deflation

I’ve been thinking about this for a while and while I can’t say that I’ve read through every trading strategy, what I have found through my years of experience is that in order to make real and lasting profits you need to attune yourself to the Major Fundamental Events (MFE’s) that set the trends-and then get in when price is most advantageous.

When I refer to Major Fundamental Events I’m not just referring to the monthly reports, although those can be used along the way. I’m talking about something that can cause a radical shift, which I’ll explain.

One thing before we start though-these MFE’s may only happen a couple times per year, if that. That’s OK though, because these trades are going to yield 1000’s of pips. One trade may last for weeks or months.

Also, we’re not at the start of an MFE now, at least in my opinion.

As you might have guessed, an MFE can be (and usually is) initiated by the Fed although certain earth-shaking events (the Lehman bankruptcy for example) can certainly do the job. Sometimes several MFE’s can occur simultaneously which is great because those tend to build on each other, strengthening the trend.

The 2 keys for profiting from this are as follows:

1. You have to recognize when an MFE has occurred.

2. You have to understand how markets will be affected after the MFE has occurred and the correlations between the different asset classes (currencies, stocks, bonds and commodities).

The most recent MFE began on March 15, the day of Bernanke’s 60 Minutes interview in which he said the Fed was “electronically” printing money. Go to this page: http://video.google.com/videosearch?…um=4&ct=title# and see the “The Chairman Part 1″ video at about 8 minutes in.

It’s true that economists and commentators were talking about the Fed printing money before the interview because everyone was well aware that the Fed had already expanded its balance sheet (quantitative or credit easing = money creation).  But the Federal Reserve admitting it on national television was a whole different matter in my opinion. The dollar bear market began in earnest from there while stocks, commodities and Treasury yields rose.

In other words, Bernanke created a rally in risky assets because he convinced investors that the value of the so-called safe assets (the dollar and Treasuries) would depreciate.  What also was interesting about this MFE was that none of the so-called experts, including the financial press, picked up on it.

Then again, none of the so-called experts said anything about what would happen to the dollar after Lehman went bust either, including such luminaries as Jim Rogers who’s been a commodity bull forever (and who got crushed in the 2008 commodity collapse) as well as Peter Schiff who also lost his shirt because he didn’t recognize that a dollar-boosting flight to safety would occur after Lehman’s bankruptcy.

Why did Bernanke make the radical decision to allow himself to be interviewed on 60 Minutes? I think that it was because despite all of its previous balance sheet expansion, the Fed to that point had been totally unable to accomplish its goal of boosting stocks and creating some measure of inflation (making commodities more expensive) by weakening the dollar in order to counter the far more dangerous deflationary pressure of the financial crisis. The S&P had made a fresh low just one week before and had declined nearly 58%. No question they were concerned that all of the actions taken to that time could potentially fail, sending the global economy deep into a depression.

By the first week in June, the S&P had gained about 40% from the March low. The dollar had lost thousands of pips to the euro, pound and A$, oil was threatening $70 and yield on the benchmark 10 year Treasury was up near 4%. That created another set of problems for the Fed however, because of the detrimental effect that rising energy prices and interest rates naturally would have on consumer spending and housing (because of rising mortgage rates).

From that point, the Fed began a serious effort to talk up the risks of deflation (while talking down the risks of inflation) and from there, the markets basically went sideways. In other words, just as his efforts to convince investors that the dollar would depreciate helped boost markets, his deflationary concerns helped throw cold water on the rally he created with his printing-dollars comments.

Market correlations are pretty straightforward once you realize something:

When you trade spot forex, you’re trading pairs-GBP/USD for example. When you buy the pound you are simultaneously selling the dollar. When you’re trading currency futures, the contract is listed in euros or pounds or A$’s-there’s no “pair” in futures. However, despite that you’re still “selling” the dollar when for example you buy the euro contract because you are trading in dollars and your contract moves against the dollar.

It’s the same thing for any instrument which is priced in dollars no matter what the asset class is. So when for example you’re buying a stock, for all intents and purposes you are “selling” dollars-your bet is that your stock is going to appreciate against the dollar.

Think of it this way-if an asset class priced in dollars goes up, what does it go up against? The dollar of course. So when all of these asset classes are appreciating, it tends to put downward pressure on the dollar.

It’s the same for the S&P-the S&P is priced in dollars so for all intents and purposes if you are long the S&P you are short dollars.

So think of it this way:

S&P/USD
OIL/USD
GOLD/USD

Or just:

Commodities/USD
Stocks/USD

How about bonds (Treasuries)?

First, by convention, when people say bonds are up or down they are talking about price.

Second, bond prices and yields move in opposite directions for a very simple reason: If you buy a bond today for $1 that yields 2% and yields go up tomorrow, of course the bond you just bought is going to be worth less simply because it yields less.

Stocks and commodities are risky assets while Treasury bonds (and notes and bills) are “risk free.” They’re risk free because if held to maturity your principle and interest are guaranteed by the full faith and credit of the U.S. government. So when the market is “risk averse” (like it was after the Lehman collapse, another MFE)), stocks are sold and bonds are bought.

So in general, stocks and Treasuries are inversely correlated. We saw that after Lehman and we saw it happen again after Bernanke’s little interview.

It all comes down to investors appetite (or lack thereof) for risk, which obviously is heavily influenced by what I call Major Fundamental Events. “Risk aversion” places tremendous upward pressure on the dollar while the acceptance of risk has the exact opposite effect.

That’s why you want an MFE to occur-things can only move one way after one happens and when you recognize it early, you can absolutely make a killing.

There were two very good articles (actually, one is a thread in the forum section) posted on FF recently that I thought had a lot of relevance for traders. What I’d like to do here is expand on both and tie them together because I think there are some very valuable forex trading lessons to be had. The first was an article posted by Piptrain called “How The USD/JPY Can Predict The End Of The Recession” and the thread that caught my attention was called “Giving Up” by Jimmy Jones.

Piptrain made the very astute observation that USD/JPY had gone from being a co-incident to a leading indicator for the S&P. This is incredibly important because if you know the market is setting up to be in either a “risk on” or risk off” trend, you can enter some trades with potentially huge returns.

To review, “risk on” means investors are buying riskier assets like stocks and commodities as they sell the safe ones-the USD and Treasury’s. Risk off is of course the opposite. The market went into severe risk off mode after Lehman Bros. collapsed last September and we’ve now come to the end of the risk on rally that Bernanke ignited in March.

What also happens when the market is in risk on mode is that the yen falls as traders sell it against the (formally) higher-yielding currencies. At least, that was the case until USD/JPY apparently became a leading indicator of the market’s appetite for risk.

USD/JPY (as well as the other yen crosses) had basically been falling right along with the S&P ever since the market peaked in October 2007 and the move into the yen accelerated when global stock markets collapsed through last Fall after the Lehman bust.  But starting at the beginning of 2009, things changed.

USD/JPY started appreciating in January even as the S&P headed lower, making a bullish divergence just as the MACD sometimes does. The way things look now, what USD/JPY was telling us was that the market was setting up to be in risk on mode; the only thing it needed was the right fundamental catalyst which it got on March 15 when Fed Chairman Bernanke went on 60 Minutes and announced the Central Bank was “electronically” printing dollars. Active depreciation of the dollar is a pretty sure way to ignite a stock rally because if the dollar looks set to depreciate, anything you buy with it (like stocks and commodities) has to gain in nominal if not real terms.

Even more interesting is that during most of the recent rally, USD/JPY was going down-in other words, it was making a bearish divergence, signaling that the rally could only go so far because investors were not truly buying risk. All it needed to completely kill it off was perhaps something like the poor NFP report we got 2 weeks ago.

An even stronger indication that the market is moving into full risk off mode is that USD/JPY is continuing to depreciate even as stocks head lower-in other words, it isn’t making a bullish divergence now which is entirely justified especially after all the recent talk about deflation being a bigger concern than inflation along with the G8 saying that now is not the time to begin withdrawing the extraordinary monetary and fiscal policies that have been implemented during the crisis.

So what can be gained from this?

1. It does indeed look like stocks and commodities are headed lower, which means the dollar will gain against the higher-yielding euro, pound and A$.
2. If stocks do go down and USD/JPY starts showing a bullish divergence, we’ll know the market is at least prepared to gain given the right set of economic fundamentals.
3. If stocks eventually gain and USD/JPY shows a bearish divergence, stay ready for an eventual decline
4. If USD/JPY gains along with stocks, the rally probably has legs.

Giving Up

Jimmy Jones is talking about giving up trading because after finding success during the rally, he’s found things to be very difficult more recently. The exact reason why Jimmy Jones has found it so difficult to trade lately is because the market entered a consolidation period where price moved back and forth but did not trend. Trading is relatively easy when markets are trending because you can “set and forget” or even take profits along the way and buy on dips (in an up-trending, risk on market) or sell on strength in a down trend. But when markets are moving sideways, as they have been over the past few weeks, it’s very easy to see your account get shredded.

Trend following systems like moving average cross-overs all share the same characteristics-they look good in a trending market but fail utterly when markets are moving sideways. They cannot tell you when a trend will end and they certainly can’t tell you when markets will go sideways, which as we know are the most difficult markets to trade. In fact, sideways markets are the main reason why so many forex traders fail.

There are some traders who claim to be good in these types of markets but for the vast majority of us (myself included), they’re just too hard. I basically avoid them like the plague and if that means I don’t have trades for a few days, weeks, or even months-fine. I’ll keep my powder dry for the time when I believe markets can trend. In other words, the decision not to trade is a trade itself.

The only way to avoid this type of price movement is to be an astute observer of what’s happening with the markets in terms of the willingness to buy (or sell) risk and what makes that especially hard is that is that different circumstances create a different set of conditions. For example, what killed the March rally in my opinion was all the talk about deflation from people like Bill Gross of PIMCO, economist Nouriel Roubini and FOMC member Janet Yellen. Why? Because if deflation is truly the risk, the dollar is not likely to depreciate which means the risky assets bought with it (stocks and commodities) are not likely to gain.

I’m not saying this is easy. You have to do your homework. But being aware of what’s going on will help you spot when the trends might start and more importantly, end.

Fed Chairman Bernanke’s little stock rally, which was initiated when he announced on 60 Minutes that the Fed was “electronically’ printing dollars, has apparently come to an end (at least for now). As a currency trader and market observer, you’ll want to know why and the reason has to do with the most famous currency pair you’ve never heard of. Ready? It’s called…

S&P/USD

That the dollar moves inversely to riskier assets like stocks (and commodities as well) isn’t a matter of some kind of mystical correlation that can somehow “break.” The key to knowing this is to understand what really is happening when stocks (or commodities) appreciate, which is easy to see once you accept the existence of S&P/USD.

Look at it this way; when stocks go up, what are they going up against? The dollar of course. The same for goes for commodities because those are priced in dollars all over the world. Well, if these riskier assets have gone up, isn’t it than also true to say the dollar has depreciated. Absolutely. So when the market is buying risk, the dollar will tend to fall as a matter of due course.

What’s really interesting is that in the rare instance (like now) when the Fed is actively trying to devalue the dollar (because the economy is faced was the more serious threat of deflation), the Fed can create a stock rally just as Bernanke intended to do by admitting to the electronic printing of dollars on national television. Why? Because if you are convinced the dollar is going to depreciate, doesn’t that also mean that anything you can buy with it is going to be more expensive? Of course. And the convinced you become that the prices of liquid assets (like stocks and commodities) are going to rise, the more inclined you will be to buy them.

So what’s really happening in the current environment is that the Fed, through its actions and comments on the dollar (and on deflation/inflation which is the same thing) is pushing the market for riskier asset classes up and down. Let’s look at some recent action.

Bernanke’s rally pretty much fizzled out in the middle of May, but it got a temporary boost (about 4%) in the week following the last meeting on June 24 when members removed the deflationary concerns which had appeared in the April 29th statement. But then something interesting happened.

On June 30, San Francisco Federal Reserve Bank President Janet Yellen expressed some deep concerns about deflation. “I’ll put my cards on the table right away,” she said. “I think the predominant risk is that inflation will be too low, not too high, over the next several years.”

Now, remember what we said; if the market is convinced the Fed is depreciating (creating inflation), riskier assets are going to be bought because inflation means their prices are going to rise (at least nominally). No one wants to hold cash if the potential for inflation is on the horizon, because cash is guaranteed to lose value in an inflationary environment.

Conversely, if inflation really isn’t a threat and the possibility of deflation exists, there’s no reason whatsoever to buy riskier assets. Afterall, your cash is guaranteed to increase in value in a deflationary environment because prices are going down!

In fact, in a deflationary environment you make more money simply by being a “lender” (keeping for money in the bank or in Treasuries). A little arithmetic will show you how this works.

Your real (inflation adjusted) rate of interest is equal to the nominal rate (what the bank is paying you) minus the rate of inflation or R = N – i.

Let’s say inflation is 3% and your bank is paying you a nominal 4% on your deposit. Your real (R) interest rate is the Nominal (N) rate minus inflation or R = 4% – 3% which equals 1%. In real terms you’ve only earned 1% on the money you have in the bank

Now, let’s say there’s deflation (negative inflation) of -2% for the year and your bank is paying you a nominal rate of 3% on your deposit. What’s the real rate of interest you’ve earned?

R = N – I or R = 3 – (-2) = 5%. In real terms, you’ve earned 5% on your deposit!

Now, if I’m guaranteed to earn a risk-free return of say 5%, and I think prices are going down, why in the world would I buy a riskier asset? In the hope that someday its price might go up? Hope is a bad rational for making a trade.

So, Ms. Yellen, with her deflationary concerns, helped kill the rally. She wasn’t alone however; the Fed, with its expert manipulation of the media via the pundits seen all over Bloomberg, started so make plenty of deflationary noises around the middle of May.

As a trader, there are times when you can put this to very good use for longer term trends (which really is where the money is made). If the Fed does start talking about inflation and making noises like it might raise interest rates, do yourself a favor and sell the dollar as you buy riskier assets like stocks and commodities.  But if they continue to talk about the risks of deflation, there’s little reason to sell the dollar or to buy riskier assets. Buy the dollar at that point because it will be in demand.

BTW, Thursday’s weak market action off the surprisingly good unemployment numbers, along with the subsequent decline of S&P futures overnight, bodes very poorly for stocks and very good for the dollar. I can hardly think of a more bearish sign for stocks than the market failing to rally on good news. Afterall, it the market can’t rise when the news is good…