The Four Letter R-Word
Forex traders hear a lot about Risk; whether the markets are
tolerant, averse, or neutral. It is a headline that is bandied about on
a regular basis. Quantifying the value of risk, and its forex impact,
may be so much harder to do in the trading arena, than reporting each
day on whether the herd was charging towards, or away from risk.
In its natural state the financial market has three major attitudes
towards risk that models its behavior and actions throughout each of
the global trading session. The three are; risk aversion, risk
tolerance and risk-neutral. Headlines overplay the four letter Risk
word, it should be used sparingly as daily risk levels do not reflect
the big picture of fair value on global risk, and its forex
Risk-aversion is characterized by investors selling assets in times
of global contraction that are considered risky, and swapping them for
the safety of the bond market, mainly U.S. Treasuries. Risk-aversion
can be seen relatively easily; commodities decline (global commodities
are priced in Usd values, and as such create a short commodity/Long
dollar move), as investors consider that consumption will slow, while
S&P futures also head lower at a sustainable pace.
In the currency market, risk-aversion strengthens the dollar, as
investor sell foreign denominated assets to buy U.S. Treasuries. In
this period, higher yielding currencies (those with a higher overnight,
or ten year note rate) are the ones being sold the most as the Usd is
The risk-tolerance phase is seen when Treasuries and bonds are sold
as investors look for higher yields in a long-term play that reflects a
confidence that the global economy is expanding. In periods of relative
calm and positive macroeconomic reports, traders dilute holdings in the
safety of the bond market and invest their capital in stocks,
commodities and higher yielding foreign currencies. Usually, bull
markets are characterized by risk-tolerant phases and in this period
S&P futures and global commodities head higher. Therefore in this
period the dollar is sold.
In most cases, risk-neutrality happens when the financial market
moves side-ways, unable to push to test support or resistance, and when
global fair value on risk is accepted. At this stage the global economy
will be hitting its peak, or hitting its trough, in the business cycle
phase. This will be characterized by a re-distribution period, as
investors shift their assets between the various financial instruments
in preparation for the next leg of fair value on risk.
The main difference in the Neutral phase being that the shifts are
not only session-by-session, they literally happen hour-by-hour as big
players try to make their automated moves without detection. Sentiment
is seen to change from one to the other, empowered by the relentless
flow of global market trades that trigger as a contingency play, as
each individual market accepts risk neutrality, or not.
The sideways moving market tends to be the more volatile as the
channels are traded, and fair value sought at each regional market open
and close. June through August has been risk tolerant enough to move
prices in equities. However, the regional market activity has not been
strong enough to attract increasing volume levels to be able to make a
stance on risk for the next phase of trade to be confidently called,
and therefore the currency markets continue to spin their wheels each
day as dollar values are fought over.
Looking towards the next three months of trade, tenured forex
traders understand that fair value on the Usd, and on risk, will be all
about the phase that global business cycle are entering. The stages
are; Trough> Expansion> Growth> Peak> Contraction. The five
cycles take 10-15 years on average to work through and complete. The
U.S. economy however has been completing the cycle in half that time,
and that is making Usd long-term valuations harder to reliably plan.
Therefore when in Trough-to-Expansion, or Peak-to-Contraction
phases, the market runs on risk neutrality and stocks dominate reads on
fair value. This leads to a very high correlation (averaging 90%)
between equity trade and Usd movement; stocks go up and Usd goes down.
When we get into the Expansion or Contraction, phase, and either one
is in full flow (lasting a 5-8 year period globally, or 2-3 years in
the US) risk tolerance takes over, interest rate differentials dominate
the valuation of currencies, and stock market correlations reduce
(averaging 60%). Fair value on risk and on the Usd becomes all about
growth and interest rates.
Fed Fund Phase:
In times of Growth the Usd will increase against those currencies
not showing inflation, and/or, higher interest rate outlooks. As and
when the Federal Reserve raise overnight interest rates, it will be
because of an inflation fear coming from economic expansion, and it
will very likely be in a drip-fed manner of slow and steady increments
as the attempt to keep the speculative interest on the long side of the
Usd at bay.
However, the Usd will then be challenged by regional growth that
does not carry the weight of massive debt and current account/trade
imbalances. The Usd may never get back to 90.00 on the dollar index if
global regions expand at the same pace as America. As in 1972 under
President Nixon, it looks as though the U.S. in 2009 has set up Usd
devaluation with an over-commitment to Treasury debt that now looks
challenging, to say the least.
Weak Dollar Phase:
Coming out of a time of global Contraction and into a period of
global Growth (possibly) a strong currency is not what is required, by
any region. However, the U.S. looks to be the one region that literally
cannot afford a stronger dollar. The insurmountable look to the U.S.
Treasury debt numbers leave many to believe that the only way forward
with sustainable growth, that has any chance at all of creating
expansion numbers over and above the forward obligation to pay interest
on the debt mountain, is with a lower value dollar.
Forex traders will be looking again at whether the global economy is
prepared to welcome a slimmed down version of the greenback, something
that seems a ‘must-have’ for the Federal Reserve. That however can only
happen in the current environment with an increasing global equity
market, and a boisterous oil market arena that maintains a high level
of long speculative interest.
We have to go back to the rule book set in 1972-73 when the last
major forex rule was torn up and re-set, to a time that the dollar
index was born if we are to gauge the potential in a ever-decreasing
Usd value Traders and investors may have to accept that going forward
the Usd/Risk link may become eroded as the debt mountain surpasses
equity direction as the thing that helps or impedes daily Usd
Percentage Risk Phase:
If volume hits this market in September, and following the laws of
probability the month has a good chance of being negative (Shwartz
Stock Market Handbook has it as historically being the worst performing
equity month of the year), forex trader eyes will be all about whether
the Usd gets bought in the same number as previously seen in the recent
Risk Averse periods of trade. If stocks pull back and the Usd does not
get bought at a 90% correlated rate, we will have a signal of two
Firstly that the market is valuing risk on forward Growth and
interest rate differentials. Secondly, that the equity pull-back may be
a technical signal that it will find support before making the next leg
higher, rather than being the start of an equity collapse.
Risk Tolerance and Interest Rates will be affected by the global
business cycle. Whatever the headlines roar about this session being
tolerant on risk, or not, we now fully understand that at this pivotal
a time, risk will be seen in the percentage correlation between
equities and the Usd changing from the current 90% rate.
Forex Trader Phase:
Forex traders will be looking to see that Usd/Chf is moving hard
when they place their trades, if not they will be questioning the moves
because swissy has become correlated to dollar index moves holding, or
not. They will also be looking for oil and S&P futures markets to
stay aligned, because in any play in forex, whatever the pair being
traded, the Usd does affect the momentum flow.
The Usd affects every major traded cross pair, for example; Eur/Usd
x Usd/Jpy = Eur/Jpy. Also, Eur/Usd ÷ Gbp/Usd = Eur/Gbp. The synthetic
pairs (no Usd on one side or the other) can only move as a percentage
of the change in the major pair moves against the Usd; knowing what the
drivers of the Usd are doing allows for targets to be realistically
set, and lot size accordingly adjusted.
Getting secondary confirmation from inter-related markets is a
must-do for any level forex trader, especially when fair value on risk
is so hard to find as global markets transition from Trough to Growth.
TheLFB trade team will guide forex traders with updates issued
regionally, trade plans that absorb the noise and create stability,
signals that track inter-related movements, daily videos that put words
into pictures and with constant analysis of sentiment and momentum in
the global market.
Written by TheLFB Trade Team, © 2007-2008 LFB Services, LLC. All rights reserved. http://www.TheLFB-Forex.com