Guest post from Andi Thornton. This was written last Sunday. If you saw the carnage last night with HUGE swings on lots of pairs you will hopefully now understand why all of us were “sitting on our hands” this week and waiting to see what happened.
If you were in trades yesterday and made a lot, you got lucky. If you lost you have my sympathies BUT a wise trader will leave things well alone right now. If you are taking part in these markets you are gambling and run the risk of losing everything.
Here is Andi’s article looking forwards into 2019. I too suspect $ weakness in 2019 BUT that doesn’t mean it will start next week!:
There are no 2 ways about it, forex trading is difficult at the moment, long gone are the days of forward guidance and standard monetary policy with currencies reacting in a certain way. Going into 2019 we need to have a cautious and pragmatic view on what the future holds. The one thing we can say is that the current themes are likely to carry forward for some time to come. For example, as we entered 2018, oil prices were low, inflation was non-existent, Brexit was on everybody’s radar and Donald Trump was busy causing chaos, 12 months on and very little has changed there!
What can we look forward to in the coming 12 months? My own personal opinion is that we are likely to see dollar weakness. Why is this when the Fed are tightening monetary policy, let’s look at a couple of charts:
This chart shows the 10 year, 5 year and 2 year yields for the U.S. Treasury. We can see recently that yields have dropped in line with the risk aversion that we are seeing in the market currently, but that’s not the most important point to note. The most important element is the convergence of the different yields, this is far more telling. This is what’s known as a flattening yield curve because the difference between the different yields is falling, which suggests uncertainty because the yields for the longer term bonds are beginning to converge with shorter term investments.
This is another interesting chart which shows what happens when the yield curve, the spreads between yields, converges and inverts. As you can see from the yellow line, when yields converge and invert, drop below the zero level, we often see a significant drop in GDP and essentially a recession in the US. This is why yields are important to watch, they are in effect forward guidance in terms of what is likely to happen. And guess what, we are there now.
You may be asking why I have focused so far on the US dollar, well the answer is simple, 62% of the currency reserves held across the globe are in US dollars. Commodity prices are also listed in US dollars. Finally, 95% of all trades taken are derivatives of US dollar currency pairs. For example, if you take a trade on the EURCAD you are trading the EURUSD and USDCAD. Therefore, what happens to the US dollar has by far the biggest impact on the currency markets.
We are also seeing the Fed coming to the end of its tightening process. We have seen fairly aggressive interest rate increases over the last 18 months but the view now is that they are moving towards a more natural level of interest, which could see the Fed pause but definitely slow down next year. This has an impact on the US dollar as other central banks are now looking to begin tightening cycles, therefore the interest rate differentials between countries is likely to reduce, again affecting the dollar due to the unwinding of carry trades held in US dollar denomination.
Couple of other charts that I wanted to highlight which further showed that the US economy may start struggling in the very near future:
This chart shows government spending over recent years and as we can see due to Trumpenomics the US is spending considerably more than previous years.
At the same time we start to see government revenues drop which means that to continue to operate at current levels the US government needs to sell further debt to finance its spending programme. However, for the US government to find buyers for that debt the dollar needs to be held at a reasonable level, and potentially weaker than it currently is. This is one of the reasons why Trump is so anti-Fed because their actions are increasing the value of the dollar which ultimately will hurt the spending power of the US government.
There are a whole bunch of other reasons why the US economy looks as though it could be heading for a rocky road, for example, trade wars, and shutdown, balance of power between the Senate and House, but hopefully the above has given you some insight both on my views but also on how you can use fundamentals to start to predict where a currency might start to struggle.
Of course all of that gives us some insight into what might happen with the US dollar but how do we use this information to our advantage in trades next year. The problem I have is I can’t see any economy in the developed world doing particularly well at the moment. The US dollar has been a certain buy over the last 12 months, but if we are going to lose that conviction where do we look to invest.
From a purely fundamental perspective if we start to see weakness in the US dollar then emerging markets will start to do quite well. So much of their debt is held in US dollars the weakening means that their debt is easier to service, giving emerging economies more money to spend on “emerging”. I certainly wouldn’t advocate new traders dipping into emerging market currency pairs, it is somewhat fraught with risk, but recently India has been earmarked as the next Silicon Valley from a data perspective. Over the coming months and years we could see the Indian rupee do quite well on the global stage.
In terms of developed economies, the Eurozone was looking to be one of the brighter opportunities but recently we have seen economic data and forward guidance from the ECB talking of slowing economic momentum, however despite this, there is still a suggestion that the ECB is looking to increase interest rates towards the end of 2019. They do need to because should we find ourselves in the middle of a global recession the Eurozone has very little ammunition that it can use at present. Of course we also have the increasing level of populism and the ever-present Brexit risks, but the Italian concerns seem to have somewhat eased.
The biggest risk event in the first few months of the year will be Brexit. Clearly this will have an impact on both the EU and UK so is something that needs to be watched. Should the UK and EU reach a deal then this could be the catalyst to generate strength against the US dollar, however if we see a rejection of the current deal on the table, and no alternative offered, both the EU and UK would suffer. The UK would probably suffer more because of the inevitable leadership challenges, 2nd referendum and general election, all of which could be on the table in a no deal Brexit. Monetary policy from the Bank of England will almost certainly be on hold until that decision is made. The Bank of England have already cited that no deal Brexit could lead to a significant recession so we are unlikely to see any interest rate movements soon.
Japan is another area where we see little evidence of strength, in fact recently numbers have suggested potential negative inflation again. However, we know the Japanese yen is a safe haven, therefore if we find ourselves in a risk off environment, and the dollar weakening which would prevent it from being a safe haven option, we could start to see some Japanese yen strength. Important to remember that the yen is also negatively correlated with oil so something else to keep an eye out.
Finally the commodity currencies, and the Canadian dollar has continued to come under significant strength from falling oil prices.
The key to the Canadian dollar is to watch for any recovery in oil. Also if the dollar weakens that is beneficial to commodity prices as they are priced in US dollars, another factor to keep an eye on. This would also be the same for Australia and New Zealand, but by far the biggest risk to the Aussie and New Zealand dollar is the dwindling global trade volumes and the tensions between US and China. Neither the RBA or RBNZ are expected to make any significant changes to monetary policy in the coming year.
In conclusion, it’s all about watching the US dollar and how that impacts on the rest of the world. In addition looking for a capitalist where you can take advantage of US dollar weakness, like a positive Brexit or risk aversion with the yen for example. I started this article by saying that the Forex market has been difficult to trade this year, and I suspect next year will be no different, but there should be opportunities to make some pips by using a combination of fundamentals and technical analysis.
Have a safe and prosperous 2019.
Andi
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