december 2005 • strategies, news and analysis

8/14/2019 December 2005 Strategies, News and Analysis

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December 2005 Strategies, News and Analysis for Forex Trader

Volume 2, No. 12

THE DEATH OF FLOATING

EXCHANGE RATES

and the FX market of the future

CRUNCHING THE NUMBERS:Yen outlook

MARKET CHARACTERISTICS:Trading the U.S. forex session

THE RATE-HIKE SCENARIO:Will the U.S. hold off while Europe steps up?

REFCO COLLAPSEimpacts forex traders

INTERVIEW WITH

Clarkson Jones,Monarch Capital Management


2/43

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

Letters . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Industry News

FXCM rescues Refcos retail

forex customers . . . . . . . . . . . . . . . . . . 9FXCM has reached a deal that will allow

Refcos forex customers to access their funds.

Global Markets

The end of the U.S.

rate-hike cycle? . . . . . . . . . . . . . . . . . 10A look at what the Fed might do next,

and the likely impact on the dollar.

By Currency Trader Staff

ECB lets rate cat out of the bag . . . . .13A look at the Euro in light of the ECBs

decision to hike interest rates.

Spot Check . . . . . . . . . . . . . . . . . . . . 16Dollar-yen

The dollar-yen rate has had an incredibly

bullish fall, gaining 10 percent fromSeptember to November. Will it keep up

the pace?


Advanced Concepts . . . . . . . . . . . .18The dollar index and firm

exchange rates

Its a question with huge implications for

currency traders: Is the floating exchange-

rate system destined for the historical dustbin? And what will take its place if it is?

By Howard Simons

Currency Trader

Interview . . . . . . . . . . . . . . . . . . . . . . . 26Clarkson Jones: Art, science, and forex

This currency fund manager blends discre-

tionary judgment with a systematic base.


Trading Strategies . . . . . . . . . . . . . .30Trading around the clock, part II

Is it advantageous to trade certain currency

pairs in specific trading periods? Find out how

the major currency pairs behave in the U.S.

trading session.

By Kathy Lien

CONTENTS

2 December 2005 CURRENCY TRADER

continued on p. 4


3/43
http://www.fxcm.com/


4/434 December 2005 CURRENCY TRADER

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 System Analysis . . . . . . .34Trend/countertrend system.

Currency Futures . . . . . . . . . . . . . . .36Eurex U.S. posts tepid early volume numbers

in currency futures. Plus, pro currency man-

agers look to end year on high note.

International

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

Global News Briefs . . . . . . . . . . . . .40

Events/New Products/Key Concepts

and Definitions . . . . . . . . . . . . . . . . . 41

Global Economic Calendar. . . . . . .42

FXCM

Gain Capital

International Traders Expo

Institute of Higher Earning
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5/43
http://www.forex.com/linkc.html?src=ccytradermagDEC05



Editor-in-chief: Mark Etzkorn

[email protected]

Managing editor: Molly Flynn

[email protected]

Associate editor: David Bukey

[email protected]

Contributing editors: Jeff Ponczak

[email protected],

Editorial assistant and

Webmaster: Kesha Green

[email protected]

Art director: Laura Coyle

[email protected]

President: Phil Dorman

[email protected]

Publisher,

Ad sales East Coast and Midwest:

Bob Dorman

[email protected]

Ad sales

West Coast and Southwest only:

Allison Ellis

[email protected]

Classified ad sales: Mark Seger

[email protected]

Volume 2, Issue 12. Currency Traderis published monthly by TechInfo, Inc.,150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2005TechInfo, 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

Kathy Lien is a chief strategist at FXCM, where

she is responsible for research and analysis for

DailyFX.com, including technical and fundamental

research reports, market commentaries, and trading

strategies. She was an associate at JP Morgan Chase,

where she worked for more than three years in credit

derivatives, cross markets, and foreign exchange trading. Liens expe-

rience encompasses trading both in and out of the forex market,

including interest rate derivatives, bonds, equities, and futures. She

has written for various industry publications and news outlets, includ-

ing CBS MarketWatch, and she is frequently quoted on Bloomberg and

Reuters. She is also author of the forthcoming book Day Trading The

Currency Market (John Wiley & Sons).

Howard Simons is president of Rosewood Trading, Inc., and astrategist for Bianco Research. He writes and speaks frequently on a

wide range of economic and financial market issues.

Thom Hartle is a private trader and president of

Market Analytics Inc. (www.thomhartle.com). In a

career spanning more than 20 years, Hartle has been a

commodity account executive for Merrill Lynch, vice

president of financial futures for Drexel Burnham

Lambert, trader for the Federal Home Loan Bank ofSeattle, and editor for nine years ofTechnical Analysis of

Stocks & Commodities magazine.

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.thomhartle.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]://www.thomhartle.com/


7/43
http://www.tradersexpo.com/



LETTERS

Im a FX trader with five years experience and Ive beena regular reader of Currency Trader magazine from itsfirst issue. I notice you use the phrase spot forex in

some articles. I know the word spot has a certain meaningif we refer to trading markets, but my fundamental question

is this: Should this term be used for the retail foreignexchange market traded through many electronic plat-forms?

My concern is caused by our Polish SEC interpretation,which says FX trades are just one-day financial futures con-tracts and cannot be considered spot transactions. That hascertain tax and legal implications here. Which approach isthe correct one? Fundamental explanations would be high-ly appreciated.

Tom SymonowiczPoland

Although we obviously cant comment on Polish trading regula-tions, when we use the word spot, were specifically referring tocurrency transactions that are not conducted on regulatedexchanges (such as the currency futures contracts traded at theChicago Mercantile Exchange).

So, the spot designation covers both cash transactions in theinterbank market (the network of major currency trading bank-ing institutions) as well as those transactions executed throughretail forex brokers (which might, in turn, be trading with mem-bers of the interbank market).

The lines between futures and spot are fuzzy in the U.S., too:The Commodity Futures Trading Commission (CFTC), whichregulates exchange-traded financial futures, has long sought toextend its reach to spot forex trading. Recent court decisions havehampered its progress in this regard, though.

Bob DormanAd sales East Coast and Midwest

[email protected]

(312) 775-5421

Allison EllisAd sales West Coast and Southwest

[email protected]

(626) 497-9195

Mark SegerAccount Executive

[email protected]

(312) 377-9435

Three good tools for targeting customers . . .

CONTACT

Getting interest-rate

differential data

Outstanding magazine the articles written byKathy Lien are exceptionally insightful andinformative. Im looking forward to her book. In

the meantime I have a question. She has written aboutinterest-rate differentials in various articles. I would like to

know where (i.e., from which data provider) I can down-load historical daily interest-rate data so I can calculate thedifferentials in independent analysis.

For example, she has shown charts of the AUD-USD andNZD-USD along with the respective five-year yield differ-entials. I subscribe to Reuters DataLinks worldwidefutures package, but they dont have this type of data.

JosephKathy Lien replies:Typically, most traders get the historical data for interest rates from Bloomberg. However, the monthly cost is relatively high.

Alternately, historical currency interest rates are readily available free of charge from central bank Web sites, but it sometimesrequires a bit of inventive Google keyword searching to find them.Here are the links for daily U.S., Australia and New Zealandrates. These should be updated daily and can be manually fedinto your charting package.

U.S.: www.federalreserve.gov/releases/h15/data.htm

Australia:www.rba.gov.au/Statistics/AlphaListing/alpha_listing_i.html(under Interest Rates and Yields > Money Market)

New Zealand:www.rbnz.govt.nz/statistics/1834998-08.html#P338_26909(under Interest Rate)

On the spot
mailto:[email protected]:[email protected]:[email protected]://www.federalreserve.gov/releases/h15/data.htmhttp://www.rba.gov.au/Statistics/AlphaListing/alpha_listing_i.htmlhttp://www.rbnz.govt.nz/statistics/1834998-08.html#P338_26909http://www.rbnz.govt.nz/statistics/1834998-08.html#P338_26909http://www.rba.gov.au/Statistics/AlphaListing/alpha_listing_i.htmlhttp://www.federalreserve.gov/releases/h15/data.htmmailto:[email protected]:[email protected]:[email protected]


9/43

INDUSTRY NEWS

December 2005 CURRENCY TRADER 9

R etail customers of Refcosunregulated foreignexchange brokerage whohad their accounts frozen in the after-math of Refcos collapse could be infor good news.

Forex Capital Markets(FXCM), a New York- based brokerage, hassigned a Memorandum ofUnderstanding with Refco

agreeing to purchase RefcoFX.com, the bankrupt bro-kerages retail foreignexchange arm, for $110million.

The deal still must beapproved in bankruptcycourt, which could happen atany time, according to FXCM CEODrew Niv.

The (bankruptcy) judge haspushed the hearing back, but it could

be as soon as the end of November,Niv says.

At the hearing, the judge will set theparameters for an auction, which willlast 20 days. At the end of the auction,the winning bidder gains control ofthe accounts.

Niv says he has heard that a fewother firms besides FXCM are interest-ed in Refcos forex accounts, butnobody needs to make an official biduntil right before the auction.

Once the deal closes, Refcos forexcustomers will have access to theirfunds.

All retail foreign exchange cus-tomers that went through RefcoFX.com will be made whole, andFXCM is buying back the 35 percentshare that Refco owns of FXCM, Nivsays. (Refco is) using the proceeds ofthat to give customers their money.

Niv says the deal is important for theforeign exchange industry, as the Refcodebacle has left many traders leery of

placing money in a forex account forfear of losing their funds.

FXCM is protecting the reputationof the online foreign exchange indus-try by demonstrating that there arestrong, responsible forex firms able to

stabilize the indus-try in difficulttimes, Niv says.We believe thatour efforts to

make these cus-tomers wholeunderlines thatcommitment.

Refcos CapitalMarket divisionprimarily consists

of hedge-fund cus-tomers, and Niv has no intentions oftaking over those accounts.

Refco Capital Markets has been inthe news lately as hedge-fund legend

Jim Rogers is claiming Refco moved$362 million in assets to the CapitalMarkets arm, where it is currentlyfrozen.

The problem with Refco CapitalMarkets was that this was the entityRefco used as a bank for all other enti-ties, Niv says. It was the one thathad the bank credit line, so all the trad-ing used Refco Capital Markets as aclearing firm. Because of that, somemoney from every entity was at Refco

Capital Markets.Refco is claiming all (Rogers)money was in Capital Markets, andsince that money was frozen, hismoney was frozen. This deal will freeup all the retail customers, but(Rogers) will have to win a lawsuit.Im freeing the (retail) customers nowto avoid that.

A representative for Rogersdeclined comment.

There is a gray area in the law,Niv says. Because there is no specific

exemption, the lawyers for Refco inter-preted [the law] as a blanket license toseize those assets. Jim Rogers is mak-ing the argument that these are fundsthat were held in trust and are notassets of Refco.

Personally, I agree with Jim Rogers,but a court will decide it. This showscustomers how important it is for theirfunds to be in a regulated entity.

Free at last

FXCM rescues Refcos retail forex customers
http://www.fxmoneymachine.com/



The year 2005 has been a good one for the U.S.dollar. The greenback rallied sharplythroughout the year, shrugging off a three-year bear market. Many in the forex world

point to the steady rate increases by the Federal Reservethroughout 2005 as a key factor sending the dollar spiralinghigher, especially against the Euro.

With the U.S. fed funds rate at 4 percent after 12 consec-utive rate hikes by the Federal Open Market Committee(FOMC) since June 2004, the key question for forex traders

is how much higher can the funds rate go and what will itmean for the dollar?

The Fed steadily hiked rates throughout 2005 while mostother central banks were holding monetary policy steady.This increased the attractiveness of the U.S. currency toglobal investors, as interest-rate differentials shifted signifi-cantly in the dollars favor.

Looking around the globe

The European Central Bank (ECB) has held rates steady at 2

percent while Japan has had a zerointerest-rate policy since 2001. Forinvestors chasing yield, the shift to theU.S. dollar was a no-brainer andhelped propel the greenback to two-year highs. The Euro was around $1.16in mid-November (Figure 1). The dol-lar has also rallied to its highest levelin 27 months vs. the yen, around118.91 (Figure 2).

Some analysts are predicting thehike-fueled dollar rally may be near-

ing its end, however.We are in the later innings of thetightening cycle, compared to theEuropeans and the Japanese, says JimGlassman, senior economist at J.P.Morgan Chase.

Many economists agree the Feds cur-rent tightening cycle may come to anend early in 2006. Most market watchersbelieve the Fed will kick up the fundsrate by another 25 basis points at each ofthe next two meetings on Dec. 13 andJan. 31. That would leave the rate at 4.50

GLOBAL MARKETS

Increasing interest rates in the U.S. have helped the dollar strengthen vs. the

Euro to levels not seen since early 2004.

FIGURE 1 EURO/U.S. DOLLAR

Source: eSignal

The end ofthe U.S. rate-hike cycle?

The U.S. Feds streak of interest-rate hikes has been a boon for the U.S. dollar. However, analysts

think the tightening period is about to come to an end. Does that mean trouble for the buck?

BY CURRENCY TRADERSTAFF


11/43CURRENCY TRADER December 2005 11

percent. From there, however, many speculate the Feds tight-ening cycle may be over.

A wildcard will be incoming Fed Chairman Ben

Bernanke, who is expected to take office in early February.Paul Kasriel, director of economic research at NorthernTrust Company, calls the new chairman a complicatingfactor in forecasting the funds-rate outlook.

There is some feeling that he might have to push thingsa little higher to earn the respect of the markets, Kasrielsays. He notes the markets have currently priced in short-term rates to about 4.75 percent.

Regardless, most analysts expect theFed to stop hiking by the spring of2006 when rates are between 4.5 or 5percent.

Factors to consider

Ethan Harris, chief U.S. economist atLehman Brothers, pointed to threeconditions that must occur for the Fedto halt its current tightening cycle.First, Harris says signs financial condi-tions are tightening must emerge. Hespecifically points to the housing mar-ket.

By spring it should be clear thehousing boom has ended, he says.

Second, Harris says the Fed mustbelieve the economy is slowing downa bit. Looking ahead, economists doexpect a moderate slowing. WhileHarris forecasted a gross domesticproduct (GDP) figure of 3.5 percent forthe first quarter of 2006, he expectsgrowth to slow to around 2.5 percentfor the remaining three quarters ofnext year.

Northern Trusts Kasriel also expects a modest slowdownin the U.S. economy next year. Kasriel forecasts a 3-percent

GDP measure for the fourth quarter of 2006 vs. 3.3 percentfor the same period in 2005.Finally, Harris says, the Fed must believe inflation is

under control in order to halt the recent series of rate hikes.Recent verbiage from the FOMC hasnt hinted an end to

rate hikes is imminent. But economists will be watching forchanges in the wording of the FOMC minutes and monitor-ing growth and inflation reports closely in the weeks andmonths ahead.

Inverted yield curve?

Another factor that may slow down the Fed is the shape ofthe U.S. Treasury yield curve. With short-term rates press-

ing closer to 10-year T-note rates (especially if more ratehikes occur), this could be additional impetus to slow downthe Fed.

The Fed is disinclined to invert the yield curve at thisjuncture, Glassman says. If you go back over the past 50

to 100 years, central banks dont push short-term ratesabove long-term rates unless there is a clear and presentinflation danger.

The inflation data

Most economists agree the spike in energy prices is themain culprit behind the recent surge in headline inflationdata in the U.S. The Consumer Price Index (CPI) hit a 14-year high at 4.7 percent in September. However, the corerate (which excludes food and energy) for the month post-ed a more moderate reading of 1.9 percent.

Almost nothing outside of energy looks that threaten-ing, notes Lehmans Harris.

What economists and the Fed will be watching for in thecoming months, however, are signs that higher energy costs

continued on p. 12

TABLE 1 2006 FOMC MEETINGS

Differing policies on interest rates between Japan and the U.S. have led to two-

year highs for the dollar vs. the yen.

FIGURE 2 U.S. DOLLAR/JAPANESE YEN

Source: eSignal

March 28

May 10

June 28-29

Aug. 8

Sept. 20

Oct. 24

Dec. 12



are being passed along as price increases in other areas

of the economy.Consumers have already seen some relief on the ener-

gy front as of mid-November, as both gasoline and nat-ural gas prices had retreated off their September andOctober highs (Figure 3), which could bode well forinflation numbers into the New Year.

Energy prices are unlikely to spike a lot higher,Kasriel says. Youll see inflation moderate going for-ward.

What could the end of rate hikes mean

for the dollar?

At this time last year, many forex analysts and traderswere fixated on the U.S. twin deficits (domestic and for-eign) and how they would pressure the greenback in2005. However, forex traders quickly shifted their focusto the more bullish Fed story earlier this year.

Market watchers voice concern that an end to Fed ratehikes in the U.S. could weigh on the overall dollar out-look into 2006.

While the Fed is nearing the end of its tighteningcycle, there could be other central banks that are goingto enter tightening cycles, Kasriel says.

That could spell a narrowing of the positive interest rate

differentials that have recently been in the dollars favor.Kasriel believes the ECB, the Bank of Japan, and pos-

sibly even the Bank of England could potentially tight-en rates in 2006.

The dollar might have some rate competition fromabroad, he says. I think the dollar will be weaker nextyear.

Lehmans Harris agrees. Into the first quarter, Harrissees potential for the dollar to remain strong untilinvestors see the Fed moving to the sidelines, he says.Sentiment around the dollar should shift and the mar-ket should resume its longer-term decline.

Harris and Kasriel both think the 2005 rally in the dol-lar is a shorter-term correction in the overriding longer-term bearish trend. Harris sees potential for a 10-percentdrop in 2006.

Bearish fundamentals

Several economists warned that forex market focus couldshift back to the bearish fundamental and structural situa-tion seen in the U.S., which could weigh on the dollar.

It is important for investors not to get too swayed byshort-term trends in the currency markets, Harris says.There still is a fundamental imbalance in global economicaffairs.

He points to the current account deficit, which was likelyto hit $700 or $800 billion on a yearly basis in 2006.

Investors will start to question the huge borrowingrequirements the U.S. has, Harris says. He calls this achronic risk to the currency.

Kasriel agrees that forex traders could shift their focusback to this larger issue in 2006.

Global investors are going to start to wonder just howthe U.S. intends to pay interest and dividends on all thiscapital it is importing, he says.

GLOBAL MARKETScontinued

Both unleaded gasoline and natural gas futures have dropped

significantly since their recent spike highs.

FIGURE 3 ENERGY RELIEF

Source: eSignal


13/43

A fter months of hawkish talk,European Central Bank (ECB)President Jean-Claude Trichet letthe cat out of the bag on Nov. 18.

After two and a half years of maintaininghistorically and exceptionally low interestrates...the governing council is ready to make adecision, Trichet said at a Frankfurt Europeanbanking conference on Nov. 18.

The market and most currency analysts inter-preted this as a clear sign an initial hike willoccur at the Dec. 1 policy meeting, with addi-tional rate hikes following in 2006.

With higher energy prices pushing headlineinflation to uncomfortable levels for the infla-tion-conscious ECB, officials have been warningfor months that a rate hike may be in the cards.But ahead of the unexpected Nov. 18 commentsby Trichet, most analysts had expected the ECBto wait until early 2006 to make their first poli-cy move. The ECB has kept its key refinancing

policy rate unchanged at 2 percent since June2003.

The comments were a surprise they came out of theblue, says Jamie Coleman, managing director at ThomsonFinancial IFR. While these comments practically cement a.25 basis point rate hike at the early December meeting, hesays, the question for currency traders is how much moretightening can be expected and can it reverse the recentweakness seen in the Euro/U.S. dollar (Figure 1)?

Pulled In Two Directions

The ECB is in a difficult position as it has a mandate for pricestability, yet growth numbers emerging from the Eurozoneremain extremely lackluster and sluggish. Eurozone head-line inflation has been steadily above the 2-percent target 2.5 percent in October and 2.6 percent in September.

Eurozone Finance Ministers have been speaking publiclyagainst the need for a rate hike by the ECB because they feelit would not help the slow-growth scenario that continues

to unfold there. As of mid-November,the European Commission was fore-

casting gross domestic product (GDP)growth of 1.3 percent for 2005.The Eurozone is slowly recover-

ing from pretty poor performance inthe first half of the year, saidCharmaine Buskas, an economist atEconomy.com, ahead of TrichetsNov. 18 comments. This is a conun-drum for the ECB. Do they act to pro-tect their price stability to keep it inline with their mandate or do theystand aside and allow growth to

CURRENCY TRADER December 2005 13

continued on p. 14

ECB lets rate cat out of the bag


The dollar sagged vs. the Euro in 2005, but rate hikes by the ECB

might favor the Euro.

FIGURE 1 EURO/U.S.DOLLAR, WEEKLY

Source: TradeStation

EURO / DOLLAR RATE AT A GLANCE

Average daily range (past 40 days) 0.0112

Average weekly range (past 26 weeks) 0.0241

52-week high/low 1.3666 / 1.1638

EUR U.S.

Prevailing interest rates (%) 2.25 4.0

Next central bank meetings Dec. 1, 2005 Jan. 12, 2006

GDP Q3 2005* Q2 2005 Q1 2005

EUR U.S. EUR U.S. EUR U.S.

1.6 4.3 1.1 3.3 1.3 3.8

All data as of Dec. 1 *Estimates

Will the ECBs new stance on interest rates shift the Euro-dollar dynamic?



unfold organically?Trichet appeared to be keenly aware of the

political pressures from Eurozone FinanceMinisters. Trichet noted the ECB would main-

tain moderation and accommodation and thepolicy would remain accommodative.

This is the worst piece of central banking Iveever seen, says Thomsons Coleman. He sayswe are going to hike, but not by much. To down-play the impact of hikes before they even starthiking takes away some of their credibility.

Looking ahead at the Euro

David Powell, currency analyst at Ideaglobal,says the market is pricing in a 40-percentchance of a 2.75-percent rate by March. The

ECB is set to meet next on Jan. 12.But, given the overall sluggish growth fore-

casts for the Eurozone into 2006 and the still-negative interest-rate differential vs. the U.S.,analysts are not turning wildly bullish on the European cur-rency.

In fact, some still see room for additional downside in theEuro in the weeks ahead, especially given the ECBs mixedmessage that any future tightening could be moderate.

Key levels

Thomsons Coleman points to a key resistance area at $1.1865

in the Euro/U.S. dollar (EUR/USD) rate. As long as thatresistance ceiling remains in place, he expects additionaldownside pressure on the Euro in the days and weeks ahead.

On the downside, he highlights $1.1590 as potential sup-port. That level represents a roughly 38.2-percent retrace-ment of the lifetime range of the Euro from .8230-$1.3665, hesays (Figure 2). Declines under $1.1590 would open the

door to the $1.1450 region.

Turning point

Into 2006, while the U.S. Fed is expectedto ratchet up the Fed funds rate a fewmore times, most analysts acknowledgethe U.S. tightening cycle is nearing anend. The persistent and consistent ratehikes in the U.S. have been a main factorsupporting the U.S. dollar, especially vs.the Euro, throughout 2005.

Once it becomes clear the Fed isdone with its tightening cycle, analysts

say the opportunity may exist for aturning point in market sentiment andmarket focus. In fact, forex players may become more focused on structuralproblems within the U.S., including thegiant current account deficit, whichcould draw money flows away fromthe greenback.

That in turn, could open the door forEuro strength, some analysts say.Ideaglobals Powell sees potential forthe Euro to return to the $1.2200 zoneby the end of first half 2006.

GLOBAL MARKETScontinued

On the daily time frame, EUR/USD appeared to be holding its breath in

mid-November to late November.

FIGURE 2 EURO/U.S.DOLLAR, DAILY


HIT YOUR MARK!Advertise in

Active Traderand Currency TraderMagazines

Contact Bob DormanAd sales East Coast

and Midwest

[email protected]

(312) 775-5421

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and Southwest

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(626) 497-9195

Mark SegerAccount Executive

[email protected]

(312) 377-9435
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15/43

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T

he last time we looked at the dollar-yen (USD/JPY) rate in Spot Check inthe April 2005 issue, the currency pair

had (at the end of March) just complet-ed a three-month bounce off a major support leveland was trading around 107.13. The price-patternanalysis at the time indicated more upside move-ment was likely, and in conclusion we noted, If alonger-term trend materializes, its viability willdepend on the larger factors that impact the dol-lar[.]

A longer-term trend did, in fact, materialize, tak-ing the dollar-yen another 10 percent higher by lateNovember (Figure 1). After a late-July to early-September pause that brought the pair back down

to 108.76, the market took off on a virtually unbro-ken uptrend that reached 119.92 on Nov. 28 a10.67 percent jump and the dollar-yens highestlevel in more than two years (Figure 2).

We conducted a study to see what has happenedother times when the dollar-yen has gained 10 per-cent or more, low to high, over a three-month peri-od. There have been 23 such moves, but as is oftenthe case with this type of measurement, many ofthese moves were part of larger moves that is athree-month 10-percent gain was followed byanother up month that completed a second (over-

lapping) 10-percent three-month gain, etc.These 23 moves comprised 13 distinct marketruns, of which seven lasted only three months (i.e.,a single, three-month 10-percent rally followed bya decline of at least one month), four that lastedfour months, one that lasted five months and one(ending in August 1998) that lasted eight months.The most recent 10-percent, three-month rally coin-cided with the spike high in May 2004 (Figure 1).

Table 1 shows the month-to-month closingchanges, as well as the largest up moves and downmoves, for the first six months after three-month,10-percent rallies. With the exception of month 2,

SPOT CHECK

Dollar-yen


The dollar-yen rate has rallied nicely since bouncing off its 1999

low in late 2004 and early 2005. One the verge of topping 120,

the market's next obvious highs are above 135 and 145.


FIGURE 1 ON THE RUN

After pulling back in July and August, the dollar-yen gained 10percent in a furious September-November rally.


FIGURE 2 FALL RALLY

Rallies like the one the yen has enjoyed

recently have, in the past, shown

the potential for significant follow-through.

However, the numbers also suggestthe possibility for at least a correction

on the not-too-distant horizon.



the market closed progressively lowereach month and the largest downmoves were generally bigger than thelargest up moves.

Figure 3 compares the post-patternclose-to-close moves for months 1-6 to

the average (benchmark) close-to-closeprice moves for each interval that is,the average of all the one-month close-to-close moves over the analysis peri-od, the average of all the two-monthclose-to-close moves, and so on. Thisprovides an indication of how the priceaction after the pattern compares to thetypical, or random, price action overthe same period.

The price action in the first threemonths was even as bearish as the typ-

ical benchmark price movement, butafter month 4 the post-pattern moveswere almost always significantly larger(to the downside) than the benchmarkprice movement.

It is always difficult when analyzingmonthly data to get a useful number of pattern samples, aproblem that in this case was exacerbated by the overlapbetween many of the three-month, 10-percent rallies. Theimplications of the statistics must be judged accordingly.

With the market on the doorstep of the 120.00 roundnumber and the possibility of the U.S. rate-hike cycle com-ing to an end early next year, dollar-yen traders have plen-ty of food for thought.

After three-month, 10-percent rallies, the dollar-yens largest average down

moves have been bigger than the currency pair's typical (benchmark) pricemoves over the past 20 years. The difference is most notable in months 6 to 9.

FIGURE 3 POST-RALLY TENDENCIES

There have been 23 months since 1985 that have capped three-month, 10-percent rallies in the dollar-yen. Month 2 doesn'tfit the overall pattern, but there's an indication of weakness in the subsequent months.

TABLE 1 THREE-MONTH, 10-PERCENT RALLIES

Month 1 LUM LDM Month 2 LUM LDM Month 3 LUM LDM

Avg. -0.9065 2.8439 -3.8217 -0.5478 4.3235 -5.6952 -2.2343 4.7809 -7.5352

Med. -0.5400 2.2000 -3.1000 1.0200 3.0300 -5.0700 -0.2900 4.7500 -6.1800

Max. 6.5400 7.9800 0 9.6000 13.9700 0 11.9900 13.9700 0

Min. -8.1500 0 -9.5700 -22.9300 0 -25.1700 -29.0100 0 -31.2500

Std. 4.1331 2.4948 3.0438 6.8564 3.6958 5.8121 8.7620 3.7073 7.4474

%>0 43.48% 60.87% 43.48%

Month 4 LUM LDM Month 5 LUM LDM Month 6 LUM LDM

Avg. -5.0970 5.1313 -9.3787 -7.1078 5.5930 -12.0374 -8.2635 5.6530 -14.5865

Med. -3.0400 4.7500 -7.8500 -3.9500 4.7500 -8.1100 -6.8100 4.7500 -10.4300

Max. 11.8700 14.8400 0 11.3300 19.8500 0 17.8700 19.8500 0

Min. -25.7200 0 -31.2500 -31.8000 0 -32.2400 -28.9000 0 -36.5800

Std. 10.0746 4.1045 8.5180 12.3708 4.9927 10.2415 12.8916 4.9939 11.2398

%>0 30.43% 30.43% 26.09%

Legend:

LUM (largest up move): biggest up move from the closing price of the pattern to the highest high at each interval.

LDM (largest down move): biggest down move from the closing price of the pattern to the low at each interval.

Std: Standard deviation.

%>0: Percentage of patterns that closed higher than the closing price of the pattern at this interval.



No global exchange-rate system lasts forever.Whether a pure gold standard, a single-cur-rency dominated standard such as thatenjoyed by the British pound during the

19th century and the U.S. dollar during the Bretton Woodssystem of fixed exchange rates after World War II, everysystem ultimately falls under the weight of its internalstresses and rigidities. A set of events eventually comesalong that causes the system to collapse.

This was true for the Bretton Woods system, the dollar-gold system created in 1944 which lasted until the early 70s,and is going on right now with the current system of float-ing exchange rates. Future economic historians are likely to

regard the past 30 years as a well-intentioned but ultimate-ly failed experiment. The abandonment of this regime willhave significant implications for global yield curves, long-term interest rate levels, and returns on assets.

Central banks are seldom ahead of the curve; they reactto events. Their behavior and that of associated govern-ments during the transition from the Bretton Woods regime is instructive in this regard. It will help guide us into theemerging world of two major currencies the dollar andthe Euro. We will also see why the New York Board of Trade(NYBOT) dollar index (DXY) is and will remain the bestinstrument for tracking and managing the U.S. dollarscourse in the years ahead.

ADVANCED CONCEPTS

The dollar index

and firm exchange ratesThe vast majority of currency traders are familiar only with the current floating-rate system.

But are we about to enter a new firm exchange rate era dominated by the dollar and Euro?

BY HOWARD SIMONS



The collapse of Bretton Woods

In the Bretton Woods system, gold was fixed at $35 per

ounce and other currencies were valued at fixed rates rela-tive to the dollar. By the late 60s, the persistent U.S. currentaccount deficit threatened the U.S. with an outflow of goldand the world with a loss of liquidity in its only reserve cur-rency. As a result, in 1969 the International Monetary Fund(IMF) was authorized bymember countries to createSpecial Drawing Rights(SDRs), dubbed paper gold,to augment internationalreserves. The SDRs constitut-ed a kind of artificial reserve

currency used internally bythe IMF and were valuedaccording to a basket of inter-national currencies.

No one could be certain ofSDRs impact. At the time, theonly historic parallels of sud-den reserve infusions camewith the discoveries of golddeposits in places such asCalifornia, Alaska, SouthAfrica, and Australia during

the gold-standard era, or tothe seizure of gold duringcolonial conquests, such asthe Spanish takeover ofMexico. Each of theseepisodes led to outbursts ofinflation.

As it turned out, central banks could not handle thenew reserve tool and they let the worlds reserves explodeout of control (Figure 1). By August 1971, reserves notincluding gold were increasing at a 70 percent year-over-

year clip the very definition of a bubble. Reserves of cur-rencies plus gold, a less telling measure as the IMF still val-ues its gold reserves at $35 per ounce (a tactic appropriatefor working inventory in a last-in/first-out accounting envi-ronment but puzzling in this context), grew more than 35percent. The decade following this burst of reserves wasunarguably one of inflation and high interest rates.

The 70s New World Order

The premise behind allowing currencies to float was that itwould lead to self-correcting trade balances. In a fixed-rateregime such as Bretton Woods, countries in a deficit posi-tion (such as the U.S. in the late 60s) see an outflow of gold

and foreign exchange reserves. These outflows lead to areduced capacity to consume, which is detrimental both tothe deficit country and to all those exporting to it. In fact,

the IMF was created in the Bretton Woods agreement toaddress the inevitable balance of payments crises associ-ated with growing economies importing too much.

Theoretically, floating exchange rates would address pay-ment imbalances by depreciating deficit countries curren-cies on the global market, thus reducing their purchasingpower. If, for example, the U.S. ran a trade deficit, it wouldbe pumping out additional dollars to exporters. Each newdollar on the world market would have a smaller claim onexporters resources and reduce the U.S.s ability to importmore. Also, U.S. exports would become cheaper on globalmarkets and expand American exports.

continued on p. 20

The implementation of SDRs helped push the worlds reserves out of control. By August1971, reserves ex-gold were increasing at a 70-percent annual pace.

FIGURE 1 CENTRAL BANKS BEHAVING BADLY

Source: International Monetary Fund

The notion that governments would

allow currencies to float freely was

politically nave in the extreme.



The end result of a weaker currency was supposed to bea move away from a deficit condition. The opposite wassupposed to occur with a stronger currency.

In practice, nothing of the sort happened. First, the notionthat governments would allow currencies to float freely waspolitically nave in the extreme. The U.S. engaged in poli-cies designed to drive the dollar lower between 1985 and1988 and again from 2002 to 2005. Other countries, particu-larly the mercantilist exporters of East Asia such as Japan,Taiwan, Korea, and China, have done much the same.

Second, many goods in international trade, includingcrude oil and industrial metals, are priced in U.S. dollarsby all parties. These goods have exhibited little currencysensitivity over time. Third, other international tradegoods, such as high-technology gear, military equipment,and food tend to be fairly price-inelastic.

Floating exchange rates were ineffective at adjustingtrade imbalances because actual physical trade was nolonger necessary for currency trading to occur. Prior to theearly 70s, currency trading was a facilitation business con-ducted by banks to clear bills of lading, or shippingreceipts, bankers acceptances, letters of credit and otherpayment mechanisms for international trade. Once cur-rencies began to float, traders discovered quickly theywere simply an interest-rate arbitrage between two coun-tries. The principal trade covered-interest arbitrage

involves the following steps, using the Canadian dollar(CAD) as an example against the U.S. dollar (USD):

Borrow USDSell USD and buy CAD at prevailing spot rateLend CADUnwind the trade in the forward market

As long as the interest-rate differentials between the

USD and the CAD permit, a trader can execute the tradeprofitably until either U.S. rates rise, Canadian rates fall, orthe spot rate for selling the USD and buying the CAD falls.This trade involves three unknown variables the two

interest rates and the spot exchange rate but has only oneequation and therefore lacks a single and exact solution.Because interest rates in both countries swing around forreasons totally unrelated to trade balances, the exchangerate can reach any level, irrespective of trade, as long as theinterest-rate differentials make the trade profitable. It is nowonder why each of the worlds major currencies haveendured at least one episode of violent movement over thepast three decades.

ADVANCED CONCEPTS continued

The weights of the Fed's trade-weighted dollar index changeannually, while the DXY has had a stable weighting scheme

since 1973 (the only change being the combination of the

various components of the Euro into a single weight).

FIGURE 2 TRADE WEIGHTS

Source: Federal Reserve and NYBOT

In the floating-rate system, the result

of a weaker currency was supposed

to be a move away from a deficit

condition, while the opposite was

supposed to occur with a stronger

currency. In practice, nothing of the

sort happened.



The dollar and trade

Lets take a look at two dollarindices: the Federal Reservestrade-weighted dollar indexand the DXY. The weights ofthe Fed dollar index change

annually after the end of theyear, which makes it uselessas a trading instrument. TheDXY has remained at a stableweighting scheme since 1973;the only change has been theaggregation of the variousconstituents of the Euro into asingle weight. The currentweights of both indices areshown in Figure 2.

A long-term monthly com-

parison of these two indicesreveals a surprisingly closecorrelation (95.267 percent)since January 1973 (Figure 3).The DXY rose faster than theFed index during the two bullish trends for the dollar,1981-1985 and 1995-2002; thisreflects the impact of tradersselling the more liquid European currencies to buy the dol-lar. Given the impossibility of using the Fed index as a trad-ing vehicle and the close relationship between a dynamic

and a static index, we can feel quite confident the DXY isrepresentative of the dollar.

Now with this picture of the dollars history in mind, letssee whether the floating dollar had a material effect on theimport and export weights of the Federal Reserve dollarindex. Figure 4shows the major development on the import

side has been the capture of Japanese market share byMexico and China. Has this occurred because of the appre-ciation of the Japanese yen (JPY) over this period, or has itresulted from a combination of Japans increasingly highexport prices, U.S. import barriers in industries such asautos, and a shift by Japanese firms from exporting to pro-

ducing goods in the U.S.? Given the stability of theEurozones weight, we have to suspect factors other thanexchange rates are operating.

Has Mexico increased its importance in the U.S. importmix by virtue of a near-continuous decline in the peso(MXN), or by virtue of its NAFTA status and its emergenceas a major petroleum exporter? Both the U.S. and Mexicangovernments have striven to put industrial production onthe Mexican side of the border in maquiladora plants for reasons as diverse as immigration policies and environ-mental regulations.

The emergence of China in the U.S. import mix hardlycan be ascribed to its exchange rate. With only one minormove in the exchange rate between the yuan (CNY) and theUSD since 1994, and a burgeoning export industry, many in

the U.S. have contended the CNY is undervalued. Perhaps,but with Chinese labor costs a fraction of those in the U.S.and with virtually non-existent health, safety, and environ-mental costs in Chinese industry, it would be a stretch to saythere is any exchange rate that would bring Chinese costs toU.S. levels.

The role of Mexico, China, Japan, and Canada in anemerging USD bloc is part of the central thesis here thatthese countries and several others will maintain a quasi-fixed or firm exchange rate to the USD. Others, such asthe UK, Switzerland, and the Nordic countries will form afirm relationship to the EUR.

continued on p. 22

The Fed's dollar index and the DXY have had a surprisingly close correlation (95.267

percent) since January 1973. The DXY rose faster than the Fed index during the two

bullish trends for the dollar, 1981-1985 and 1995-2002 a result of traders selling themore-liquid European currencies to buy the dollar.

FIGURE 3 THIRTY YEARS OF A FLOATING DOLLAR

Source: Federal Reserve and NYBOT

One of the best ways to keep

long-term interest rates low without

igniting inflation is to keep currencyvolatility low. This means moving

toward firm exchange rates.



The changes in export weights have not been as dramat-ic as those for imports. The weight for Mexico has increaseddespite the long-term strengthening of the USD against theMXN, and the weight for Japan has increased despite thelong-term weakening of the USD against the JPY. Both shiftsare the opposite of what floating exchange-rate advocatestold us to expect three decades ago.

Inflation, monetary policy,

and currency management

If the world is to move into a dollar-Euro, two-currency bloc,one of the subtle but very real benefits will be a lower spread between long-term and short-term interest rates. This

derives from Fishers Law, which states nomi-nal interest rates (i.e., not adjusted for inflation)are real interest rates plus the expected rate ofinflation. Yale economist Irving Fisher wrote inthe 20s and 30s periods during whichexchange rates were fixed that he did not

have to account for the effects of currencyvolatility. Nowadays, we have to take volatilityinto account.

Fishers Law has profound implications forcurrency traders. Lets stipulate that for anymaturity worldwide there can be only one realinterest rate; if this were not the case, traderscould profit by borrowing in the lower real-rate currency and lend in the higher real-ratecurrency until the two became equal.Therefore the difference in nominal interestrates at any maturity between two currencies

has to be the difference between the twoexpected rates of inflation.

Expected inflation is mostly, but not exclu-sively, a monetary phenomenon. If centralbanks lose control over the money supply, asthey most certainly did in the early 70s, infla-tion will rise as more money chases goods andservices. A country whose money supply isgrowing more rapidly than output will see itsexpected inflation rise and by extension willsee its currency deteriorate on world markets,all else held equal.

Figure 5 shows the long-term relationshipbetween the money supply and GDP growthin the U.S. Periods in which money supplygrowth greatly exceeded GDP growth, such asthe early 70s and the 2002-2003 period, corre-spond to periods of dollar weakness.

Inflation and the yield curve

The spread between long-term and short-terminterest rates or liquidity premium needs tocompensate investors for the obvious risks oflending money over a long period of time.

Lets use the spread between the 10-year T-note and the 90-day LIBOR as a proxy for the liquidity pre-mium. How well has it matched inflationary expectations,as measured by the spread between 10-year T-notes and 10-year inflation-protected Treasuries (TIPS)?

The history since the January 1997 advent of TIPS showsthe relationship between expected inflation and the liquidi-ty premium to be far looser than we might have imagined(Figure 6). For example, the explosive steepening of the yieldcurve in 2001-2003 corresponded to a period of meanderinginflationary expectations and a stable dollar. Once it becameapparent in April 2004 the Federal Reserve would have toreverse its ultra-low interest-rate policy, the liquidity premi-


The major development on the import side (top) has been the capture

of Japanese market share by Mexico and China. The changes in

export weights (bottom) have not been as dramatic. The weight forMexico has increased despite the long-term strengthening of the USD

against the MXN, and the weight for Japan has increased despite the

long-term weakening of the USD against the JPY both shifts being

contrary to what the floating exchange-rate system was intended toaccomplish.

FIGURE 4 IMPORT/EXPORT WEIGHTS

Source: Federal Reserve



um narrowed precipitous-ly, but inflationary expec-tations did not fall apace.

One explanation forthese periods of diver-gence is relative economic

growth at the time. In-flationary expectations in2001-2002 fell partly be-cause of slack capacity.They failed to decline in2004-2005 in large part because this very sameglobal slack capacity beganto be absorbed by the breakneck economicgrowth of China and India.

Currency volatilityDeclining currency vola-tility helps explain the flatliquidity premium ob-served in 2004-2005. Justas all investors need to becompensated for higherexpected inflation, foreigninvestors in U.S. securitiesneed to be compensatedfor the currency risk theyare assuming. The greater

the volatility of the dollar,the greater the probabilityit will decline over the lifeof the bond and the morecompensation will berequired.

Japan has acted in therole of investor of last resortin the U.S. securities marketby virtue of its massive andperennial trade surpluswith the U.S. as well as its

willingness to sell yen and buy dollars to prevent theyen from strengtheningagainst other currencies inthe dollar bloc, includingChina, South Korea, andTaiwan. While these mas-sive purchases have beengiven credit for keepingU.S. long rates lower andthe dollar firmer than theywould have been other-

continued on p. 24

Periods when money supply growth greatly exceeded GDP growth, (e.g., the early 70s and

2002-2003) correspond to periods of dollar weakness.

FIGURE 5 MONEY/SUPPLY ECONOMICS GROWTH RELATIONSHIP

Source: Bloomberg

Since the January 1997 advent of 10-year inflation-protected Treasuries (TIPS), therelationship between expected inflation and the liquidity premium has been far looser than

might be expected.

FIGURE 6 EXPECTED INFLATION ONLY PART OF THE PUZZLE

Source: Bloomberg



wise, we can see the trend of decliningU.S. long-term rates was in place wellbefore the Bank of Japan went on its buy-ing spree (Figure 7).

If the Bank of Japans manic purchas-es of U.S. Treasuries and other securi-

ties cannot account for the decline inthe liquidity premium, what can? Theanswer appears to be declining curren-cy volatility. If we map the liquiditypremium against the volatility of three-month non-deliverable forwards on theyen over this period, we see a conver-gent decline marred only by the dol-lars abrupt sell-off against the Euro inthe fourth quarter of 2004 (Figure 8).

The message is clear and has beenreceived by the central banks: One of the

best ways to keep long-term interestrates low without igniting inflation is tokeep currency volatility low. This meansmoving toward firm exchange rates.

The two blocs

If the world is in fact moving towardtwo currency blocs, weshould see a pattern of cor-relations moving toward1.00 or -1.00 against theDXY over time. This does,

in fact, appear to be occur-ring (Figure 9). If we take aset of currencies in theemerging U.S. dollar bloc,such as the Japanese yen,Canadian dollar, Mexicanpeso, Taiwan dollar (TWD),and Korean won (KRW),we see some rather decisivemovements toward corre-lations of -1.00 in the yearssince the Euro was intro-

duced. Only the MXN hasdiverged from this trend in2005; the Mexican economyhas had problems handlingthe surge of capital fromhigher oil prices.

The picture of an emerg-ing currency bloc is evenmore compelling for theEuro. Given the Euros sig-nificant 57.6-percent weightin the DXY, we shouldexpect it to be strongly neg-


Declining currency volatility explains the decline in the liquidity premium. Mapping the

liquidity premium vs. yen volatility shows a convergent decline interrupted only by the dollar's

abrupt sell-off against the Euro in the Q4 2004.

FIGURE 8 DECLINING CURRENCY VOLATILITY

Source: Bloomberg

While Japan's willingness to sell yen and buy dollars to prevent the yen from

strengthening against other currencies has been credited with keeping U.S.long-term interest rates lower and the dollar firmer than they would have been

otherwise, the trend of declining U.S. long-term rates was in place well before

the Bank of Japan implemented this policy.

FIGURE 7 U.S. SECURITIES PURCHASED BY JAPAN AND 10-YEAR YIELDS

Source: U.S. Treasury and Bloomberg



atively correlated against the DXY overthe rolling 90-day windows, and it doesnot disappoint in this regard (Figure10). It diverged significantly only in themonths leading up to the introductionof cash Euros, a period in which a num-

ber of European citizens were thoughtto be selling their legacy cash (lira,French francs, deutschemarks, etc.) fordollars to avoid taxes on these holdings.

The more interesting aspect of Figure10 is the steady convergence of theBritish pound (GBP) and the Swedishkrona (SEK) to the Euro. These coun-tries have rejected all entreaties to jointhe common currency, but their dailymovements against the DXY suggestthey are nonetheless caught in the

Euros gravitational field. Restated, theBritish have a Euro proxy without aseat on the European Central Bank.

All things must pass

One of the lessons of the floatingexchange regime was that constantcurrency volatility raised the cost ofdoing business internationally.Hedging is expensive when done cor-rectly and is even more expensivewhen done incorrectly. Worse, the

chief selling point for floatingexchange rates self-correcting tradebalances never came to pass.

The world has been taking largesteps to move away from free-floatingcurrencies. The Euro is nothing morethan a repudiation of the constant cur-rency volatility of the 80s and early 90s.Japan has moved to peg the yen to thedollar and in doing so has succeeded inkeeping U.S. capital rates low eventhough the Federal Reserve has raised

short-term interest rates. These are eco-nomic benefits of the first order.The result has been a world looking

ever more like the DXY: The dollar plusthe CAD and JPY on one side, and theEuro and its proxies on the other. Thissuggests the single trading instrument ofthe DXY will grow to be the most usefulsingle measure of the currency exchangevolatility between the dollar and Euro inour new firm exchange-rate world.

For information on the author see p. 6.

In the years since the Euro was introduced, there has been movement toward

correlations of -1.00 in DXY component currencies such as the Japanese yen,

Canadian dollar, Taiwan dollar (TWD) and Korean won (KRW). Only the MXN

has diverged from this trend in 2005.

FIGURE 9 90-DAY ROLLING CORRELATION AGAINST DOLLAR INDEX

Source: Bloomberg

The notion of an emerging currency bloc is even more compelling for the Euro.The steady convergence of the British pound (GBP) and the Swedish krona

(SEK) to the Euro despite their countries having rejected all entreaties to jointhe common currency suggest they are nonetheless caught in the Euro's

gravitational field.

FIGURE 10 90-DAY ROLLING CORRELATION AGAINST DOLLAR INDEX

Source: Bloomberg



Clarkson Jones is president of Charlotte, N.C.- based Monarch Capital Management, aforex money-management firm that tradesroughly $5 million in assets.

After gaining nearly 8 percent in both September andOctober, Jones FX Multi-Strategy trading program was up38.52 percent in 2005 (Table 1). So far, the year has been a

nice rebound from a 13.69-percent loss in 2004 (his largest

drawdown has been -21.86 percent), which was his firstdown year since launching his program in Nov. 2001. Jonesprogram posted annual returns of 78.23 percent and 164.15percent in 2002 and 2003, respectively, and his funds totalreturn since its inception in Nov. 2001 is 633.43 percent (a

compound annual return of 64.56 percent).Before trading full time, Jones, who turns 40 this month,

was a civil engineer and owner of a company (from January1991 to January 2002) that sold construction-related prod-ucts and services. He first entered the markets in 1994, trad-ing stocks and some treasuries. He then branched into com-modity futures, which he found somewhat challenging.However, his research in this area led directly to his discov-ery that currencies leant themselves [more readily] to mymethods maybe because they are so liquid, he says.Other markets became less appealing once I discoveredcurrencies.

Jones is relatively tight-lipped about many of thespecifics of his trading approach, but he has a diversifiedtrading methodology that blends multiple trading systemstriggered by both trend and countertrend signals on differ-ent time frames in five different currency pairs.

He stresses that he blends discretionary judgment withsystematic trade execution. Jones studied music as well asmathematics and physics in college, and he says theseseemingly disparate fields contribute to the way heapproaches the market.

I had two different majors engineering and fine arts,

he says. One is left brain and one is right brain. I think

CURRENCY TRADER INTERVIEW

CLARKSON JONES:Art, science, and forex




thats actually helped me to be more creative and a littlemore, I guess, artistic with my approach to the market.

I studied music and learned about pattern recognitionwhen learning how to read music, he continues. I alsostudied physics and mathematics and excelled in thoseareas it came very naturally to me and I became a civilengineer. I started my own company and made quite a bitmoney and started investing it for myself. I learned how totrade, and basically have evolved to where I am today.

CT: Can you talk a little more about the connection you see

between music and trading?CJ: Music is full of symmetry, art is full of symmetry,nature is full of symmetry. Reading the natural world isreally what pattern recognition is all about. I studied jazz I majored in the trumpet and had been learning improv-isational playing since I was a kid. Wed play and studychord structures that had resolutional feelings attached tothem as they climbed, climaxed, and descended. Marketpatterns are basically the same, but you need a method thatallows you to analyze them, manage the risk, and thenextract a profit from them.

I look for symmetry in several areas to determine the[musical] key, if you will, the market is currently playing.

Its like theres a current world view being established bythe patterns, and as a manager, I am taking opportunityflow from those patterns. Once I have the current marketkey, I apply the notes the trades and hopefully makesome music.

I have to be flexible in my approach because althoughpatterns repeat, the outcomes are random. Art is flexible,music is flexible, nature is flexible. Everything is moving,flowing, ebbing, and running, and I am following that flow.

CT: But you use a systematic approach to trade. How did

you develop that part of your trading?

CJ: Going through all thehard knocks it takes tobecome a trader, I started tolearn about the disciplineand psychology of trading,and I decided I wanted tolearn about system develop-ment.

I already had a prettyextensive computer back-ground and I started build-

ing systems for futures. I feltI needed cash data to designthe systems because therewere problems building sys-tems using futures data,where the data had to beseamed at the end of everymonth (to construct a continu-ous price series out of individ-ual contract months). Youcant build systems unlessyou have clean data. I dont

care whos generating thedata; if it has to be seamed ina specific fashion, that willlend itself to problems laterin system construction.

I was somewhat homegrown as far as doing this. Im surethere are people who know how to get around that [prob-lem], but I didnt, so I set futures aside for a while and start-ed doing a lot of research with cash markets.

I found the models I was developing really lent them-selves well to currencies, so I naturally gravitated towardthem because there was lots of liquidity and plenty of cash

data available. I started to do all my research in modelingcurrencies.

CT: Did the data situation push you toward forex, or were

there other things that attracted you to it?

CJ: The availability of the data, but also the liquidity. I want-ed to trade 24-hour markets because I thought it would giveme more opportunity for profit. I wanted something that hadsome sort of pattern-recognition feature, and the currenciesare so huge and the liquidity is so deep, it just seemed likethere was less interference with some of the patterns.

continued on p. 28

Through October, JonesFX Multi-Strategy pro-

gram had six profitable

months out of 10.Impressive back-to-back

gains in September and

October helped push thefunds year-to-date return

above 38 percent.

TABLE 1

MONARCH CAPITAL

MANAGEMENT 2005

MONTHLY RETURNS

Sources:Barclay Group and MonarchCapital Management

Month % Return

Jan. -5.65%

Feb. +7.06%

March -0.74%

April +5.98%

May -0.22%

June +4.36%

July +8.77%

Aug. -1.17%

Sept. +7.95%

Oct. + 7.88%

YTD 38.52%

I found out that using just one system

would work fine for a while, but

inevitably the market would fall out

of sync with that system.



CT: In terms of the hard knocks you took, what lessons did

you try to address in developing your systems?

CJ: I learned a lot about the psychological aspects of trad-

ing. Trying to trade from a discretionary base lends itself toa lot of emotional decision making. You can have a goodrun for a while, but eventually, if youre making decisionsfrom an emotional place, you can get yourself in trouble.

And I found that for me, day trading was not the way togo. Making decisions from a long-term perspective was

fine. I could be something of a long-term, macro trader using a buy-and-hold view.

Taking risk wasnt a problem I could always take risk,and effectively manage it. The problem was day trading

didnt fit me, so I started developing models that wouldhandle the execution for me. Creating ideas and puttingthem together in a mathematical algorithm that wouldexpress itself in the market was a fun challenge.

But I found out that using just one system would workfine for a while, but inevitably the market would fall out ofsync with that system. That was frustrating. On the onehand, discretionary trading was problematic emotionally.On the other hand, although I had learned that systematictrading was fine if you could construct it in a way thatalways fit the market, it didnt always fit the market.

I ended up falling right in the middle one approach

being left brain and one being right brain. I would have asystematic method that I could control [discreetly]. In otherwords, Id use the flexible left-brain energy to read the mar-

ket from a macroeconomic perspective and look at how asystem is performing, and I would use the systems in a veryrigid, mechanical way to execute the trades themselves.Thats what the FX multi-strategy has become a hybridstrategy that is fully systematic, with my discretion appliedover the systems.

CT: How, then, does discretion come into play?

CJ: I have six different programs that I run acrossfive different markets. I try to keep these enginesrunning so they fit the markets in the proper per-

spective, relative to the currencies Im trading.The systems running together create a portfoliomatrix with its own characteristics. I think this isthe neatest aspect of the program. Understandingthe individual pieces and the relationship to thewhole makes this method more of an art. Its like apainter who understands the relationships ofcolor, value, shape, and textures. Everythingcomes together to make a fine [piece of] art.

In one currency I might trade one strategy for aperiod of six weeks. On another currency I mighttrade another strategy for a period of three weeks.

As the market evolves and the liquidity shifts between currencies, Im able to detect change inthat liquidity flow, from my macro-fundamentalapproach to the market which is all behavioralfinance by the way, and one of the elements I use.

The other element is pattern recognition notnecessarily pattern recognition of the market itself,but pattern recognition of the systems Im trading.

In other words, how a system is trading with a particularmarket.

CT: Are you talking about managing a systems equity

curve, to a certain extent adjusting your trading depend-ing on whether a system is going through a relatively good

or bad phase?

CJ: Exactly. Basically Im looking at the equity curves,excursion analysis, and a couple of other things that areproprietary, but Im looking at the behavior of how the sys-tem is trading in a particular market to give me an indica-tion of whats next.

CT: So youre looking for signs that particular system may

be getting out of sync with a market?

CJ: Yes. And if you were just trading two markets you

CURRENCY TRADER INTERVIEW continued

Monarch Capital Managements performance is shown here (in

terms of an initial $1,000 investment) to the S&P 500 (blue line) and

the Barclay CTA Index (green line). The fund was launched in Nov.2001.

FIGURE 1 MONARCH CAPITAL VALUE ADDED

MANAGEMENT INDEX (VAMI) LINE

Source: The Barclay Group (www.barclaygrp.com)



might not have enough information to go on. Im tradingfive markets that are all interrelated.

CT: Which ones do you trade?

CJ: I trade the four major pairs and the Euro-yen. I basi-cally have five confirmations of how a system is perform-ing.

I have the systems trading live and trading a dummyin the background on all the markets to give me the indica-tions as to how to set the rotation [among the systems].

The systems themselves represent different ideas tradingon different time frames. Whats unique is how I mix thesystems in a portfolio context.

CT: Whats the range of holding periods?CJ: Im out the losers pretty quick usually in one day.Winners will last as long as a week sometimes. The averagetrade frequency is 2.8 days.

CT: How many trades will you have on at a given time?

CJ: Ill have five trades on all the time. I typically use four-to-one leverage five-to-one, max.

CT: Youre never out of the market?

CJ: Were always in, long or short, in all five pairs.

CT: What are your most important trading principles?CJ: Years ago I talked to a lot of professionals a lot offund managers. I wanted to see what they were doing,because at the time I didnt know if I was going to let themmanage my wealth or do it myself.

The story I got back then, and the one I got a couple ofyears ago, is that the most important thing is what you cansay you have right now in terms of profits. They look atconsistency and monthly profits. In other words, just stayprofitable every month. So for me, I would say thats become the most important thing, along with keepingdrawdowns manageable.

In June 2004 I de-leveraged the program by half to cut thedrawdowns to a manageable level. Thats the only majorchange Ive made. I look for consistent profits every monthbecause thats where I think investors are going to be. Theywant alpha, but they also want to know theyre not losingmoney. Since we retooled in June 2004 my biggest draw-down has been 5.75 percent.

CT: Do you ever use currency futures?

CJ: No. We look at some data in the futures, but we tradespot only. A lot of people have an issue about whether atrading program is better suited to futures and whether exe-

cution is better in futures. As an experienced trader, Ill sayfutures arent liquid enough in the Globex session, which iswhen we are trading, for what were doing. Futures used tobe much more tight than the spot market, but in the last fewyears the depth and tightness of the spot market has madeit much more competitive that I think the futures are lessattractive for what we do.

For other people it may be different. If they want to be inthe regulated exchanges for certain risk-related reasons,thats fine, but I think the spot market is far better for trading,and I think most banks and fund managers would agree.

CT: Do you think thats true for smaller traders, also?

CJ: On the retail level it may be a toss-up. When the

spreads get wide in the spot forex market, it might makesense for a small trader to use futures.

CT:As far as market characteristics go, do you think trad-

ing currencies is any different than trading anything else?

CJ: I think a tradable market is a tradable market, as longas its liquid. I think our strategy in a couple years mightlend itself to other markets. I dont know for sure, yet Illhave to see. I have my hands full right now trading curren-cies.

I might always be in currencies thats what I specializein. For now, I plan on remaining a specialist.

CT: If 2005 turns out to be a down year for currency man-

agers, it will be the first since 1994. Why do you think its

been so challenging?

CJ: I cant speak for other traders, but it appears that mostof the [currency managers] are trend followers. The curren-cies have had some good trends, but those trends haveoccurred inside a very wide volatility envelope. Theyhavent been able to capture those trends in their normalmodeling.

Rather than pursuing a trend, Im pursuing liquidity.Thats my main objective to pursue money flows, not

necessarily to use the trends as an indication of that. I douse some volume in my studies.

This year [many currency managers] are out of sync. Thereare some quality traders out there, for whom I have a lot ofadmiration, that are having losing years. For them, I think itsreversion to the mean for their programs. And I have a deeprespect for reversion to the mean because I had some of thatmyself in my program last year and I didnt like it.

I wanted to pull the volatility out and keep the focus onstaying profitable now thats what counts. [Im only con-cerned with] making alpha this month. My next challenge isto set and maintain a target volatility for the program.



Liquidity, geographical location, and macroeconomic fac-tors impact a currency pairs trading range. Knowing whattime of day a currency pair is the most or least volatile willhelp you improve your capital allocation. Trading aroundthe clock, part I (Currency Trader , November 2005) ana-lyzed the characteristics of the Asian and European tradingsessions. The following analysis outlines the typical tradingactivity of major currency pairs in the U.S. forex session.

Table 1 shows the average pip range for the different cur-rency pairs during various time frames between 2002 and2004. All sessions are described in terms of U.S. EasternStandard Time (ET).

U.S. session (New York): 8 a.m. to 5 p.m. ETNew York is the second-largest forex marketplace, encom-passing 19 percent of total forex market volume turnover,according to the 2004 Triennial Central Bank Survey ofForeign Exchange and Derivatives Market Activity pub-lished by the Bank for International Settlements (BIS).

It is also the financial center that guards the back doorof the worlds forex market, as trading activity usuallywinds down to a minimum from the U.S. afternoon tradingperiod until the opening of the Tokyo market the next day.The majority of transactions during the U.S. session are exe-cuted between 8 a.m. and noon, a period with relatively

TRADING STRATEGIES

The numbers in each column represent the average pip range for each currency pair. Forex volatility is highest during theEuropean trading session, followed by the U.S. session. The two sessions overlap during the busy four-hour period from 8

a.m. to noon ET.

TABLE 1 CURRENCY PAIR RANGES

Source: Day Trading the Currency Marketby Kathy Lien. Courtesy of John Wiley & Sons.

Asian session European session U.S. session U.S./Europe overlap Europe/Asia overlap

7 p.m.-4 a.m. 2 a.m.-noon 8 a.m.-5 p.m. 8 a.m.-noon 2-4 a.m.

EUR/USD 51 87 78 65 32

USD/JPY 78 79 69 58 29

GBP/USD 65 112 94 78 43

USD/CHF 68 117 107 88 43EUR/CHF 53 53 49 40 24

AUD/USD 38 53 47 39 20

USD/CAD 47 94 84 74 28

NZD/USD 42 52 46 38 20

EUR/GBP 25 40 34 27 16

GBP/JPY 112 145 119 99 60

GBP/CHF 96 150 129 105 62

AUD/JPY 55 63 56 47 26

All times ET

Trading around the clock,part II

In the second of two articles adapted from her new book, Day Trading the Currency Market,

Kathy Lien analyzes the characteristics of the U.S. trading session, as well as the European-U.S. and

Asian-European overlap sessions.

BY KATHY LIEN
http://www.currencytradermag.com/backissues.htmhttp://www.currencytradermag.com/backissues.htmhttp://www.currencytradermag.com/backissues.htm



higher liquidity because Europeantraders are still in the market.

For more risk-tolerant traders,British pound/U.S. dollar(GBP/USD), U.S. dollar/Swiss franc(USD/CHF), British pound/Japaneseyen (GBP/JPY), and Britishpound/Swiss franc (GBP/CHF) aregood choices for day traders becausetheir daily ranges average about 120

pips (Figure 1). Trading activities inthese currency pairs are particularlyactive because these transactionsdirectly involve the U.S. dollar.

Currency translations

When the U.S. equity and bond mar-kets are open during the U.S. session,foreign investors have to convert theirdomestic currencies, such as Japaneseyen, Euros, and Swiss francs, into dol-lar-dominated assets in order to carry

out their transactions. With the marketoverlap, GBP/JPY and GBP/CHFhave the widest daily ranges. Mostcurrencies in the forex market arequoted with the U.S. dollar as the baseand primarily traded against it beforetranslating into other currencies.

In the case of the GBP/JPY, for aBritish pound to be converted into Japanese yen, it has to be tradedagainst the dollar first, then into yen.

Therefore, a GBP/JPY trade involves two different currencytransactions GBP/USD and USD/JPY and its volatili-ty is ultimately determined by the correlations of the twoderived currency pairs. Because GBP/USD and USD/JPYhave negative correlations (which means they move inopposite directions), the volatility of GBP/JPY is amplified.Movement in USD/CHF can be explained similarly, but ithas a greater intensity.

Trading currency pairs with high volatility can be lucra-tive, but it is important to bear in mind the risk is very highas well. Traders should continuously revise their strategies

continued on p. 32

The U.S. trading session guards theback door of the worlds forex market,

as trading activity usually winds down

to a minimum from the U.S. afternoon

trading period until the opening of the

Tokyo market the next day.

The British pound/U.S. dollar, U.S. dollar/Swiss franc, British pound/Japanese

yen, and British pound/Swiss franc pairs offer the most volatility during the U.S.

forex session.

FIGURE 1 U.S. SESSION VOLATILITY

Seventy percent of European session trading range and 80 percent of U.S.session trading range occurs in this four-hour overlap.

FIGURE 2 U.S.EUROPEAN OVERLAP





in response to market conditions, because abrupt moves in exchangerates can easily stop out their ordersor nullify long-term strategies.

For more risk-averse traders, U.S.

dollar/Japanese yen (USD/JPY),Euro/U.S. dollar (EUR/USD), and U.S.dollar/Canadian dollar (USD/CAD)appear to be good choices, becausethese pairs combine decent tradingranges with lower risk. They are high-ly liquid, which allows an investor tosecure profits or cut losses promptlyand efficiently. The modest volatility ofthese pairs also provides a favorableenvironment for traders who want topursue long-term strategies.

EuropeanU.S. overlap:

8 a.m.12 p.m. ET

The forex market tends to be mostactive when the hours of the worldstwo largest trading centers Europeand the U.S. overlap (Figure 2). Theperiod between 8 a.m. and noon ETcontains 70 percent of the total aver-age range of trading for all currencypairs during the European tradinghours and 80 percent of the total aver-

age range of trading for all currencypairs during U.S. trading hours.

These percentages are indicationenough that day traders who are look-ing for volatile price action and cannotwatch the screen all day should tradethe European-U.S. overlap period.

AsianEuropean overlap:

24 a.m. ET

The trade intensity in theAsianEuropean overlap period is far

lower than in any other sessionbecause of the slow trading during theAsian morning. Of course, the timeperiod surveyed is relatively smaller,as well (Figure 3).

With trading extremely thin duringthese hours, risk-tolerant traders cantake a two-hour nap and risk-aversetraders can spend the time positioningthemselves for a breakout move at theEuropean or U.S. open.

For information on the author see p. 6.

TRADING STRATEGIES continued

Because of its short duration and early hours, trade activity is lowest during the

European-Asian overlap period.

FIGURE 3 EUROPEANASIAN OVERLAP


Related reading:

Day Trading the Currency Market, by Kathy Lien

John Wiley & Sons, 2005

Other articles by Kathy Lien:

Trading around the clock, Part I

Currency Trader, November 2005A look at how different currencies behave in the Asian and European trading

sessions.

Dollar-yen: The years hottest carry trade

Currency Trader, August 2005

How the U.S. interest rate hike cycle offered the opportunity to go long the

dollar and short the yen.

Volatility-based currency trading

Currency Trader, February 2005

How to use inside bars and volatility comparisons to spot trade opportunities.

Getting a lift from the carry trade

Currency Trader, October 2004

Explains the mechanics of the carry trade.

Forex Trading: Understanding the currency market

Active Trader, July 2004

A review of how the foreign currency market works and the economic factors

that drive it.

You can purchase and download past articles at

www.activetradermag.com/purchase_articles.htm.
http://www.activetradermag.com/purchase_articles.htmhttp://www.activetradermag.com/purchase_articles.htmhttp://www.activetradermag.com/purchase_articles.htm


33/43

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34/43

Note: Wealth-Lab's Dion Kurczek and VolkerKnapp will be hosting Wealth-Lab demonstra-

tions at the Online Trading Expo in Las Vegason Dec. 14 and 15. Go to www.tradersexpo.com

for more information.

Market: Currencies.

System concept: This trading system

combines trend-following and coun-tertrend rules and attempts to profit from both long-term trends and short-term

reversals. Trend-following traders typical-ly wait until a trend has been established

to enter the market, while countertrendtraders have a shorter-term outlook andtake advantage of brief reversals.

In an attempt to merge both methods,the system uses a channel breakout rule todetect long-term trends and then stays in

the market (up to several months) untilthe trend changes. Also, the systems

countertrend rules identify short-termreactions to extreme moves.

Figure 1 shows an example in the British

pound futures in which both parts of the sys-

tem produce profitable trades. Its trend-fol-lowing rules went long on Sept. 25, 1997because price broke above the highest high ofthe past 20 days. The system exited on Dec. 4,

when price dropped below the lowest low ofthe last 20 days a profit of $2,723 per con-

tract.While the trend-following rules main-

tained the long position, the pound rallied

strongly on Oct. 29. Here, the countertrendrules sold short and exited at that days close,which added another $855 per contract.

Rules:

Trend-following:

1. Go long with a buy stop at the highest

high of the past 20 days.2. Exit long and go short at stop at the lowest low of the

past 20 days.3. Exit at stop loss at three times the average true range

(ATR) of the past 10 days.

Countertrend rules:

1. If the open is above the previous days high, sell short

at limit at the open plus 20 percent of the 10-day ATR.Exit at the close.

2. If the open is below the previous days low, go long

december 2005 • strategies, news and analysis

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