Prepare for pivotal week in FX

As I wrote in yesterday's FX newsletter, traders should prepare for a pivotal week in the foreign exchange market with both the BoJ and the Fed holding important policy meetings.

Judging by the major banks' research reports, most analysts expect the BoJ to attempt to steepen the JGB yield curve, but the effect that would have on the JPY remains open to interpretation. It will perhaps be more crucial that the BoJ can convince the market that it is not running out of options to step up its easing measures if required, but that will be a tough task to achieve without support from Japan's Ministry of Finance. While I expect JPY strength to come to an end soon, the Japanese currency remains supported by the unwinding of carry trades and next week's central bank meetings will provide plenty of downside risk for my base scenario. Given this uncertainty, I'm afraid USDJPY might test the 100 level if neither the BoJ nor the Fed can reintroduce JPY weakness and USD strength, respectively. I hold a USDJPY long position with a S/L just below 100 and a short-term target at 105.

Speaking of the Fed, don't expect too much from Yellen & Co.! A rate hike would be a big surprise that would push EURUSD below 1.10 and USDJPY above 105, but the more likely scenario is that the Fed will (once again) not hike and merely introduce a slightly more hawkish tone to its statement instead. Although that should signal perhaps one rate hike by the end of the year, it will not be broadly USD-supportive and thus the risk of temporary EURUSD and USDJPY volatility without a sustainable breakout from recent price channels remains high, i.e. there will be a lot of risk in the market but the likelihood of an adequate compensation for that risk remains relatively low. Risk-averse traders will remain on the sidelines. Those open to more speculative positions will put on EURUSD short, GBPUSD short and USDJPY long trades.

Billion Dollar Day: A 1986 BBC documentary on FX trading

"Billion Dollar Day" is a short 1986 documentary on forex trading that was produced by the BBC. From today's point of view, where it is possible to trade in FX at a 100+ leverage using only your mobile phone, much of what the documentary depicts may seem historic or even silly, but at the heart FX prop trading has remained pretty much the same. The main difference may be that fewer institutions have retained their prop trading desks, having significantly reduced risk after the recent financial crises and the wave of financial market regulations that followed them.

My personal highlight is the Reuters pager though -- watch out for it around the 10-minute mark!

Buy the USD, but against which currency?

I still believe the US dollar will be stronger going forward and I think that its recent weakness presents an excellent buying opportunity. As I wrote in March 2015, there was no reason for the EURUSD exchange rate to go up at that time, unless the Fed would change course and oppose the dollar's strength. Well, that is exactly what happened, unfortunately:

The Federal Reserve has still not hiked rates and some even doubt that it will do so in 2016, while both the ECB and the BoJ have embarrassed themselves by botching up press conferences or entering negative interest rate territory, only to see their currencies go up in value afterwards.

The USD has lost versus most peer currencies, especially the JPY. It's still difficult for me to understand why people have been so concerned about the US economy lately. Every data release that was even slightly below expectations quickly led to more USD selling and EUR or JPY buying. As a result, USDJPY is now fighting not to fall below ¥105 (or even ¥100) while EURUSD recently tried to break above $1.15 (although it has so far failed to do so). The American economy isn't doing that bad, and market participants' obsession with the unemployment rate has reached an outright ridiculous level. At this point it's all about productivity figures!

Anyhow, speculative USD short positions are the highest since 2013. That's a good sign for traders: The extreme EUR & JPY short positions that were the cause of much volatility in 2015 have been reduced substantially, providing new entry opportunities without the risk of extremely sharp moves as in April and December 2015. Market positioning is way more neutral now, which is also a result of investors' inability to interpret central bank actions. Most likely central bankers don't really know what they're doing themselves anymore, so traders are now looking for new reference points that will help them navigate through the muddy waters that are the financial markets. Fundamentals in the US are still better than in Europe and Japan, despite the recent string of disappointing data releases.

But which currency to sell versus the dollar if you share my view? I don't really think the ECB holds much credibility in the markets anymore. Also, Draghi and his team have repeatedly said that they wouldn't introduce new policy measures in the near future because the implemented policy tools needed time to have an effect on the economy. Europe's central bankers are probably too busy discussing their independence from politicians anyway. I expect the EUR to remain range-bound for the time being -- although I must acknowledge that the sideways range in EURUSD has been going on for what looks like a disproportionately long time when comparing it to similar patterns in the exchange rate's history. Be that as it may, the BoJ seems more likely to surprise markets by introducing new easing measures. It is also in a very tricky position now where it has to make decisions within very little room for action around the zero bound. Just how negative can you go, after all? Japan's still fragile economy is in a tough spot here, and I believe both fundamentals and further BoJ actions will reverse the JPY's bout of strength into extended weakness by the end of this year. Conclusion: I'm a USDJPY buyer.

ECB and BOJ may soon buy equities, Reuters reports

As if central bankers hadn't done enough damage already, the masterminds at the helm of the ECB and the BOJ may be considering to buy equities via ETFs, at least according to Reuters. How did they come up with this brilliant idea, you might ask yourself... well, it is to "support market sentiment and stock prices".

With unconventional measures, such as helicopter money, already a part of the public (and perhaps even closed) debate about how to prop up our (so they say) worryingly ailing economies, this should not even be that surprising to be honest: The BOJ has already been buying ETFs, the ECB is buying up bonds wherever it can find them and the Fed has so far chickened out of raising interest rates (and killed forward guidance in the process, but that's another topic).

Let me ask this though: Why don't they simply buy oil, if deflation is really what central bankers are concerned about? Seriously, how does buying equities and thus pushing up stock prices help the average citizen? Doesn't it merely make the portfolios of wealthy people more valuable and hence widen the gap between the middle class and the rich (the playing field is already too uneven for the poor, so let's not even bring them into the equation)? I'm not a friend of conspiracy theories or leftist gibberish about "the 1%", but if stock buying were to become a viable tool for the ECB to "pursue its mandate", as our man Draghi likes to put it, I would really have to sit down and do some serious contemplating about how this market is now functioning versus how it is supposed to work. I thought we were living in a social free market economy, but perhaps I've just been too stupid to see what's been going on these past few years. If what we have right now is not a centrally planned economy, at least with respect to price formation in securities markets and increasingly even access to markets, then I really don't know. What else is there to say?

Money & Speed: Inside the Black Box

As a follow-up to February's video post about quants, here's a related documentary from VPRO that highlights the Flash Crash of May 6, 2010.

I vividly remember that Thursday evening when, as a risk management intern on a London trading floor, I witnessed the stocks of the world's largest corporations fall 10% and more in a matter of minutes. Markets had already been down 3-4% that day in the light of continued heavy protests in Athens. The atmosphere was eerie to say the least. On the day before, a group of angry demonstrators had set fire to a local bank, killing three employees who could not vacate the building in time. Every time the news channels resumed their live broadcasts of the violent protests equity indices and the euro dipped further. Starting at 1 p.m. New York time (6 p.m. in London) the prices of US equities began to fall sharply, triggering the first Liquidity Replenishment Points, i.e. circuit breakers, for several NYSE-listed stocks, and the chaos quickly ensued from there.

It is still not understood what caused the Flash Crash exactly, but an individual trader, Navinder Singh Sarao, who operated out of his parents' house in a poor part of London may have played a role (according to US authorities, anyway). He is currently facing trial in America after having been extradited by his home country.