Focus on Currencies, Part I
This analysis covers five factors:
- Technical analysis
- Commitment of traders (speculation vs. hedging) of currency futures
- The carry trade
Let’s kick off with the technicals.
Forex traders will note that charts marked with an asterisk are inverse of normal trading pairs. This was done to put all the currency pairs in the same frame of reference (e.g., a weakening chart on a currency pair is bullish for the U.S. dollar and U.S. dollar index).
Yen/U.S. Dollar (Monthly)*
Euro/U.S. Dollar (Weekly)
Canadian Dollar/U.S. Dollar (Monthly)*
U.S. Dollar Index (Weekly)
U.S. Dollar Index (Monthly)
The charts show that we are at a significant inflection point on the U.S. dollar index, the yen, and the euro. Let’s look at additional factors to see if we can gather insights as to which way the charts may break. Following is the political perspective.
Congress Takes Aim Over Yen
The Financial Times is reporting, “U.S. Congress Takes Aim at Tokyo Over Yen”:
“Powerful House Democrats are pressing the Bush administration to persuade Tokyo to strengthen the yen, claiming the currency’s weakness is bolstering Japanese imports at the expense of U.S. manufacturers.
“In a letter to Hank Paulson, U.S. Treasury secretary, the House members alleged that Tokyo was pursuing a cheap currency to subsidize exporters and urged Mr. Paulson ‘to press the Japanese government to reverse their weak yen policy.’
“The pressure from Democrats sets up a confrontation with the U.S. Treasury secretary, who argues the yen’s weakness reflects Japan’s economic fundamentals, rather than a deliberate policy of manipulation…
“Michigan Rep. Sander Levin, chairman of the House Trade Subcommittee, told the Financial Times: ‘Japan is clearly following policies to maintain a weak yen.’
“The yen’s fall continued on Thursday, down 0.4%, to Y121.20 against the dollar, and 0.6%, to Y157.90 against the euro.
“Japanese exports as a percentage of gross domestic product have — at 16% — surpassed the levels of 1985, when Japan was forced to revalue under pressure from the U.S.
“Takatoshi Ito, a member of the Japanese cabinet’s council on fiscal and economic policy, said: ‘Japan has not intervened since March 2004 — not even oral intervention — so the ministry of finance is clean as market fundamentals push the yen weaker.’
“Tensions over the yen are set to be reflected in legislation drafted in the Senate on currency manipulation, analysts said.
“Rep. Barney Frank, chairman of the House Financial Services Committee, said: ‘This is directly tied to the administration’s efforts to get trade promotion authority renewed. It cannot be the case that we will let the status quo go on.'”
Comments on Taking Aim
- The Democrats in Congress believe that higher prices on goods from Asia (nearly everything but food, energy, planes, and weapons) will be a good thing. It won’t
- The Democrats also must think that higher prices on goods will bring back manufacturing jobs to the U.S. They won’t
- Michigan Rep. Sander Levin, chairman of the House Trade Subcommittee, says, “Japan is clearly following policies to maintain a weak yen.” Hmmm. Like we are not doing everything in our power to maintain a weak dollar? Does any country want a strong currency? The answer to that question should be obvious: Competitive currency debasement is everywhere you look
- Takatoshi Ito, a member of the Japanese cabinet’s council on fiscal and economic policy, said: “Japan has not intervened since March 2004.” That is the fact. And oddly enough, the yen did not plunge until Japan stopped intervening. That goes to show you two things: 1) A primary trend in currencies or anything else cannot be defeated by manipulation, which is something gold bugs need to remember when screaming about these conspiracy theories purported by the Gold Anti-Trust Action Committee, and 2) sentiment was so universally bearish on the U.S. dollar by the spring of 2005 with numerous magazine covers and the shoeshine boy telling everyone that Gates and Buffett were short the dollar; that the dollar was bound to rally
- If Congress takes action against either China or Japan as currency manipulators, I fully expect a severe market reaction, and that reaction will generally not be welcome anywhere
- While cautioning against underestimating the shortsightedness of legislative bodies in general, this jawboning is more than likely nothing more than frustration by Congress and this administration that we can no longer bully the world markets into doing what we think is in our best interest (and on that, we are not even right). After all, who wants higher prices across the board on all kinds of goods and services when it will not bring a single job back to the U.S.? That is essentially what Congress is begging for.
Paulson Sides With Japan
Bloomberg is reporting, “Paulson, in Congress, Sides With Japan on Yen”:
“Henry Paulson’s defense of Japan’s currency policies over the last week is forcing traders to pay more attention to a U.S. Treasury secretary than they have in years.
“Paulson caused fluctuations in the yen at least three times in the past week by responding to questions about whether it is undervalued, as alleged by some Democrats and European finance ministers. He sparked an hour-long slide yesterday when he told the House Ways and Means Committee that the currency is set in an open market and that Japan is still struggling with deflation…
“Paulson first discussed the yen’s slide against the dollar on Jan. 31. Answering a question during testimony at the Senate Banking Committee in Washington, Paulson said he’s watching the yen ‘very, very carefully’…
“The testimony was only Paulson’s second since Bush nominated the 60-year-old for the Treasury post in May. It took Paulson three months to even mention the dollar. When he did, he said he favors a ‘strong dollar,’ a script developed by fellow Goldman alumnus Robert Rubin, who was Treasury secretary from 1995-1999.
“‘He has a very hands-off approach to markets and doesn’t seem to want to comment very much,’ said Sophia Drossos, a currency strategist at Morgan Stanley in New York. ‘He brings a high level of financial savvy. He is viewed as the Republicans’ answer to Robert Rubin’…
“Paulson’s remarks may also have had an impact because investors are growing wary about the magnitude of the yen’s decline. The currency is near a 20-year low on a trade-weighted basis, and Commodity Futures Trading Commission figures on Feb. 2 showed a record 173,005 positions betting on a weaker yen…
“‘As soon as he mentioned that he was watching it very closely, that gave traders something to run with,’ said David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn. ‘It took literally a couple of days for the market to fully understand,’ he said.
“Paulson ‘did an admirable job’ in cogently laying out his view, Gilmore added. ‘The interesting thing is that he was so prepared to speak on the yen.'”
Comments on Paulson
- Supposedly, Paulson is watching things “very, very carefully.” So what? Is the U.S. going to sell dollars and buy yen? Wouldn’t that be fun? (Especially if Japan reacted as it did before, by selling yen to buy dollars)
- Sophia Drossos, a currency strategist at Morgan Stanley, said: “He has a very hands-off approach to markets and doesn’t seem to want to comment very much,” and “He brings a high level of financial savvy. He is viewed as the Republicans’ answer to Robert Rubin” OK, Sophia, if his approach is hands-off, exactly why should anyone care what he is watching, or, for that matter, saying? Why does that make him “savvy”? Is he really Robert Rubin?
- David Gilmore, a partner at Foreign Exchange Analytics, had to say: 1) “As soon as he mentioned that he was watching it very closely, that gave traders something to run with” and 2) The market ran with it even though “It took literally a couple of days for the market to fully understand” and 3) Paulson “did an admirable job” in cogently laying out his view. Sheesh. I will leave this to the reader to sort out the various contradictions in those statements.
Let’s now turn our focus on speculation as defined by the Commitments of Traders reports (COTs).
Commitments of Traders
For those unfamiliar with this frame of reference, commercial traders and noncommercial traders have to report their open interest in futures (in this case, currency futures) once a week. Those results are summarized in COT reports. A quick glance at any of the following charts will show noncommercial, commercial, and nonreportable positions.
Think of commercial traders as either producers or hedgers. In the case of something like gold or corn, the commercials will be the miners or the farmers. But they could also be jewelry makers or cereal makers like Kellogg’s. In short, the commercials represent someone wanting to hedge future costs from rising or producers wanting to lock in prices at which they can profitably produce. In the case of currencies, the commercials might be importers or exporters not wanting to take on currency risk. The commercials might also be big trading houses wanting to hedge exposure to various markets for one reason or another. Commercials are thus hedgers.
Think of the noncommercials as the big hedge funds speculating one way or another (long or short) in a commodity or currency. The nonreportable positions would be a small trader speculating one way or another on currencies or commodities. Trading size determines reportability.
Using the COT Report
Investopedia offers advice on using the COT report:
“In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, are more reliable, as they capture traders’ positions in a specific market.
“There are three primary premises on which to base trading with the COT data:
- Flips in market positioning may be accurate trending indicators
- Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals
- Changes in open interest can be used to determine strength of trend.”
The COT reports come out on Friday as of the previous Tuesday. (This delay is nonsense in the current electronic age, but it is what it is.)
If you are still with me, following are a few snapshots from the most recent currency COT reports:
The above chart shows that the noncommercials (big speculators) are short 128,526 contracts in the yen (betting it will fall lower, or that if it rises, they can make more elsewhere). This is part (but likely only a small part) of the infamous carry trade (shorting the yen and investing elsewhere, typically U.S. Treasuries). Each contract represents 12,500,000 yen (as of this writing, $102,804 per contract). The total amount bet on interest rate differentials between the yen and the U.S. dollar as of the report date is $13,212,986,904.
The article on Paulson above made this statement: “The currency is near a 20-year low on a trade-weighted basis, and Commodity Futures Trading Commission figures on Feb. 2 showed a record 173,005 positions betting on a weaker yen.”
The COT charts in this blog were reported on Friday, Feb. 9, so we can see some unwinding of positions since then. Or can we? Notice I said reported on Feb. 9. They reflect positions as of Tuesday, Feb. 6. Just as with stock market short interest (reported only once a month), potentially useful information is kept from the small traders while others potentially know. This is not as bad as short interest in stocks, but there is no real excuse for it. We do not know the current position of the COTs.
At any rate, the carry trade in the yen will unwind at some point. It will not be to the benefit of the U.S. dollar when it happens. For more thoughts on this idea, please refer to “Mr. Practical on the Yen, Carry Trade, and Credit Expansion.”
One more point: An unwinding of the yen position will be yen supportive and dollar negative. That increases (but certainly does not negate) the likelihood that the trendline break in the yen as shown on the first chart is a fake one:
A quick look at what the noncommercials are doing shows a chart that is about as lopsided as it gets. There seems to be mammoth one-sided speculation on the British pound versus the U.S. dollar.
62,500 pounds is currently $121,950, and the big specs are long 92,728 contracts, thus there is $11,308,179,600 bet on U.S. dollar versus British pound currency differentials. This will get unwound at some point, and in contrast to the yen, an unwinding of these contracts should be U.S. dollar supportive when it happens. Timing the reversal is, of course, the issue.
For whatever reason, hedge funds are short 80,646 contracts on the Canadian dollar.
The unwinding of this trade would be supportive of the Canadian dollar and that similarity to the yen suggests a possibility that this is a potentially false breakdown.
Speculation on the euro is not as massive, nor is it as one-sided, as some of the others. However, small speculators (nonreportable positions) are substantially long (relative to small spec positions), with commercials net short 65,632 contracts and the big speculators long 45,330 contracts. The unwinding of those contracts would likely be supportive of the U.S. dollar. Each contract represents 125,000 euros (as of this writing, $162,562 per contract, or $7,368,935,460 total on 45,330 contracts). On the surface, this might not seem like such a big deal (at least as compared with the yen). But one must also look at the relative weighting of currencies within the U.S. dollar index, and that is where the rubber meets the road.
What is the U.S. dollar index?
- A widely recognized benchmark that reflects the value of the U.S. dollar on global markets
- A geometric average that tracks the value of the U.S. dollar against a basket of 6 currencies
- The USDX is based upon the original U.S. dollar index calculated by the Federal Reserve Bank, base year of 1973.
The following pie chart tells the story:
What the Swedish krona is doing in the index, I haven’t a clue. But the key issue is that those expecting a huge rebound in the yen to sink the U.S. dollar index are likely barking up the wrong tree (at least from the standpoint of an unwinding of futures contracts). The yen is only 13.6% of the index, while Europe (the euro and pound) comprise 69.5% of the weighting, with the euro a whopping 57.6%.
This concludes Part I of Focus on Currencies. This is NOT a complete view. The carry trade in the currency markets (as opposed to the futures market) dwarfs the significance of the COT data according to some well respected economists. The message here is that it is easy (too easy) to focus on one or two aspects of a trade while missing the big picture. Tomorrow, I will attempt to fill in some of the rest of the picture with a focus on the carry trade, as well as a brief discussion on the fundamental factors that drive the relative valuations of currencies.
Mike Shedlock ~ “Mish”
February 12, 2007