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Volume 3, No. 5

MEXICAN PESO:

TRADING THE SOUTH OF THE BORDER CURRENCY

INTERVIEW WITH MONEY MANAGER

PETER PANHOLZER

FOREX

MONEY MANAGEMENT STRATEGIES

THE EURO INDEX NEW HEDGING

AND TRADING TOOL

JAPAN AND THE YEN:

NEW ERA OR MORE OF THE SAME?

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Contributors . . . . . . . . . . . . . . . . . . . .6

Global Markets

Yen still in holding pattern . . . . . . . . .8The outlook for the yen in the aftermath

of the Bank of Japans decision to

raise interest rates.

By Currency Trader Staff

Mexican peso: Settling downprior to summer elections? . . . . . . .10Taking a look at the pesos future for

the remainder of the year.

By Currency Trader Staff

Big Picture

Japan: Rising Sun

or just another day? . . . . . . . . . . . .14Analyzing what Japans apparent

economic rebound means for the yen.By Marc Chandler

The return of reserve

diversification . . . . . . . . . . . . . . . . .20What do recent central bank reserve

diversification moves mean for the

dollar and the euro?

By Barbara Rockefeller

Trading Strategies

FX money management . . . . . . . . . .24

Cracking open the myth of 2-to-1money management and exploring

practical money-management techniques.

By Boris Schlossberg

Advanced Concepts

The euro index: The dollar index

meets its match . . . . . . . . . . . . . . . .26A look at the development of a viable

and tradable euro index.

Howard L. Simons

Currency System Analysis . . . . . .30Channel Midpoint indicator

CONTENTS

continued on p. 4

2 May 2006 CURRENCY TRADER

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CONTENTS

Have a question about something youve seen inCurrency Trader?

Submit your editorial queries or comments to

[email protected].

Looking for an advertiser?

Consult the list below and click on the company name for a direct link to the ad in this months

issue ofCurrency Trader.

Index of advertisers

Currency Trader Interview . . . . . .34Peter Panholzer on market sentiment

How a top currency trader uses contrarian

opinion.

By Mark Etzkorn

International

Market Summary . . . . . . . . . . . . . . .38

Industry News . . . . . . . . . . . . . . . . .40RefcoFX customers left in limbo

Refco and its creditors refused to accept

FXCMs bid for RefcoFX.com.

Key Concepts . . . . . . . . . . . . . . . . . .40References and definitions.

Currency Futures . . . . . . . . . . . . . .41News and data from the currency

futures world.

Global News Briefs . . . . . . . . . . . . .42

Events . . . . . . . . . . . . . . . . . . . . . . . .43Conferences, seminars, and

other events.

New Products and Services . . . . .43

Global Economic Calendar . . . . . .44Key dates for currency traders.

Forex Trade Journal . . . . . . . . . . . .46Buying a pullback in the U.S.-Canadian

dollar rate.

FXCM MetaStock

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About the authorEdward Ponsi is the President of FXEducator LLC and is the former Chief

Trading Instructor for Forex Capital Markets (FXCM). An experienced trader

and mentor, Ed gives personal, one-on-one trading instruction to students

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What is FOREX? Why is it the fastest growing

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This is neither a solicitation to buy or sell any type of nancial instruments, nor intended as investment recommendations. All investment trading involves multiple substantial risks of mon -etary loss. Dont trade with money you cant afford to lose. Trading is not suitable for everyone. Past performance, whether indicated by actual or hypothetical results or testimonials are noguarantee of future performance or success. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT,

THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS OR TESTIMONIALS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULARTRADING PROGRAM. Furthermore, all internal and external computer and software systems are not fail-safe. Have contingency plans in place for such occasions. Equis International assumesno responsibility for errors, inaccuracies, or omissions in these materials, nor shall it be liable for any special, indirect, incidental, or consequential damages, including without limitationlosses, lost revenue, or lost prots, that may result from the reliance upon the information materials presented.
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Editor-in-chief: Mark Etzkorn

[email protected]

Managing editor: Molly Flynn

[email protected]

Associate editor: David Bukey

[email protected]

Contributing editor: Jeff Ponczak

[email protected]

Editorial assistant and

Webmaster: Kesha Green

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Ad sales East Coast and Midwest:

Bob Dorman

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Classified ad sales: Mark Seger

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Volume 3, Issue 5. Currency Traderis published monthly by TechInfo, Inc.,150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2006TechInfo, Inc. All rights reserved. Information in this publication may not bestored or reproduced in any form without written permission from the publisher.

The information in Currency Tradermagazine is intended for educational pur-poses only. It is not meant to recommend, promote or in any way imply theeffectiveness of any trading system, strategy or approach. Traders are advisedto do their own research and testing to determine the validity of a trading idea.Trading and investing carry a high level of risk. Past performance does notguarantee future results.

For all subscriber services:www.currencytradermag.com

A publication ofActive Trader

CONTRIBUTORSCONTRIBUTORS

Marc Chandler is the head of global for-

eign exchange strategies at Brown Brothers

Harriman and an associate professor at New

Yorks School of Continuing and Professional

Studies. From May 2001 through Oct. 1, 2004, hewas chief currency strategist at HSBC Bank

USA. Prior to HSBC, he was the chief currency

strategist at Mellon Financial, a senior currency strategist at

Deutsche Bank, and the director of research at EZAAssociates.

Howard Simons is president of Rosewood Trading, Inc.,

and a strategist for Bianco Research. He writes and speaks

frequently on a wide range of economic and financial

market issues.

Barbara Rockefeller(www.rts-forex.com) is an interna-

tional economist with a focus on foreign exchange. She has

worked as a forecaster, trader, and consultant at Citibank and

other financial institutions, and currently publishes two daily

reports on foreign exchange. Rockefeller is the author of

Technical Analysis for Dummies (2004), 24/7 Trading Around the

Clock, Around the World (John Wiley & Sons, 2000), The Global

Trader (John Wiley & Sons, 2001), and How to Invest

Internationally , published in Japan in 1999. A book tentatively

titled How to Trade FX is in the works.

Boris Schlossberg is a senior currency

strategist at Forex Capital Markets in New York

and author ofTechnical Analysis of the Currency

Market (John Wiley & Sons, 2006). He is also a

guest lecturer at www.fxstreet.com , covering

proper risk management, trader psychology,

and true market structure. Schlossberg is a frequent commen-tator for Reuters and Dow Jones/CBS Marketwatch currency

and bond market sections. He has been an independent trader

since 1999, trading a variety of instruments including stocks,

options, futures, and currencies.

Jos Cruset ([email protected]) is a private trader,

software engineer, and trading system researcher. He holds an

MBA and a NASD-Series 3 certificate and has worked many

years in the banking industry.
http://www.rts-forex.com/http://www.fxstreet.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]://www.fxstreet.com/http://www.rts-forex.com/

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In the wake of the big news the Bank of Japans(BOJ) March 9 decision to end its easy monetary pol-icy the dollar/yen rate (USD/JPY) has goneabsolutely nowhere. The pair has remained locked

within the same narrow range roughly 115.00 to 119.00 that has confined action since early February (Figure 1), andwhich is itself well within the boundaries of the December2005 high of 121.39 and January 2006 low 113.40 (Figure 2).

Is a breakout on the horizon? Will an actual shift from thezero interest-rate policy (ZIRP) strengthen the yen later thisyear? When will the BOJ actually bump rates up and whatwill this mean for the popular yen carry-trade?

Before diving into these questions, lets first take a look atwhat the BOJ has actually done in the aftermath of its earlyMarch bias shift.

Quantitative easing

The BOJ has indeed already begun a monetary policy tight-ening of sorts. During its long battle with deflation, thebank had effectively dropped interest rates to zero. Looking

for another tool, the bank also flooded the banking systemwith extra cash.

They increased their reserves so banks could lend outmore cash, says David Powell, currency analyst atIdeaglobal.

The BOJs quantitative easing target stood at 30 trillionyen. Now, the BOJ has shifted down its target to 6 trillionyen, which it aims to achieve by June 9.

They are well on their way, Powell says. It has beenreduced significantly.

Once the BOJ has finished withdrawing all the excess liq-uidity from the banking system, the policymakers can beginconsidering an actual hike to the overnight rate, which cur-rently stands at zero percent.

At the BOJs April 11 meeting, monetary policy was heldsteady and no timing was offered for the actual end to ZIRP.

Is the carry trade dead?

Many analysts have warned the end of the BOJs easy mon-etary policy could wreak havoc on the world financial mar-kets, as global portfolio managers and large hedge fundsunwind their so-called yen-carry trades. But that has yet to

happen. With Japanese rates at zero, it had become a popu-lar strategy in recent years to borrow money in Japan and

invest it in other assets around the world. However,because official Japanese rates are still at zero, analystssay the carry trade is still in play.

It is a bit premature to forecast the end of the carrytrade, Powell says. Even when they do hike rates, itwill be at a moderate pace and it will still be far belowanything else in the G-10.

However, Charmaine Buskas, economist at MoodysEconomy.com, has noticed a change in the trend in theCommodity Futures Trading Commissions (CFTC)

Commitment of Traders (COT) data, which tracks thepositions of different types of traders (large speculators,hedgers, small traders, etc.).

The data has shown yen short positions are unwind-ing, she says. But for a wholesale reversal of shortpositions, you are going to see further action by theBOJ.

Timing and size of a rate hike

The third quarter of this year is the earliest marketwatchers say an actual bump up in the Japaneseovernight rate would occur, and some point to thefourth quarter or even early 2007.

GLOBAL MARKETS

Japan has sent out signals it is finally ready

to begin raising interest rates this year,

but the yens response so far has been muted.

Yen still inholding pattern

BY CURRENCY TRADER STAFF

The USD/JPY just recently broke down out of a narrow range -

roughly 115.00 to 119.00 - that has confined action since early

February.

FIGURE 1 SHORT-TERM BREAKDOWN

Source: TradeStation

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10/48CURRENCY TRADER May 2006 9

Most economists expect a 25 basis-point hike, butBuskas offers a more gradual hiking scenario. Shethinks the third quarter is the likely time for a rateincrease, but says the BOJ may choose to hike by lessthan 25 basis points.

I think they are really going to treat the tightening

cycle with kid gloves, she says. Theyll start off with10 basis points and see how that goes.

That forecast compares with JP Morgans view theBOJ will hike rates by 25 basis points at both itsAugust and December meetings, which will leaverates at .50 percent at year-end.

A look at the economic numbers

Most economists agree the overall growth picturelooks positive for Japan.

It looks more like a real recovery, says RobertMellman, senior economist at JP Morgan. For a long

time, it had just been export-led, but now it seemsmore balanced. Profit margins have been high, profitgrowth has been good and theyve gone from defla-tion to inflation.

JP Morgan expects Japan to post a respectable 3.2-percentgross domestic product (GDP) growth in 2006. Ideaglobalanalysts forecast a 3.0-percent GDP reading in 2006, whileMoodys Economy.com projects a 2.0-percent figure.

Inflation, of course, is the critical factor in the wake of thelong fight against deflation. Core CPI data posted a 0.5-per-cent month-over month reading in February, following a0.5-percent rise in January, according to Ideaglobals

Powell.The core measure does not exclude oil, Powell notes. It

excludes only fresh food. When you factor in the huge rally inoil and energy costs, you have to wonder how much inflationis really there.

Even within Japan there is some debate regarding thelevel of inflation.

The BOJ has been saying inflation has been on a sus-tainable upward trend, but not everyone in Japan agreeswith that, Powell says. The Ministry of Finance is morecautious.

Buskas believes core prices are the big

question mark.They have been slow to rise, shesays. The BOJ will look for another cou-ple of months of steady increases in coreprices.

Yen strength ahead?

The outlook for the yen is quite posi-tive, Buskas says. We have solid funda-mentals for the first time in a decade andthis paves the way for interest-ratehikes.

Many analysts are forecasting a down-

side break from recent ranges in the dollar/yen pair laterthis year, with the key trigger being an actual rate hike bythe BOJ.

Buskas expects to see a global shift in forex dynamicsahead.

Instead of going short the yen, players are going to bemore interested in going long the yen, she says. By themiddle to the latter half of the year, the market will beforced to take a bigger-picture look at the U.S. and its

unsustainable external deficits.She points to a rate hike as the catalyst to spark a down-side breakout in the dollar/yen with an initial target at the110.00 area.

Once a rate hike sets the trend toward a stronger yen intomotion, gains toward the 108.00 area could be seen by theend of first quarter 2007, Ideaglobal analysts say.

Tim Mazanec, senior FX strategist at Investors Bank &Trust, offers another view.

This quarter I think we will see a breakout, he says.

Even after the breakdown shown in Figure 2, the dollar-yen still

remains within the boundaries of a larger consolidation between

the Dec. 2005 high of 121.39 and Jan. 2006 low 113.40.

FIGURE 2 BIGGER PICTURE CONSOLIDATION


U.S. DOLLAR/JAPANESE YEN AT A GLANCE

Daily range (past 40 days): Average: .99 Median .98

Weekly range (past 26 weeks): Average: 2.35 Median: 2.16

52-week high/low: 121.39/104.19

U.S. Japan

Prevailing interest rates (%) 4.75 0.00

Next central bank meetings May 10 May 19

GDP Q4 2005* Q3 2005 Q2 2005

US JPN US JPN US JPN

1.7 0.8 4.1 -0.1 3.3 1.2*Estimate All data as of April 28

continued on p. 12

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GLOBAL MARKETS continued

With the peso hovering around roughly 11 vs.the U.S. dollar (see Figure 1), some analystssay the currency may have settled into asideways consolidation as the interest-rate

differential between the U.S. and Mexico has narrowed, andwith the Mexican presidential and congressional electionslooming in July.

The peso had been on a clear uptrend vs. the dollar, mov-

ing from 11.70 in mid-2004 to 10.40 in late 2005-early 2006.Higher oil prices and tighter Mexican monetary policythrough mid-2005 helped support the peso. But after top-ping out at 9.75 percent in August 2005, the Banco deMexico shifted course and began cutting rates in an effort tospur economic growth.

After several rate cuts, the Banco de Mexico againslashed the overnight rate by .25 basis points on April 21,dropping the official rate to 7 percent. At the same time, thebank indicated that the cut was the end of the nine-montheasing cycle.

Peso actionHeading into April, the higher U.S. Treasury market rates

have sparked some volatility and defensiveness in thepeso market, explains Enrique Alvarez, head of LatinAmerican Research at Ideaglobal. Given the manufacturingties between the U.S. and Mexico, concerns that higher U.S.rates could ultimately slow the economy were seen as even-tually triggering a slowdown in the Mexican economy.

Weve been in a very wide range of about 10.40-11.00,Alvarez says. My sense is that it wants to flatten out and

hover around 11.Guillermo Estebanez, currency strategist at Bank of

America, adds, We think the outlook for the peso is notquite as bullish as in previous years.

He points to tightening monetary conditions in the U.S.as a factor.

The peso is part of a class of assets emerging markets,which tend to be bid up in conditions of loose liquidity, hesays. We think liquidity conditions will become less favor-able for emerging markets.

U.S. rate action will be key to watch

Because of the close correlation between U.S. and Mexicangrowth, some in the market say the pace and timing of

future rate increases by the U.S. Fed willbe key for peso market action. The U.S.Federal funds rate currently stands at4.75 percent.

If U.S. rates stagnate around 5.00percent, we should see a new range from11.10-10.90 short to medium term,Alvarez says.

However, Alvarez adds, if the U.S.Fed hikes short-term rates to 5.25 per-

cent or beyond, it could spark a newpeso range in the 11.15-11.30 region.We expect peso weakness largely as

a function of the narrowing of interest-rate differentials between the U.S. andMexico, says Alonso Cervera, senioreconomist at Credit Suisse.

The economy

Looking at the economic fundamentals,Mexico appears to be in good shape.

The outlook for the Mexican econo-

After rallying vs. the dollar during the first quarter of the year, the peso has

stalled, perhaps because of uncertainty regarding presidential elections in July

and the narrowing of U.S.-Mexican interest rates.

FIGURE 1 PESO PAUSE

Source: ADVFN (www.advfn.com)

Mexican peso:Settling down prior to summer elections?

The peso has been gaining strength vs. the dollar since February. But upcoming events may keep

a lid on the currencys movements in the near future.

BY CURRENCY TRADER STAFF

continued on p. 12

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GLOBAL ECONOMY continued

JAPANESE YEN continued from p. 9

my continues to be quite positive,Cervera says. The economy is growing ata pace between three and four percent,with a low inflation rate.

Cervera pegged recent headline infla-tion at 3.4 percent, with the core rate at 3.0percent.

In the April edition ofEmerging MarketsFX Roadmap issued by HSBC GlobalResearch, HSBC analysts forecast a 3.4-percent Mexican GDP growth in 2006, fol-lowing 2005s 3.0-percent reading.

Mexico, a large oil exporter, has benefited from theworldwide rally in crude oil prices in recent months.Cervera points to the $31 billion in Mexican oil exports in2005, or 4.1 percent of Mexican GDP, as an overall bullishfactor for the economy.

The politics

With the Presidential election looming on July 2, marketwatchers say the uncertainty up until that time could sparkless foreign appetite for the Mexican arena.

In general, elections tend to be problematic, says Bankof Americas Estebanez. They tend to cause volatility.

On July 2, the entire Congress will also be up for reelection.Currently, there are three top contenders for the

Presidency and recent polls show them nearly tied in termsof popularity. The three main candidates are Andre Lopez

Obrador, from the PRD, Felipe Calderon, from the center-right PAN, and Roberto Madrazo, from the PRI.

Uncertain scenarios could make investors nervousabout Mexico, Cervera says. This is a tighter race than wehad originally thought.

Analysts seem to agree the favorite candidate for themarkets is the current ruling PAN party; most feared is from

the PRD party.But despite the presidential win, analysts add that

Congress will likely be split and no candidate will have aclear majority, which could keep overall macro policiesmoving in the same direction.

Overall, most analysts see risk for additional peso weak-ness between now and year-end, with forecasts rangingfrom 11.20 to 11.70, depending on the outcome of the presi-dential election.

MEXICAN PESO FUTURES (MP) AT A GLANCE

Daily range (past 40 days): Average: 000817 Median: 000775

Weekly range (past 26 weeks): Average: 0.001722 Median: 0.001450

52-week high/low: 0.097900/0.088875

U.S. Mexico

Prevailing interest rates (%) 4.75 7.00

Next central bank meetings May 10 May 26

GDP Q4 2005* Q3 2005 Q2 2005US MEX US MEX US MEX

1.7 3.3 4.1 3.25 3.3 4.1*Estimate All data as of April 28

Getting a lift from the carry trade, by Kathy Lien

Currency Trader, October 2004.

Correctly assessing the risk environment paves the way to

capitalizing on the interest-rate differentials between

currencies.

Dollar-yen: The years hottest carry trade, by Kathy LienCurrency Trader, August 2005.

The buck was on the short side of many carry trades last

year, but the current interest-rate hike cycle offers the opportu-

nity to go long the dollar and short the yen.

The short-term British pound/Japanese yen carry trade

Currency Trader, December 2004.

It pays to have a currency pairs rollover charges on your side.

Find out how the daily rollover has affected GBP/JPY a

popular carry trade in recent years.

All traders, big and small:

The Commitment of Traders report

Active Trader, March 2003.

In futures, as in stocks, the institutional money usually dic-

tates price action. The Commitment of Traders report gives

you a glimpse of what the big money is doing in the markets

you trade. An article for beginners.

Larry Williams looks inside futures

Active Trader, January 2006.

An interview with Larry Williams in which he discusses the

twists he puts on the commitment of traders report.

Floyd Upperman: Digging into COT data

Active Trader, February 2006.

Its not just a matter of hedgers vs. speculators. In this inter-

view, an engineer turned trader discusses ways to make

sense of the futures Commitment of Traders report.

Ive been a believer of a strong dollar and continue toexpect that. He sees a break above 119.00 leading to a quickrally toward the 122.00-123.00 zone.

All ranges eventually break out, Mazanec notes.If he is wrong and the market instead breaks down, hesees a target at the 112.00-111.00 area.

Related reading

You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm.
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This interview with pioneering currency fund manager Peter Panholzer,

head of trading and chief investment officer at DynexCorp and Panholzer Advisory Corporation

(PAC). Panholzer, who was an early advocate of both currency funds and trading systems,

has spent more than three decades trading forex.

You can download this free article as a PDF file by going to

www.activetradermag.com/purchase_articles.htm

and following the links for the free article offer. Offer ends Wednesday, May 31, 2006.

FREE

ARTICLE OFFER!Until Wednesday, May 31, you can download the following article for

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Peter Panholzer: Currency system architect

(Currency Trader, November 2004)

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Japan is emerging from an economic periodcomparable to the U.S. Great Depression. Thegradual adjustment to monetary and fiscal

policies has already begun: Tax increases and areduction of bond issuance are already in the works, andthe Bank of Japan (BOJ) signaled an end to its quantitativeeasing strategy, under which it provided something on themagnitude of five to six times the amount of liquidityJapanese banks required. Overnight interest rates continueto be near zero, although there are widespread expectationsthe BOJ will deliver a first rate hike this summer.

This assumes the normalization of the Japanese businesscycle. The economy is enjoying sustained growth and isexpected to be among the fastest growing of the majorindustrialized countries this year. Corporate profits are near

record levels and the stock market is at 14-year highs.Commercial land prices in Japans three largest metropoli-tan areas are rising for the first time in 15 years. Theimproved macro-economic performance has given rise tothe belief that Japan is back.

The real situation is more complicated and, in many

ways, rather than heralding the return of the Rising Sun,suggests it is just another day in Japan.

Changing relationships

In fairness, though, one must acknowledge the Japaneseeconomy today is not the same one that entered into a peri-od of malaise more than 15 years ago. Several key relation-ships that underpin the domestic economy have fundamen-tally changed.

First, the relationship between Japanese companies hasgenerally weakened, as evidenced by the reduction of crossshareholdings (when companies have equity stake in other

companies). Some studies indicate cross shareholdings fellfrom 46 percent of the total outstanding shares in the early90s to 27 percent in 2002. They are now are believed to be

closer to 20 percent.At the same time, significant industry consolidation has

occurred. In the 80s, there were 14 large oil producers andabout the same number of paper companies. Now there arefour main oil producers and three large paper companies.Numerous steel companies have been reduced to a field offour and they are producing roughly the same amount ofsteel the industry did almost a decade ago, with a workforce reduced by a third, according to a recent report inFinancial Times.

These changes highlight the transformation of theemployer-employee relationship in Japan. Although life-

time employment still is offered by some firms, reports sug-gest it is not as widely practiced in the past. There has alsobeen a significant increase in the use of contract workers.Industry estimates suggest contract workers now accountfor almost one-third of the Japanese work force, comparedto only one-fifth previously.

The relationship between Japanese companies and theirmain banks has also changed. This seems especially true formanufacturing companies. Many, though clearly not all,have reduced their dependence on banks. The process econ-omists call disintermediation has taken root in Japan.Many large manufacturing companies use their own cashflow and their profits to finance investment rather than relyon bank loans. More than before, Japanese companies aregoing directly to the capital markets to raise funds by issu-ing stocks and bonds.

The loosening of the relationship between industrial cap-ital and finance capital was largely predicated on the pro-

THE BIG PICTURE

Japan:Rising Sun or just another day?

Things seems to be picking up for Japan after a long malaise,

but the countrys economy and currency arent necessarily out of the woods yet.

BY MARC CHANDLER

Todays Japanese economy is not the same one that entered into

a period of malaise more than 15 years ago.

8/8/2019 CT200605


longed banking crisis that played such a critical role in hob-bling the Japanese economy. But as in industry, so too in

finance: The government encouraged intensive consolida-tion among Japanese banks. In the 80s there were a littlemore than a dozen large banks. Today there are four.

This consolidation was integral to the resolution of thenon-performing loan problem that paralyzed the bankingsystem for a decade. There were many false starts, but in thespring of 2002 the efforts became earnest. The goal of cut-ting the non-performing loans in half in three years wasachieved. Currently, non-performing loans at the top fourbanks average around 2.5 percent.

Japans bad loan problem was partly resolved by thetransformation of another important relationship that of

foreign investors. Drawing on their experience in their owncountries, U.S. and European financial institutions were sig-nificant buyers of bad loans from Japanese banks. Some for-eign financial firms, for example, reportedly garneredreturns nearly twice the recovery rate of the U.S. S&L crisisof the early 90s.

The role of foreign investors in the Japanese equity mar-

ket has also increased markedly. Prior to Japans depres-sion, foreign investors owned less than five percent of out-standing Japanese shares. According to the Tokyo StockExchange, foreign ownership is currently closer to 25 per-cent.

In many respects these changes are giving the markets

greater influence. Just as strong fences make for goodneighbors, so can a robust regulatory regime make forstronger markets. Japan belatedly has introduced mark-to-market accounting, and consolidated reporting makes formore transparent corporate activity. Also, Japanese compa-nies must more rigorously account for pension liabilities,which is particularly important given the countrys agingpopulation.

Cursed by too much money

In two critical ways, however, Japan 2006 is the same as the Japan of old. First, the main economic drivers haventchanged. The Japanese economy continues to stand on

three legs: exports, government spending, and investment,with only a modest role for consumption. Second, Japan

continues to generate surplus savings and struggles to useit efficiently.

From the last deep trough in GDP in Q4 2001 through Q42005, the Japanese economy expanded by about 10 percentin real terms. Financial Times economics columnist MartinWolf recently noted that exports accounted for almost athird of that growth. The strong exports are a function of asignificant decline in the Japanese yen. In real trade-weight-ed terms, the yen depreciated by 30 percent betweenDecember 1999 and February 2006. On the demand side, thebooming Chinese economy accounts for a third of Japanstotal export increase from 2001 to 2005.

The second leg of the economy is government spending.Between Q4 2001 and Q4 2005, government spendingaccounted for almost 15 percent of Japans growth, and per-sistent budget deficits have accumulated into a significantlevel of debt. Even this year, when there is widespreadrecognition that the Japanese economic recovery has broad-ened and deepened, the budget deficit this year will likely

be in excess of six percent of GDP.An Organization for Economic Cooperation and

Development (OECD) estimate from the end of last yearputs Japans national debt at more than 160 percent of GDP,more than any other member (Italy stands second, near 128percent). Because of a various intra-government loans, the

measure of net debt may be closer to 82 percent (the com-parable figure for Italy is 103.5 percent).Investment accounted for almost a fifth of the Japanese

growth during this period. Japanese investment exceedsother major industrialized countries roughly 40-percenthigher than in the U.S. and Germany. What befuddles manyobservers is that such high investment has not generatedstrong growth, nor will it likely in the future. TheInternational Monetary Fund (IMF) estimates potentialgrowth for Japan at around 1.5 percent. By comparison, itestimates potential U.S. growth near 3 percent.

Private consumption accounts for less than 40 percent ofcontinued on p. 16

Contrary to the impression one would make from U.S. industry captains

who claim Japan is manipulating the currency market, Japan has notintervened in the foreign exchange market for nearly two years.

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Japans growth. (In the U.S., by contrast, consumptiondrives nearly 70 percent of the worlds largest economy.)Nor is the outlook particularly favorable, despite the cycli-cal expansion underway, the tightness in the labor market,and the upward pressure on wages. A combination of high-

er sales taxes and the elimination of a previous income taxcut may reduce disposable income.

While there are arguably cultural impediments to con-spicuous consumption, the lack land reform may exacer-bate the problem. The inefficient use of land leads to highland prices in Japan, even after a decline over the pastdecade, and small dwellings also curtail consumption.Trans-generational mortgages have been reported. A lowlevel of consumption, under-developed capital markets, arelatively small service sector, and a political system domi-nated by one party are often characteristics of a developingcountry.

Simply, Japan does not enjoy excess savings it suffersfrom it. Surplus often is wasted; Japan has proven to be a

terribly inefficient user of capital. It still requires roughly 70

percent more capital to produce a given unit of GDP com-pared to the U.S.

Japans private sector saves between 25 and 30 percent ofGDP. Although household savings have slipped a bit lately,the increase in corporate savings offset this. On top of that,Japan has been running a current account surplus of 3 per-cent of GDP.

This co-existence of high private savings and investmentwith a slow growth runs counter to economic orthodoxy,which teaches national savings are the pool from whichinvestment capital is provided. In turn, investment is thekey to long-term growth.

Nationalism and socialismThe U.S. and Western Europe emerged from the GreatDepression through a combination of socialism (the cre-ation of the modern welfare state) and nationalism, includ-ing but not limited to its military expressions. Japan alsohas practiced a mixture of socialism and nationalism inemerging from its Great Depression something thatspeaks to a changed relationship between the citizenry andthe state.

Japans Prime Minister Junichiro Koizumi appears tohave purposefully reinvigorated the countrys nationalism.This can be seen in the controversial textbooks that white-

wash Japans 20th-century history, much to the chagrin ofneighbors such as South Korea and China. Although thisproblem obviously did not begin with Koizumi, it has con-tinued unabated during Koizumis tenure. Koizumisnationalism also lies behind his insistence of visiting the

Yasukuni Shrine that includes some of Japans war heroesand criminals.

Sometimes national interests are at stake, but the waythey are expressed is often in nationalistic terms. For exam-ple, there is a simmering territorial dispute between Chinaand Japan (both of which are major energy importers) overthe East China Sea, which is thought to have vast oil andnatural gas deposits.

Another expression of Japanese nationalism is the stepstoward remilitarization, which requires a reinterpretation, ifnot a constitutional change. Japan is located in a dangerousneighborhood. Its most proximate threat comes from North

Korea, which has demonstrated the capability to launch amissile attack on Japan. Longer-term, the most obvious

change in the status quo comes from its regional rival

China, which is pursuing an ambitious arms program.At the end of the Cold War, many wondered whether the

U.S. still required Japan to act as a large aircraft carrier inthe Pacific. However, the rise of global terrorism and thearms race in Asia, amid concerns that the U.S. may be over-stretched, obviously underscores the opportunity to re-examine Japans defense strategy. The recent U.S.-Japanagreement on the mutual defense of Taiwan and the firstuse of Japanese forces outside of Japan point to a somewhatmore assertive foreign policy that is perfectly consistentwith the rise of nationalism. Efforts to secure a seat on theUnited Nations Security Council are another example of

this recent tendency.The socialist component is similar to the Wests after theGreat Depression. For example, as lifetime employmentbecame less common and unemployment rose as the econ-omy stumbled through its trough, the Japanese governmentexpanded the services it provided, including the beginningsof unemployment compensation and job banks.

High unemployment (by Japanese standards) andincreased contract work have contributed to the number of Japanese without savings reportedly doubling in the pastfive years to 24 percent the highest level since the 60s.Welfare payments and education assistance tied to incomelevels have risen markedly. The New York Times recently

THE BIG PICTURE continued

Provided the economic recovery remains intact and core inflation continues to

rise, its possible the Bank of Japan will raise interest rates twice this year.

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reported the number of Japanesehouseholds receiving welfare pay-ments has risen by more than 37 per-cent since 2000, to more than one mil-lion.

Although elementary and juniorhigh school are mandatory and free in Japan, the number of these studentsreceiving aid based on householdincome rose by more than a third toalmost 13 percent between 2000 and2004. Of the major cities, Osaka andTokyo have the highest assistance rates 28 and 25 percent of school children,respectively.

In addition to economic considera-tions, demographic changes will influ-

ence the development of Japans wel-fare state. In the past Japan relied on thesubstitution of welfare by family. Fornumerous reasons this was recognizedas unsustainable, and the result was theimplementation of the Long-Term Careservices Insurance Act in 2000. The challenge posed by theaging population is going to intensify in the next couple ofyears as the baby boom generation begins retiring. At thesame time, the population as a whole has begun to decline.Social security benefits are growing as a percentage of GDPand now stand at nearly 25 percent. Nearly three quarters of

the social security benefits go to the elderly.Japan has implemented (to varying degrees) the kind of

Keynesian demand-management, income-distribution proj-ects practiced in the West, but it may find a new use for itsprevious asset demand management efforts. The countrystotal national assets are 20 times larger than nationalincome and 26 times larger than worker compensation. Thecapital gain from a one-percent increase in asset prices isequivalent to a 26-percent wage increase. Rising asset pricesare in the nations interest in a very real way.

The distribution of that gain is a different story. Thegrowth of the welfare state in Japan is in part a response to

the growing disparity that has been a consequence of boththe economic malaise and the economic policies pursued inrecovery. The state is assuming some of the functions of themore traditional family-centric model of welfare (non-mar-ket relationships) and the corporate-centric model (lifetimeemployment, pension programs) previously provided. Thegrowth and shape of Japans welfare state is an expressionof the nations changing social contract.

Now what? The interest-rate picture

Japans cyclical economic recovery has sufficient momen-tum to allow the Bank of Japan to begin to normalize mon-etary policy. Through intervention, purchasing, and thereby

monetizing the governments debt and providing incred-ibly excessive reserves to the banks the BOJ in essencetook the advice of some economists that to end deflation,Japan ought to drop yen from a helicopter.

Contrary to the impression one would get by listening toU.S. industry captains who claim Japan is manipulating the

currency market, Japan has not intervened in the foreignexchange market for nearly two years. The BOJ appears tohave successfully mastered the preferred practices of theU.S.: Rather than manipulate the currency market, manipu-late interest rates and other financial variables, such asreserves. Although the BOJ continues to monetize its debt,it has begun mopping up the excess reserves. By the middleof June this operation should be complete and reserves willlikely be near the required amount of approximately six tril-lion yen.

This sets the stage for a rate hike in July or August.Provided the economic recovery remains intact and core

inflation continues to rise, as the BOJ forecasts, it is possiblethe BOJ will raise rates twice this year. The overnight callrate could be near 0.50 percent by the late 2006 or early2007, which would match the expected rate of inflation. Thereal rate then will remain close to zero and, therefore, mon-etary policy will remain accommodative.

The yen picture

The outlook for the yen is not clear cut. Against the dollar,the yen often trades in identifiable ranges appearing totrend largely as it moves from one trading range to another(Figure 1).

continued on p. 18

Over the past three years, the dollar/yen rate has made significant moves up and

down, but it has also spent a great deal of time including most of this year in

trading ranges (horizontal bars).

FIGURE 1 USD/JPY RATE, WEEKLY


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The rise of long-term interest rates in Japan and the yensrelative weakness is encouraging institutional investors inJapan, such as life insurance companies, to keep more of theirfunds in Japan. Foreign investors continue to scoop up Japanese equities. These portfolio flows can be expected to

exert upward pressure on the yen. However, such pressure islikely to be mitigated by the fact that with interest rates in Japan remaining low in absolute terms and relative to othercountries, the yen will still be seen as a financing currency that is, the yen carry trade (short the yen vs. another currency)

may still be attractive for some investors and speculators.The yen has depreciated markedly over the past couple

of years against other Asian currencies, which, given thesignificance of intra-regional trade, translates into a declinein the yen on a trade-weighted basis. On an inflation adjust-

ed trade-weighted basis, the BOJ calculates that the yen isnear a 15 year-low. As the Japanese economic recovery con-tinues and monetary policy is gradually normalized, theyen might recover some of that lost ground.

However, the rise of China is changing the Asian eco-nomic landscape. The South Korean won and the Taiwanesedollar, for example, have become more correlated with themovement of the Chinese yuan vs. the dollar and less cor-related to the yens movement vs. the dollar since Chinachanged its currency regime in July 2005 by instituting amanaged float. With the Chinese yuan expected to con-tinue to appreciate in the coming months, and with rate

hikes by other countries in East Asia, including SouthKorea, Thailand, and Taiwan, it is possible the yen willremain weak in the region, even if it rebounds against theU.S. dollar later in the year.

Prime Minister Koizumi is expected to step down in thefall. His most likely successor is the chief cabinet secretaryShinzo Abe. Abe is part of Koizumis reform wing of theLiberal Democrat Party. That, coupled with the relativeindependence of the BOJ, means there will likely be a highdegree of continuity in macro-economic policy. Kozumisreforms and altered economic relationships will make JapanInc. work a bit better, and the improved balance sheets of

Japanese banks will allow for the conduct of more effectivemonetary policy.Japan is enjoying an export and investment-led econom-

ic recovery, with a budget deficit almost double other G7members. Corporate Japan is posting record profits. Thestock market looks like it has legs. But do not confuse thiscyclical recovery with a resolution of Japans excess savingsproblem. Without addressing this surplus capital problem, Japans penchant for wasting capital will persist and theresulting global imbalances will remain a potential sourceof global instability.

For information on the author see p. 6.


Related readingOther Marc Chandler articles:

Surplus savings revisited

Active Trader, April 2006.

Can excess capital really be a bad thing? The ideas of

Charles Conant from more than a century ago offer

some clues about this conundrum facing the new Fed

chief.

3-D economics: Debt, deficits, and the dollar

Active Trader, December 2005.

While the U.S. undoubtedly has a significant amount of

foreign debt, those numbers dont tell the entire story.

In fact, a closer look shows how the U.S. deficit actual-

ly reveals the strength of the U.S. and its economy.

Whos afraid of the big, bad deficit?

Currency Trader, April 2005.

Contrary to conventional wisdom, the current account

deficit does not drive the dollar, according to one

strategist.

You can purchase and download past articles at

www.activetradermag.com/purchase_articles.htm.

With the Chinese yuan expected to continue to appreciate in the coming

months, and with rate hikes by other East Asian countries, it is possiblethe yen will remain weak in the region, even if it rebounds against

the U.S. dollar later in the year.

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20/48
http://www.traderbrasil.com/

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For two months this spring, new significanthigher highs in the euro were interrupted bydownward corrections lasting four or five days(Figure 1). So, when a corrective down move

started on April 20, as shown by a lower low and a lowerclose than the day before, technical analysts could reason-ably expect that this retracement also would last four or fivedays.

Instead, it lasted only two days after the significant high.The end of the move occurred on a Friday, and while theeuro had already made a new low (as expected), it closedup on the day and then rocketed upward when the marketopened Sunday night. The following Monday, the euro sur-passed the previous significant high, and the correctivedown move was decisively over.

What happened? This was a really good instance of fun-damentals trumping the technicals.The Swedish central bank theRiksbank announced on Friday,

April 21 that it was increasing the pro-portion of euros in reserves from 37percent to a total of 50 percent, andreducing the dollar to 20 percent from37 percent. The announcement carriedweight as hard evidence of a trend themarket had been fearing for over ayear reserve diversification. Overthe past few years, other countries hadraised the proportion of euros inreserves, including Russia and China,but this was the first time the euro was

given such a high weight (50 percent),and the dollar such a low weight just 20 percent.

Just one week earlier, the UnitedArab Emirates and Kuwait had eachsaid they were considering reallocat-ing currency reserves, committing abigger share to the euro.

In addition, an organization namedthe Gulf Cooperation Council, madeup of six oil-producing states in theMiddle East, confirmed it was consult-ing the European Central Bank (ECB)

THE BIG PICTURE

The return

of reserve diversificationReserve diversification is again on the lips of forex traders and analysts. The last time this topic was

hot, it turned out to be a red herring. But although youre never supposed to say it in trading, this time

things might be different.

BY BARBARA ROCKEFELLER

The Swedish Central Banks decision to tilt its currency reserves toward theeuro and away from the dollar cut short a correction in the EUR/USD and

resulted in a swift move to new 2006 highs.

FIGURE 1 FUNDAMENTAL MOVE

Source: chart by Metastock; data courtesy of Reuters DataLink.

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on a possible monetary union of their own. A memoran-dum of understanding is being prepared and is likely to besigned within a few weeks by Bahrain, Kuwait, Oman,Qatar, Saudi Arabia, and the United Arab Emirates, who

may aim for a single currency by 2010. Alot of work wouldhave to done in a short while, such as determining mone-tary and fiscal convergence criteria and the location of anew central bank, but these are trivial considerations inlight of the euro becoming a reserve currency in its ownright. Its not assuming too much to suppose the ECB willpropose a big role for the euro as a reserve currency in thenew union.

Until now, I have pooh-poohed reserve diversification asa key factor determining forex rates, and judged that dollar-selling on an announcement of some minor reallocation wasan inappropriate and exaggerated response. After all, the

amounts are small, usually only a few billion dollars a

mere blip in the daily forex volume of almost $2 trillion. Inthe autumn 2005, reserve diversification was cited as a

major factor in the dollars decline at the time but thenwe got hard data from the Bank for InternationalSettlements indicating that dollar-based reserves didnt fall,but actually rose. So, diversification was a false story andonly an excuse for traders to do what they wanted to do sell dollars.

The dollar did not rise specifically on the news the diver-sification story was false; it was rising at the time, anyway,so its hard to be sure. But traders are like a dog that does-nt remember it ate your sock, puzzled when you yell at itwith ruined sock in hand. They live in the moment, and thesock-eating moment has passed. In trading, this phenome-

non is calledDont bother me with the facts. The diversi-fication story seemed logical and compelling, and maybewould be logical and compelling someday, even if it wasntat that moment.

Its different this time

And they were right. The story is back, its not false thistime, and the deduction is logical and compelling that thedollar has a big, fat negative hanging over its head. In short,its different this time.

Sweden is a modern and successful European country,not some tin-pot dictatorship or banana republic. Its centralbank is highly regarded as thoroughly competent (note that

the Riksbank reduced the share of the Japanese yen inreserves to improve the rate of return on the combined port-folio). This is financial rationality.

Moreover, Sweden is politically neutral, so the decision

cannot be seen as having anything to do with the U.S. rolein world affairs. For conferring respectability on reservediversification, Sweden is at the top of the list onlySwitzerland would carry more weight, and Switzerland isnot an International Monetary Fund (IMF) member anddoesnt share information about its reserves.

The six Middle East oil producers combined hold nearly$1 trillion, and are adding to it to the tune of $300 billion peryear with oil at current prices near $70. While Swedishreserves are not big (only about $21 billion), the Middle Eastnot only has bigger reserves but a bigger potential to add toreserves. During previous oil crises in 1973 and 1979,

experts were quick to point out that financial markets were

not developed in the region and that markets outside theU.S. were not free. Constraints on capital flows pretty much

made it inevitable that petrodollars would be recycled backto the U.S.And recycling is exactly what happened. Although today

Middle Eastern financial markets are still in their infancy,they nonetheless exist, and some of the windfall profitsfrom higher oil prices are being recycled within the MiddleEast in new investment projects. Construction in Abu Dhabialone is growing by over 350 percent annually. Financialmarkets in Europe are also freer and bigger and more liq-uid. From the point of view of global capital flows, the exis-tence of a single currency is a vast improvement over earli-er conditions. As advertised, its efficient. But more impor-

tantly, European leaders are determined to attract MiddleEast capital flows and are actively promoting the euro.Then theres China, which said at the April IMF meeting

that it is subsidizing the U.S. consumer with its purchas-es of U.S. paper for its reserves. This is an incorrect usage ofthe word subsidize, and not a little insulting. The U.S.buys Chinese goods and China uses the export proceeds to buy dollar investments. This is a pure, commercial quid-pro-quo, not a subsidy, which implies a gift or somethingfor nothing.

The implication is malicious that China can choose totake its investments elsewhere. China has over $800 billion

continued on p. 22

If traders are saying that reserve diversification is on their minds and they are

impressed by the Swedish Central Banks diversification move and the price

action bears it out then the story is credible.

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in reserves today, probably reaching $1 trillion by the end ofthe year. Again, a reallocation would have more of anannouncement effect than an actual market effect. The forexmarket can easily swallow a few hundred million at a time,but most of the $1.9 trillion traded every day is speculativein the first place, not transaction-driven, and traders needincentives and a story. Reserve diversification fits the bill.

Whether its a small, respectable country like Sweden, ora big, controversial country like China, the next announce-ment of reserve diversification to the euro is highly likely tohave the same effect as the Swedish announcement in April.Reserve diversification is a theme on the rise, and although

we should be getting used to it, traders love an Event totrade on, and the announcement of another country choos-ing the euro as a secondary reserve currency is a fine excuse.

Would it be safe to automatically sell the dollar theinstant you hear such news? Yes, until reserve diversifica-tion becomes old hat. Here the analysis becomes a bit circu-lar. You know the topic is old hat when it stops working,and you know it has stopped working on the first occasionwhen it does stop working. But thats months, if not years,away.

When fundamentals fail to trump

Going into the Feds May meeting, controversy reigns over

whether its one and done, meaning the May hike in theFed funds rate to 5 percent is the last, or if the economy hasenough steam to justify another hike at the June meeting.

On Wednesday, April 26, the stock market and dollar bothrallied on good housing market data and a higher consumerconfidence indicator (when drops were forecast in bothinstances). The yield on the 10-year Treasury note rose to5.081 percent from under 5 percent the Friday before, andFed funds interest rate futures raised the odds of a June moveto 52 percent from 38 percent the week before. The dollargained from 1.2418 at the close the night before to 1.2388.

Uh-oh. This is only 30 points when the average daily

range is 80 to 100 points. The dollar should have ralliedmore. The small move was a failure of good fundamentalsto overcome the euros uptrend. Overnight, the dollar ral-lied again and for the same reason favorable data butagain it failed to break out of the hourly range or even tosurpass the good-news move from the day before (Figure2). Experienced traders started to get very worried. If goodnews was failing to lift the dollar, any bad news was likelyto trash it.

Then Fed Chairman Ben Bernanke spoke to aCongressional committee on the economic outlook. Unlikehis predecessor, who delighted in declining to say anythingclear and substantive, Bernanke came right out and said


The failure of good economic news to significantly lift the dollar vs. the euro (i.e., push down the EUR/USD rate) was

another indication of the dollars weak position.

FIGURE 2 WHEN THE MARKET IGNORES THE FUNDAMENTALS

Source: eSignal

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24/48

that its reasonable to expect the economy to moderate,instead of keeping up the sizzling 5-percent pace of the firstquarter, and At some point in the future, the committeemay decide to take no action at one or more meetings in the

interest of allowing more time to receive information rele-vant to the outlook.With the usual exaggeration, the market started to question

whether even the May rate hike is the dead certainty it expect-ed only the hour before Bernanke started speaking. The eurobroke out of its normal standard error channel to make anew high over 1.2500, a level not seen since the HurricaneKatrina-inspired spike in September 2005. The Katrina spikewasnt a true fundamental change, and it didnt hold.

This rise to the 1.2500 level seems real i.e., having realfundamentals behind it. (It doesnt get more real than thechairman of the Federal Reserve.) We can expect the stock

market to rally and the bond market to take yields lower.Gold could rise because the dollar is weaker or fall becausethe Fed doesnt see inflation probably the former,because thats more fun.

How do you know when a fundamental factor is going tobe decisive? Because we lack a hierarchy of factors and cantput weights on the many variables that affect traders, theonly way to know in advance whether some development

is critical is to read what traders say they care about.Traders are not disinterested parties, of course. Many

times they have an agenda, which is their own existingposition, or they want to mislead others in order to build a

new position. Reporters at the major financial newspapersand wire services are often misled, too. You have to readeverything with a dose of salt.

But if traders are saying that reserve diversification is ontheir minds and they are impressed by the Swedish move and the price action bears it out then the story is credible.

In April, the Riksbank story trumped what should havebeen a bigger correction in the dollars favor. The Bernankestory was pre-figured by the failure of the dollar to rallybeyond a normal range on good news, meaning the marketwas already expecting an unfavorable outcome. Now thatthe euro has broken out to the upside, many technical ana-

lysts will expect the usual profit-taking pullback to a rangeinside the old channel.But the new fundamental landscape argues against the

usual technical interpretation it will almost certainlytrump the channel, and it will be necessary to draw a new,steeper, one.


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Just as in trading there are really only two deci-sions to make trend or fade so, too, inmoney management there are only two strate-gies to follow: You can either suffer numerous

small losses and hope that an occasional large win willmore than offset the drawdowns in your account, or youcan harvest many small profits and suffer an occasional

large loss that you hope doesnt overwhelm the profit cush-ion you have built.

Of course, novice traders rarely face these two choices;they simply lose money. Some lose money in small incre-ments over a long period of time, while others lose moneyin shockingly huge chunks and are out of the game beforethey even have a chance to learn how to properly use theirtrading software.

Why do novices inevitably lose? Because they trade in arandom fashion. They rarely practice consistency in theirsetups. They rarely understand the dynamics of price flow,and even when they learn it, they frequently misunder-

stand the nature of technical analysis.Trading randomly is one of the quickest ways to lose

money in FX. Many threads on many Internet bulletinboards have been started using the random entry coin flipapproach and some basic form of money management, suchas risking $1 for every $2 of profit; within a matter of weeks

or months, the originators of those threads have foundthemselves either in deep drawdown or completely broke.

Ironically enough, the practitioners of the random entrymethod inadvertently prove that market action is not ran-dom. If it were random, then they presumably should per-form no worse than skilled traders. But alas, like a luckyidiot who sinks a half-court shot during a contest but couldnever win a one-on-one game against a professional basket-ball player, so, too, these novice traders will fall by the way-side when competing against professional technical traders

over any reasonable length of time.

The notion that technical analysis doesnt matter its just money management that matters is, like so manytrading myths, complete nonsense. Money managementalone will not make you a successful trader. It is, however,a vital complement to any intelligent technical setup.

Money-management strategies are as unique as eachtrader, and one of the most pernicious myths perpetrated

on the gullible public is that money-management strategiesare sacrosanct and thus all traders must follow the samemoney-management rules in order to achieve success.

That is utter nonsense. In fact, the longer the traderstrade, the more flexible, the more complex, the more cre-ative their money-management skills become. Because FXoffers retail traders unprecedented liquidity and limitlesscustomization, money-management strategies in FX aretruly variable.

The myth of 2:1

Lets start the most classic money-management technique

preached by every trading book ever printed: In every tradeyour reward-risk ratio must be at least 2 to 1 that is, youmust try to obtain 2 points of gains for 1 point of risk. Thisway the trader needs be correct only 40 percent of the timeand will still have a positive expectancy to his trades.

On the surface this idea sounds eminently logical and

practical. In real life, however, its quite difficult to squeezeout 2 points of profit for 1 point of risk. Try it and see. Firstlook at the price action on the smallest time frame and seehow hard it is to risk 1 point in order to capture 2 points.

On the smallest level the FX trader faces the overwhelm-ing barriers of the spread. Even in the most liquid financialinstrument in the world, the EUR/USD, the spread is 3points wide, so in effect the trader must make 5 points inorder to earn 2, thus forcing him to generate an improbableratio of 5:1 in order to simply meet this goal.

Moving on to a 10-point increment, a 10-point risk for a

TRADING STRATEGIES

FX money managementIn the first of two articles adapted from his new book, Technical Analysis of the Currency Market,

Boris Schlossberg addresses money-management myths and looks at ways to manage trades

and capture profits in the real world.

BY BORIS SCHLOSSBERG

One of the most pernicious myths perpetrated on the trading public

is that money-management strategies are sacrosanct and all traders

must follow the same money-management rules to achieve success.

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20-point profit still requires a 23-point gain and allows foronly a 7-point risk of loss in the tightest spread pairs likeEUR/USD and USD/JPY; in effect, this means a tradermust generate 3 points of profit for 1 point of risk just tomeet the 2:1 reward/risk ratio.

Expanding the time line to longer time frames, a 100-point risk with a 200-point profit target provides muchbetter odds. Here the spread plays a minuscule part as itrequires only 203 points of profit and allows for 97 pointsof risk, generating very close to a 2:1 ratio.

But lets step back a second. What if you were simply notpredisposed to patiently stay in the trade for the time nec-essary to see it to fruition? If you were impatient, wouldntit be much more probable that you would try to take yourprofits far sooner, perhaps at 100 points in the money oreven 50 points in the money, turning what in effect wassupposed to be a 2:1 trade into a 1:1 or 1:2 reward-to-risksetup? You will do what every trading book preaches notto you will cut your profits short by not letting themrun. But given your personality, can you really be expected to

do it any differently?But lets suppose you are different. You possess the patience

of a saint, you have the discipline to follow this rule inviolably.Imagine the following scenario: You place a trade inEUR/USD. Lets say you decide to short the pair at 1.2500 witha 1.2600 stop and a target of 1.2300. The trade is going well.The price moves your way. EUR/USD first drops to 1.2400,then to 1.2350, and slowly makes its way toward 1.2300.

At 1.2335 the price action pauses and the pair starts toinch back up, first trading through 1.2350, then 1.2375. You,however, are patient. You have nerves of steel. You hold on,looking for your 2:1 reward-to-risk. The price starts to move

back down and you are starting to feel vindicated. Back to1.2350, 1.2325; slowly but surely you see the target in sight.1.2320, 1.2310, 1.2305. Your take-profit order sits on the plat-form waiting to be filled. The price ticks a few more pipsdown, reaching all the way to 1.2301 but then it bouncesback, first slightly, then violently, until in a matter of secondsits at 1.2350, then 1.2370.

You remain calm. The price nearly touched your target. Itsbound to test that level again. You wont make the same mis-take others make of cutting your profits short. You will stayin the trade and follow the classic money-management rules.

Of course, the price never does see 1.2300. Instead the

pair verticalizes and soon reaches 1.2600, easily takingout your stop. You are now faced with the idea that you hada 199-point profit and allowed it to become a 100-point loss.Welcome to real trading.

Modifying the approach

How many episodes like that do you think a novice tradercan experience before abandoning all sense of discipline andproper money management? This is the reason why the 2:1reward-to-risk strategy is mostly a fantasy, an ideal. In prac-tice most traders will modify the strategy in one of two ways.

First, once price moves in the direction of the trade by the

amount of points risked, professional traders will move

their stop-loss to the breakeven point to assure themselves

that a winning trade will not become a losing trade. So inthe case of our EUR/USD trade the trader would move thestop to 1.2500 once the price breached the 1.2400 level.

This, however, still presents a dilemma for most traders.Suppose the price retraced all the way back to 1.2500, stop-ping the trader out. There would be no losses, but also nogains. The trade would be a scratch. In trading there is noth-ing more frustrating and psychologically unnerving than tobe right on direction and walk away with no profit. Its theequivalent of working very hard all day long at your job andthen losing that days pay through a hole in your pocket.

For this reason many traders practice a scale-out

approach. Typically traders will let go of half of their posi-tion once the gains match their risk value. In our EUR/USDexample the trader would sell half at 1.2400 and then movethe stop to the break-even point, assuring himself of har-vesting at least some profit out of the trade.

This approach allows the trader to remain in the trade foras long as necessary because it satisfies the most basic desireof trading the need to get paid. By selling half of the posi-tion at 1.2400 and half at 1.2300, the trader is able to harvestonly a 1.5:1 reward-to-risk ratio, which of course is mathe-matically inferior to 2:1. However, trading is not a game ofmathematics but one of psychology, and frequently what is

mathematically optimal is psychologically disastrous.Professional traders recognize this fact. They also under-

stand that market dynamics are fluid and will rarely con-form to rigid reward/risk ratios. By constantly monitoringtheir positions and adjusting their risk parameters to thereality of the markets, professional traders are able to notonly generate positive reward/risk ratios, but also producemore profitable trades.


Next month: More money-management strategies from the book

Technical Analysis of the Currency Market.

Related reading

Technical Analysis of the Currency Market: Classic

Techniques for Profiting from Market Swings and Trader

Sentimentby Boris Schlossberg (2006, John Wiley & Sons).

Other articles by Boris Schlossberg:

Progressive entry technique, Currency Trader, July 2005.

A staggered trade-entry approach allows you to be more flexi-

ble and structure your trade depending on market develop-ments.

Forex options, Currency Trader, June 2005.

Forex options are a breed apart. Traders accustomed to stan-

dard calls and puts need to familiarize themselves with some

new concepts and terminology before trading these exotic

instruments.

You can purchase and download past articles at

www.activetradermag.com/purchase_articles.htm.

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There are a few ways to answer the seeminglysimple question, Whats the euro worth?The first and most reflexive response would be to run over to your nearest quote screen

and punch in the exchange rate between the euro (EUR) andthe U.S. dollar (USD). This is the standard answer, but it isvery incomplete.

A second way, and an attempt at greater completeness,would be to reference several cross-rates between the EURand the currencies of its major trading partners, such as theBritish pound (GBP) and the Swiss franc (CHF). While this

would provide a more complete answer, it confuses datawith information: All those cross-rates without somemeasure of their relative importance just muddle theissue. Also, the relative importance of these cross-rateschanges constantly.

A third way would be to quote the EUR in terms of anabsolute standard. Both gold and the InternationalMonetary Funds Special Drawing Rights (SDR) have beenposited as such standards, with gold by far having thegreatest number of adherents and cultists.

But if 2004-2006 has shown us anything, it is that gold isreally nothing more than just another

commodity whose price may or maynot reflect absolute currency stability(or inflation expectations). If the long-only commodity indexers start buyinggold in large quantities, or if one ortwo major central banks decide toplace a greater portion of their reservesinto gold (as opposed to, say, the USD)gold ceases to be an absolute standard.This certainly appears to haveoccurred in late 2005, when the curren-cy-adjusted movements of London

gold in USD, EUR, and GBP turnedparallel even though the currenciesthemselves did not (Figure 1).

With gold no longer an absolutestandard and SDRs unavailable toinvestors, we must seek a fourth wayof quoting the EUR: a fixed basket.

The basket case

For more than three decades, the dollarindex (DXY) has demonstrated the util-ity of a fixed-weight basket approachto answering the question, Whats the

ADVANCED CONCEPTS

The currency-adjusted movements of London gold in USD, EUR, and GBP

turned parallel even though the currencies themselves did not. The lesson is

that gold is simply another commodity one whose price may or may not

reflect absolute currency stability or inflation expectations.

FIGURE 1 CURRENCY-ADJUSTED LONDON AM GOLD

The euro index:

The dollar index meets its matchThe launch of tradable euro index futures and options may be the next step in the ascendancyof a new dollar-euro currency regime.

BY HOWARD L. SIMONS

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dollar worth? For more than twodecades it has functioned as the basisfor exchange-traded futures andoptions. As we move ever-closer towhat was described in the December2005 Currency Trader as a firmexchange-rate environment (see The

dollar index and firm exchange rates,in Related reading) organized intoUSD and EUR blocs, it would be usefulto have a euro parallel to the DXY.

Once we agree on an indexingapproach, we run into the problem ofhow to assemble the index, how toweight the index, what to include in theindex, etc. Think of all the indices youknow about; each claims to be the bestfor a given purpose, but you have nosingle way to make that determination.

The European Central Bank (ECB)created a 12-currency Euro EffectiveExchange Rate index, but stopped

publishing it in October 2005 in favorof a 23-currency index. This latter

index looks like European politicalcorrectness run amok. In includes thesmall-weight currencies of countries on the Europeanperiphery, such as Latvia, Lithuania, Estonia, Malta,Cyprus, the non-Euro Scandinavian currencies, and non-European trading partners such as Hong Kong, Singapore,and Korea.

Figure 2 depicts three index approaches. The original 12-currency Euro Effective exchange rate index is on the left; itscomponents are highlighted in the legend box on the right.If we add nine additional currencies the Chinese yuan(CNY), Czech koruna (CZK), Cypriot pound (CYP),Estonian kroon (EEK), Latvian lat (LVL), Lithuanian litas

(LTL), Maltese lira (MTL), Polish zloty (PLN), Slovakiankoruna (SKK), Slovenian tolar (SIT), and the Hungarianforint (HUF) to the mix and designate their 17.35-percentcollective weight as Other (OTH), we arrive at the new23-currency index depicted on the right. The middle stackof five currencies comprises the Euro index (ECX).

The 23-currency index has several problems. First, someof its components are currencies destined to become part ofthe euro. Second, several of its larger component currenciesare not freely floating at all. These include the managed

continued on p. 28

Three euro indices are shown: the original 12-currency Euro Effective

exchange rate index (left); the five-currency Euro index (ECX) discussed

here (middle); and the 23-currency index (right).

FIGURE 2 THREE EURO INDICES: ARE THEY EQUIVALENT?

The ECX and the 23-currency index had more moderate histories compared to

the EUR/USD rate, both during the euros 2001-2002 weakness and later

during its 2004 strength.

FIGURE 3 THE EUR/USD RATE AND EURO INDICES

Compared to

a single-currency rate,

a trade-weighted index

is less volatile andreduces the overall

risks involved in timing

and placing a hedge.

8/8/2019 CT200605


float of the HUF against both the USD and EUR, and theessentially fixed CNY.

Third, this index has too many members whose curren-cies are too closely correlated to make the distinctionsmeaningful. The cross-rates between the Danish krone,

Swedish krona, and Norwegian kronemay be of deep and lasting importanceto our Scandinavian friends, but theseare not lynchpins of global finance.

Fourth, and most important for cur-rency traders, the cumulative bid-ask

spreads on 23 different currencies (notall of them deep and liquid) maketrading this index too expensive.

The New York Board of Trade(NYBOT) got around this problem inthe time-honored tradition of equity basket traders: It constructed a repre-sentative sample out of five differentcurrencies the U.S. dollar, Japaneseyen, British pound, Swiss franc, andSwedish krona. The exchanges newEuro Index (ECX) is a geometric weight-

ed average of these five designed tomatch the original 12-currency index.This it did between its January 2001inception and mid-July 2005, at whichpoint the 23-currency index weakenedon a relative basis to reflect the USDsfourth-quarter 2005 rally (Figure 3).

Both the ECX and the 23-currencyindex had more moderate historiescompared to the EUR/USD rate, bothduring the euros 2001-2002 weaknessand later during its 2004 strength. This

may be the cleanest example of theadvantage a trade-weighted index hasrelative to a single-currency rate: It isless volatile and therefore reduces theoverall risks involved in timing andplacing a hedge.

Of course, having a less-volatilehedge instrument does not necessarilytranslate into having a higher return onyour hedge. If, for example, we were tocompare the euro-denominated MorganStanley Capital International Euro index

(MSER) with the dollar-denominatedRussell 3000 and hedge the MSER intoUSD using the euro, the ECX, and the23-currency index, we would get widelydiffering results (Figure 4). It just so hap-pens the EURs burst of strength in 2003-2004 propelled its results higher; theopposite would have been true in 2001

and the first half of 2002.European investors might see the world quite differently,

however. They would want the benefits of a diverse indexsuch as the ECX to hedge their multi-currency portfolios. Asmany European global investors have portfolios denominat-

ADVANCED CONCEPTScontinued

The EURs burst of strength in 2003-2004 propelled its results higher, but

the opposite would have been true in 2001 and the first half of 2002.

FIGURE 4 COMPARATIVE INDEX PERFORMANCE, HEDGED & UNHEDGED

The unhedged portfolio underperformed over the entire period, but it

outperformed both hedged portfolios from January 2001-May 2002. Also, after

the start of 2003, the EUR-only hedged portfolio outperformed the ECX-hedged

portfolio. However, such a hedge presumes the bond manager is willing to act

like a position trader in currencies over an extended time period.

FIGURE 5 HEDGING A NON-EURO BOND PORTFOLIO

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Market: Currencies.

System concept: The Chan-nel Midpoint indicator is themiddle line between the two boundaries of a DonchianChannel that is, the midpoint between the highest and lowestprices of the past nbars.

The indicator follows the trendlike a moving average but it has

the benefit of remaining static(i.e., its value does not change)during consolidation phases.This behavior makes the indica-tor useful for distinguishingbetween trending and non-trending periods with thegoal of producing clean-er trade signals (fewerwhipsaws).

Trend-following sys-tems typically make most

of their profits from asmall number of largetrades; most trades aresmall gains or losses. Thistest will determine if theChannel Midpoint indica-tor can provide the basis ofa higher-probability trendsystem.

The system uses twoChannel Midpoint indica-tors based on different

time frames. The rules aresimilar to a standard mov-ing-average crossover sys-tem: the system goes longwhen the shorter-termChannel Midpoint indicator crosses above the longer-termChannel Midpoint indicator and goes short when the oppo-site occurs.

Figure 1 shows a trade example in Japanese yen futures.The longer-term (250 bars) Channel Midpoint indicator isgreen and the shorter-term indicator (150 bars) is red. Bothindicators follow the long-term trend, but during consoli-dation periods they go flat. With its long-term look-back

periods (150 and 250 days), the system is geared towarddetecting major trends.

The system went short on July 31, 2000 when the short-term indicator crossed below the long-term indicator. Thedowntrend persisted until early March 2002, at which pointan extended consolidation developed and both indicatorsremained flat. The next crossover occurred on Oct. 2, 2002when the system exited the short position and reversed to the

CURRENCY SYSTEM ANALYSIS

The majority of the systems profit occurred in the final four years of the test period.

FIGURE 2 EQUITY CURVE

The system caught a major downtrend in the Japanese yen.

FIGURE 1 SAMPLE TRADES

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

ChannelMidpointindicator

30 May 2006 CURRENCY TRADER

8/8/2019 CT200605


long side. The system made 19 points of profit in this trade.

Rules:

1. Go long and exit short the next day at the market ifthe 150-day Channel Midpoint indicator crosses above

the 250-day Channel Midpoint indicator.2. Go short and exit long the next day at the market if

the 150-day Channel Midpoint indicator crosses belowthe 250-day Channel Midpoint indicator.

Test period:January 1991 to December 2005.

Test data: The system was tested on the following cur-

LEGEND: Starting capital Equity at the beginning of thesimulation period Ending capital Equity at the end of thesimulation period Net profit Profit at end of test period,less commission Net profit % Profit at end of test period in

percent of starting equity Annualized gain % Compounded annual growth rate Exposure The area of theequity curve exposed to long or short positions, as opposed tocash Number of trades The total number of round-triptrades plus open positions Avg profit/loss The average

profit/loss per trade in dollars Avg profit/loss % The aver-age percentage profit/loss per trade Avg bars held Theaverage number of bars held per trade Winning trades The

total number of winning trades Winning % The percentageof winning trades Gross profit The total profit generatedby the winning trades, minus commissions and slippage Avgprofit The average profit per winning trade Avg profit % The average percentage profit per winning trade Avg barsheld The average number of bars held per winning trade Max consecutive The maximum number of consecutive win-ners Losing trades The total number of losing trades Losing % The percentage of losing trades Gross loss The total loss generated by the losing trades, minus commissionsand slippage Avg loss The average loss per losing trade Avg loss % The average percentage loss per losing trade Avg bars held The average number of bars held per losingtrade Max consecutive The maximum number of consecu-tive losers Max drawdown Largest decline in equity indollars Max drawdown % Largest percentage decline inequity Max drawdown date Date on which the max draw-down was realized Wealth-Lab score An overall measureof profitability, exposure (efficiency), and risk Profit factor Gross profit divided by gross loss Recovery factor Net

profit divided by max. drawdown Payoff ratio Averageprofit of winning trades divided by average loss of losing trades Sharpe ratio Annualized average return divided by theannualized standard deviation of returns Ulcer index Ameasure of the portfolios overall volatility Wealth-Lab errorterm The average of the absolute values of all percentage dis-tances along the equity curve from its linear regression line Wealth-Lab reward ratio Annual percentage return dividedby the Wealth-Lab error term Luck coefficient The per-centage profit of the largest winning trade divided by the average

percentage profit of all winning trades Pessimistic rate ofreturn A statistical adjustment of the wins to losses ratio thatestimates the worst-expected return from previous results Equity drop ratio The standard deviation of all drops in theequity curve measured from each equity low to the previousequity high divided into the annualized return.

Currency System Analysis strategies are tested on a

portfolio basis (unless otherwise noted) using Wealth-

Lab Inc.s testing platform. If you have a system youd

like to see tested, please send the trading and money-

management rules to

[email protected]: Currency System Analysis is intended for

educational purposes only to provide a perspective

on different market concepts. It is not meant to rec-

ommend or promote any trading system or

approach. Traders are advised to do their own

research and testing to determine the validity of a

trading idea. Past performance does not guarantee

future results; historical testing may not

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