anything like that.

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Thoughts on CANSLIM

Last week I received an inquiry from a fellow member at Trade2Win.

I have your book and I think its great, im about half way through. I have read some of your posts here and think you give excellent consistent answers. I read that you are a canslim follower with a small deviation. Im not by any means looking for easy answers but the way I see it is surely canslim is too abvious and prone to manipulation to work in its pure form? I was wondering what your interpretation of canslim is, as I have much respect for your work.

First of all, let me clarify what we’re talking about here. CANSLIM is the acronym for a stock trading system developed by William O’Neil, creator of Investors Business Daily (IBD). It can be found in the book How to Make Money in Stocks, which is now in its 4th edition. The original edition is one of the first books I read about when I was getting my start in trading and I still consider it to be perhaps the single most influential of all the one’s I’ve read.

To put it most simply, the CANSLIM approach combines technical analysis and fundamental analysis into one full long-only individual stock trading system. On the technical analysis side the focus is really only on chart pattern analysis. It doesn”t employ or even discuss indicators. As for the fundamental analysis, it is has both top down and bottom up elements to it, but is mostly the latter – focusing primarily on the companies.

Gaming the system
Here’s where the cynicism of the modern trader come in to play. The trader asking me about CANSLIM has suggested that it’s “too obvious” and “prone to manipulation”. I personally don’t see it that way.

To be sure, there is definitely some CANSLIM gaming that goes on, but it’s more about the lists the folks at IBD publish than the core strategy. There is a list of 100 stocks the IBD folks put out each week (I think) which lists the stocks they consider the best bets based on the CANSLIM criteria. Because inclusion in that list can generate a great deal of investor action in a stock, there are those who try to anticipate stocks joining the list and trying to profit from the bump new entrants can see. This, however, is a minor thing in the grand scheme.

Richard Dennis, creator of the Turtles, was reported to have said that he could publish his trading system rules in the paper and not have to worry about it hampering his performance. I’m with Dennis on that. There are millions of traders and investors using a vast array of methods for deciding what and how to take positions in the markets. Even the ones using the same system have variations in how they are doing so in terms of timeframe and instrument and such. On top of that, there are always those who simply can’t stick to the rules. We know this to be true. That’s one reason why I don’t see the CANSLIM methodology as being “too obvious” or anything like that.

Further more, CANSLIM is based mainly on intermediate and longer-term trends. These are not readily manipulated because they are generally founded in core fundamentals, like the trend in earnings.

Laying it all out
Those who have read The Essentials of Trading know that in the appendix I have posted the full stock trading methodology that I have used for many years and continue to use at present. As noted in the book, it has CANSLIM as the foundation. I’m not saying the CANSLIM methodology is for everyone. It isn’t. From the first time I read How to Make Money in Stocks, though, it made intuitive sense to me, and still does.