USDJPY Fibs

The July 13 - August 7 rally in the USD/JPY pair that broke through a previous downtrending channel to the upside corrected at the 62% fibonacci as measured from the May 6 high. Interestingly this latest downturn has taken a bullish turn after retracing 62% from it's short term peak on August 7.

There have been bullish USD/JPY commentary from Forex.com as reported by bloomberg recently as well.

USD/JPY Fundamentals

I have compared Japanese trade balance data with the USD/JPY exchange rate to determine that the dollar could appreciate as much as eight cents in the next eight months.

USD/JPY exchange rate

Japanese exports and imports are both down, like the rest of the world.

Japanese trade balance (imports minus exports) turned signifcantly negative during December and January. This caused Japan to become a net importer during the worst of the global recession.

Trade numbers take a little while to work themselves into the exchange rate. I lagged the USD/JPY by 10 months and compared it to a 3 month average of Japanese trade balances. The results are depicted. The correlation is better than 83%.

Throughout 2008 and 2009, the correlation between USD/JPY exchange rates and Japanese trade balances has been positive.

Three month average trade balance is significant against the exchange rate at the 1% level. The regresion reveals the following equation.

USD/JPY = 109.126 + 0.00001498 * Trade Balance 3 Month Moving Average

Using this equation, excel calculated predicted what the USD/JPY exchange rate would be 10 months after the recorded trade balance.

The model explains 69% of the exchange rate movement so there are some errors to deal with. The residuals use USD/JPY exchange rates 10 months after the observed trade balance figure. They are calculated as Actual exchange rate - Predicted exchange rate. The results show that, as of July, the USD/JPY is the most undervalued iti has been since the begining of 2008.

Inflation Expectations Ahead of FOMC Meeting

Inflation expectations are above 1.92 again. Look for the Fed to bring an end to all their bond purchases.

New Correlation Charts

Here is how to read these charts which measure correlations and potentially profitable hedged carry trades. Daily periodic returns are the percent change (natural log) of the currency as per daily New York close.

The first chart measures the correlation between the DPR of 23 tradable currencies on FXCM. The bottom chart measures the correlation in the prices of the currencies. If the price is rising, a strong positive correlation will mean the other currency's price will rise as well. The middle chart displays how much interest will be earned if a trader takes positions in each of the corresponding currencies. If the correlations and interest rate swaps are positive, you can buy on pair and sell the other. Price appreciation (depreciation) will average zero and you are free to earn interest at FX leverage rates.

Currently, I am long AUD/USD and short EUR/USD. The AUD/JPY and CHF/JPY pair looks attractive right now and I may be adding that soon.

Positve Supply Shocks

A quick reminder about the macro environment: Positive supply shocks are characterized by lower prices and higher quantities demanded. They can be caused by lower input costs.

Year over Year Eurozone PPI numbers are down over 6%.

An old San Fransisco Fed article instructs us to focus on nominal GDP (or spending) to get a handle on inflation during positive supply shocks.

Hedging a Breakout

Selling the EUR/JPY breakout would have been an effective and profitable hedge against the NZD/USD and GBP/USD breakouts early in the Tokyo session today. All three breakouts to the upside failed and ended up costing me. It was apparent that the Euro was the weakest of the major currencies. Next time I will look to hedge my breakout plays with a long-reversal on the weak currency.

Long the breakout

Short the breakout

British Stagflation

High Prices

High CPI

Currency devaluation

Expansionary Monetary Policy

125 Billion Pound asset purchase

0.50% Bank of England rate

What to watch out for

Increasing wages

Imports

New taxes

Euro, Frank Weakness Ahead

Trading ranges from Friday were tight so I am hoping for some break outs early on Sunday in the east coast. The Euro and Frank Yen pairs are begining the week in a bad position and I am looking for them to follow the path of the dollar from last week.

More Yen Strength to Come

Heading into the Tokyo open the Yen is strong while the Euro and Aussie are notably weak. Currencies were slow tuesday as the equity markets sold off and came dangerously close to signally a bearish downturn. Wednesday in the Currency market may be a repeat of Monday with a big flight to quality. The Yen and US Dollar will be strong.

Potential Trouble in US Equities

The the GBPJPY is 95% correlated with the S&P 500 over the last five years, and the currency pair just tanked after completing the same head and shoulders pattern that the US stock market is setting up for. S&P 500 futures have been bad since the market opened this week and will likely be bad all day today, Monday.

The USD/JPY used to be highly correlated to the US stock market as borrowers would borrow money to buy US stocks, or deleverage and sell US stocks. That correlation broke down when the US Fed dropped it's interest rate to 0-0.25%. There was no reason to to buy the USD/JPY when the GBP/JPY still returned a healthy margin. The GBP/JPY correlation should hold as long as the Bank of England doesn't interfere. They do have rate decisions and a lot of economic data coming out, so the GBP/SPY correlation should be monitored closely

Faster Than Bloomberg

I've been buying Yen all throughout the Asian session. I covered my Sterling bet and got short the dollar as the Western European markets are about to open. They are all waking up to a lovely piece titled "Yen Advances Verses Euro on Concern Credit Losses Increasing" (Bloomberg)

GBP/JPY Breaks Down

The Japanese sold the pound aggressively at the open in Tokyo. The Pound was driven below it's seven day low against the yen. I put this sell on a couple of hours ago. The play is similar to the Kiwi short that I posted a short while ago. While the kiwi drifted back up to the 20 EMA and I covered, the GBP continues to be weak. The ICH on the 30 minute chart is also providing some downward pressure on the GBP/JPY and that may be helping my new position.

In equity news, the S&P 500 futures are pointing to a lower open. The futures are trading 90 points above the 880 level that would confirm a head and shoulders topping pattern.

Economic Events

Tuesday
AUD Interest rate decision @ 4:30 - Predicted to remain at 3.00%
GBP June GDP estimate @ 23:00 - Previously -0.9%

Wednesday
EUR Q1 GDP estimate @ 9:00 - Previously -2.5%

Thursday
AUD Employment @ 1:30 - Previously -1.7K
GBP BoE rate decision @ 11:00 - Expected to remain at 0.5%
CAD Housing starts @ 12:30

Friday
CAD Employment @ 11:00 - Previously -41.8K

Times are GMT. (DailyFX)

Sell Kiwi on the Open

The NZD/USD opened weak in Sydney. The price is trading between the second and first bollinger band and below the previous days low. I'm putting on a short with a stop at the 20 period EMA.

Developments

As a weak stock market could be a cue to buy dollars, a strong stock market can be a dollar killer. My USD/CAD and USD/EUR positions pulled back as the S&P moved higher. The USD/CAD was due for a move dow; I was expecting it and I had tighted my stops just last night. The AUD/USD is showing some relative weakness, however, even though their retail sales were better than expected. More investigation is required about the Aussie.

Apparently the Euro is correlated to higher makrets; I'll have to look at this. (Bloomberg)

Sell EUR/USD

I added a short EUR/USD position to my portfolio and will use that as my primary AUD/USD hedge. The USD/CAD is still open and I'm riding it until it falls out of it's channel. I have my stop placed just under the monthly 50 day moving average, or at 75% of my gains.

The EUR/USD price is 96% correlated to the AUD/USD and the periodic returns are 66% correlated. One day VaR at 0.1% is about $350. I'm holding enough excess margin for two of these but I'm going to hold off expanding for now.

Green line means long, red means short.

Analysis

The AUD/CAD trade has been constantly rising, and by way of the dollar, you can earn a positive carry. The trade looks like it is getting too hot though. DailyFX has a buy at .9420 on the AUD/CAD, and I am looking to do more heding by tightening my stops on the USD/CAD and buying the USD/EUR.

The daily charts on all parts of the AUD/CAD trade look like they're reaching a peak but the month charts show that the pairs have a lot of room to run. I am looking forward to a AUD/USD breakout similar to what is currently happening to the AUD/CAD.

Alternative Plans

I have big gains in the USD/CAD but the currency has to turn around sometime. I've locked in about half of my gains this month. When the AUD/CAD falls and takes out my stops, I will look to sell the EUR/USD and wait for the AUD/USD to take off.

Also, it is important to keep in mind that if the stock market rolls over long dollar trades will work well as people run to safety. A downward stock market move could be a big retest, or a smaller and short term bull market correction.

Oanda has a tremendous FX econometrics center that I just discovered. You can compare yeild curves, inflation trends, just about anything you can imagine for the major currencies.

I'll be testing two new brokerages in the comming weeks; FXpro and Oanda. FXpro recently won an award as Europes best FX broker. In addition to MetaTrader 4, they offer 500:1 leverage and CFD's on metals, futures, and selected equities. They're also experimenting with continuous interests payments instead of end of day swaps. I'm very excited to start testing these platforms.

Stories

U.K. economy shrinks more than expected (Bloomberg)

British economy could pull down the pound (Bloomberg)

Gold/Oil Spread

I can't tell if there is a relationship between the GLD/USO spread yet. There may be a time lag.

It should work great

The AUD/CAD just became free to hold. This means I can hold three differernt currency pairs and cancel all their price movements out. I'll be buying the AUD/USD and the USD/CAD and selling the CAD/AUD.

I took some measurements on the AUD$/$CAD portfolio and compared them to the AUD/CAD.

The long term correlation is usually strong but it broke down for two years early in the decade. For a while though, it was steady around -98%. Currently the 12 month, 6 month, and 3 month correlations are -91%, -86%, and -63%

You can see that the value of the portfolio declined from 2002 until 2005, the same time that the long term correlations fell apart and then flattened out like it should afterwards. This highlights the main risk to this type of trade.

The final chart is the distribution of values. You can see that the CAD/AUD is almost a mirror image of the AUD$/$CAD because of the distribution shifts left.

Based on one day value swings over the last two years, there is a 0.1% chance of loosing over $490 with this trade. Likewise, there is a 50% chance of no change in value and a 0.1% chance of gaining over $510.

Developing Stories

Record Correlations
Worst may be over for Treasuries
EUR/USD expected to fall

Oil and Gold

The USO appears to have strong support at 36 but it could move either direction, judging from the chart. A move to the upside is positive to the USD/CAD.

Falling gold prices this month have held the AUD/USD back. I'll be monitoring the GLD for clues on what the Aussie will do next.

FX Correlations

The coup de grâce of this blog will be the correlation calculations. I constantly track 24 major currencies for both price and daily periodic return correlations. Here are the charts.

EUR/USD, AUD/USD

The EUR/USD and AUD/USD prices are 96% correlated and their daily returns are correlated 66%. You can earn 1.56% from selling the EUR/USD and buying the AUD/USD. Returns on this trade are 34% correlated over the long term to the AUD/USD:USD/CAD trade. I need to do some more portfolio analysis before I get in.

AUD/USD Analysis

Reserve Bank of Austrialia rates: 3.00%
U.S. Federal Reserve rates: 0.25%


FXCM currently pays 1.35% or $0.37 per day per $10,000 contract.

My goal is to find a currency that will effectivly hedge away price depreciation (and appreciation) risk while earning a fair amount of carry. 1.35% does not sound like alot initially, but at 200 times leverage, it is significant.


I've identified three variables that together explain over 91% of the AUD/USD movement. They are the CAD/USD pair, the AAA corporate risk premium, and the VIX. The AUD/USD is negativley correlated to each of these variables. That is, if one goes up, the AUD/USD should fall.

The regression equation for the AUD/USD is as follows:

AUD/USD = 1.8306 -0.8354CADUSD -0.059AAARP -0.0006VIX



Comparing Prices


Comparing Periodic Returns




6 month rolling correlation AUD/USD, CAD/USD: -0.94




AUD/USD and the VIX

AAA Corporate Bond Risk Premiums

AAA Risk Premiums as functions of CAD/USD and AUD/USD

Good Morning Asia

My number one hedge, the USD/CAD, has increased it's roll to $0.02 per contract beginning this evening.

I bought the USD/CAD as a hedge against the AUD/USD on June 2. The hedge has exploded for a gain of nearly 700 pips.

FX Coverage Begins

This blog will focus on low delta, highly correlated, positive carry FX trades. I search for currency pairs that show a large degree of price correlation and a net positive interest rate differential. For example, if the AUD/USD and USD/CAD pair have been correlated to a -0.95 degree. A trader can sell both pairs and earn a positive rate of $0.65 per day per bundle on ThinkorSwim. The goal of the trade is to have one pair go up in the same ratio of the other. The net price appreciation should be zero and the carry should provide a hansom return. Based on current rates, the AUD/USD and USD/CAD bundle can return up to 150% in carry alone, depending on the amount of leverage.

Risk management is an important part of my strategy. FX markets are traded on huge amounts of leverage and while I take advantage of this to amplify the interest rate differentials, I am careful to pair my trades so they have low price risk, low portfolio volatility, and a safe amount of capital, should the spreads between pairs widen.

Check back for updates.