Forex: Making Sense of It All

One of the things we try to do as traders is to impose some type of order on the marketplace so that we can gain a better understanding of what is taking place. At times this seems like an impossible task as there are so many competing and contradictory events and policies that color the market on a daily basis.

And that is the challenge that the markets present. Oil prices are rising, yet we are told there is no inflation. The Japanese have had a major catastrophe and the BOJ is printing money, yet the Yen is strengthening. Market correlations sometimes also come into play, as do risk themes. However, the most important thing to look at is monetary policy of a given country. Look no further than the U.S. Fed.

Yesterday at the FOMC meeting, Bernanke remarked on the improving economy but made no changes to monetary policy. QE2 has been flooding the world with cheap dollars, so an over-supply of dollars has produced weakness, despite risk themes in the market. While there are pockets of individual data that contribute to an economy, how its Central bank responds is more important. There is most decidedly heightened risk around the globe, from the nuclear aftermath in Japan to the unrest in the Arab region, particularly Bahrain. Not to mention the potential re-surfacing of the Euro debt crisis. One would think that the dollar would be in demand as a safe-haven reserve, yet it has barely budged higher. In fact, the dollar is at an all-time low to the Swiss franc, another safe-haven currency.

So while it used to be good enough to say, "buy the currencies of countries with strong economies and sell those of the weak", it is also important to gauge the policy response as well. Don’t forget that currency pairs can be driven by economic weakness as well as economic strength.

In the forex market:

Aussie (AUD): The aussie is mostly lower though higher against the Dollar and Euro as fundamental weakness in those two has trumped the flight to safety.

Kiwi (NZD): The kiwi is also mixed despite lower than expected consumer confidence figures. This highlights the weakness in both euro and dollar.

Loonie (CAD): The loonie is mostly weaker despite the rebound in oil prices as it is taking direction form weakness in the U.S. economy.

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Euro (EUR): Inflation in the EU rose at the fastest past in nearly 2 years as CPI data came in a little hotter than expected. This puts additional pressure on the ECB to potentially raise rates despite the fact that yields are already rising on the sovereign debt of nations like Portugal, who were just downgraded again. (Click chart to enlarge)

(Click to enlarge)

Pound (GBP): The pound is mostly lower despite the fact that the jobless claims figures unexpectedly declined the most in nearly 8 months. Jobless claims were expected to rise by 1.3K but they fell by over 10K.

Dollar (USD): The dollar is mixed this morning as fundamental weakness from QE2 and dismal housing starts numbers is being tempered by risk aversion in the market.

Yen (JPY): The yen still continues to strengthen despite the additional liquidity added to the market by the Bank of Japan. While the nuclear situation is still uncertain, Japanese stocks experienced a "dead-cat bounce" on short-covering; though then Yen did not reap the correlative benefits.

At the end of the day, watching Central bank actions on policy can be the most telling way to get an idea of what is taking place in ALL markets. While individual economic releases and extraordinary situations can shift sentiment, until a Central bank acts to change policy to reflect the new information, consider policy to act as pressure on a currency in either direction.

Sometimes the market likes to get ahead of itself and get in front of these changes, but as individual traders it is more important to tag along early then to try to get out in front and lead. Because as we know, policy cannot make sense for extended periods of time, and the market can remain irrational longer than you can stay solvent!