Friday, 2 December 2016

Forex, The Four Letter R-word

Forex Risk

A lot is written about Forex Risk; whether the markets are tolerant, averse, or neutral. It is a headline that is bandied about on a regular basis. Quantifying the value of risk, and its forex impact, may be so much harder to do in the trading arena, than reporting each day on whether the herd was charging towards, or away from risk.
In its natural state the financial market has three major attitudes towards risk that models its behaviour and actions throughout each of the global trading session. The three are; risk aversion, risk tolerance and risk-neutral. Headlines overplay the four letter Risk word, it should be used sparingly as daily risk levels do not reflect the big picture of fair value on global risk, and its forex implications.

Aversion Phase:
Risk-aversion is characterized by investors selling assets in times of global contraction that are considered risky, and swapping them for the safety of the bond market, mainly U.S. Treasuries. Risk-aversion can be seen relatively easily; commodities decline (global commodities are priced in USD values, and as such create a short commodity/Long dollar move), as investors consider that consumption will slow, while S&P futures also head lower at a sustainable pace.
In the currency market, risk-aversion strengthens the dollar, as investor sell foreign denominated assets to buy U.S. Treasuries. In this period, higher yielding currencies (those with a higher overnight, or ten year note rate) are the ones being sold the most as the USD is bought.

Tolerant Phase:
The risk-tolerance phase is seen when Treasuries and bonds are sold as investors look for higher yields in a long-term play that reflects a confidence that the global economy is expanding. In periods of relative calm and positive macroeconomic reports, traders dilute holdings in the safety of the bond market and invest their capital in stocks, commodities and higher yielding foreign currencies. Usually, bull markets are characterized by risk-tolerant phases and in this period S&P futures and global commodities head higher. Therefore, in this period the dollar is sold.

Neutral Phase:
In most cases, risk-neutrality happens when the financial market moves side-ways, unable to push to test support or resistance, and when global fair value on risk is accepted. At this stage the global economy will be hitting its peak, or hitting its trough, in the business cycle phase. This will be characterized by a re-distribution period, as investors shift their assets between the various financial instruments in preparation for the next leg of fair value on risk.
The main difference in the Neutral phase being that the shifts are not only session-by-session, they literally happen hour-by-hour as big players try to make their automated moves without detection. Sentiment is seen to change from one to the other, empowered by the relentless flow of global market trades that trigger as a contingency play, as each individual market accepts risk neutrality, or not.
The sideways moving market tends to be the more volatile as the channels are traded, and fair value sought at each regional market open and close.

Transition Phase:
Looking towards the next three months of trade, tenured forex traders understand that fair value on the USD, and on risk, will be all about the phase that global business cycle are entering. The stages are; Trough> Expansion> Growth> Peak> Contraction. The five cycles take 10-15 years on average to work through and complete. The U.S. economy however has been completing the cycle in half that time, and that is making USD long-term valuations harder to reliably plan.
Therefore, when in Trough-to-Expansion, or Peak-to-Contraction phases, the market runs on risk neutrality and stocks dominate reads on fair value. This leads to a very high correlation (averaging 90%) between equity trade and USD movement; stocks go up and USD goes down.
When we get into the Expansion or Contraction, phase, and either one is in full flow (lasting a 5-8-year period globally, or 2-3 years in the US) risk tolerance takes over, interest rate differentials dominate the valuation of currencies, and stock market correlations reduce (averaging 60%). Fair value on risk and on the USD becomes all about growth and interest rates.

Fed Fund Phase:
In times of Growth the USD will increase against those currencies not showing inflation, and/or, higher interest rate outlooks. As and when the Federal Reserve raise overnight interest rates, it will be because of an inflation fear coming from economic expansion, and it will very likely be in a drip-fed manner of slow and steady increments as the attempt to keep the speculative interest on the long side of the USD at bay.
However, the USD will then be challenged by regional growth that does not carry the weight of massive debt and current account/trade imbalances. The USD may never get back to 90.00 on the dollar index if global regions expand at the same pace as America. As in 1972 under President Nixon, it looks as though the U.S. in 2009 has set up USD devaluation with an over-commitment to Treasury debt that now looks challenging, to say the least.

Weak Dollar Phase:
Forex traders will be looking again at whether the global economy is prepared to welcome a slimmed down version of the greenback, something that seems a ‘must-have’ for the Federal Reserve. That however can only happen in the current environment with an increasing global equity market, and a boisterous oil market arena that maintains a high level of long speculative interest.
We have to go back to the rule book set in 1972-73 when the last major forex rule was torn up and re-set, to a time that the dollar index was born if we are to gauge the potential in an ever-decreasing USD value Traders and investors may have to accept that going forward the USD/Risk link may become eroded as the debt mountain surpasses equity direction as the thing that helps or impedes daily USD valuations.

Percentage Risk Phase:
Following the laws of probability and the (Shwartz Stock Market Handbook has it as historically being the worst performing equity time of the year), forex trader eyes will be all about whether the USD gets bought in the same number as previously seen in the recent Risk Averse periods of trade. If stocks pull back and the USD does not get bought at a 90% correlated rate, we will have a signal of two things;
Firstly, that the market is valuing risk on forward Growth and interest rate differentials. Secondly, that the equity pull-back may be a technical signal that it will find support before making the next leg higher, rather than being the start of an equity collapse.
Risk Tolerance and Interest Rates will be affected by the global business cycle. Whatever the headlines roar about this session being tolerant on risk, or not, we now fully understand that at this pivotal a time, risk will be seen in the percentage correlation between equities and the USD changing.

Forex Trader Phase:
Forex traders will be looking to see that USD/CHF is moving hard when they place their trades, if not they will be questioning the moves because Swissy has become correlated to dollar index moves holding, or not. They will also be looking for oil and S&P futures markets to stay aligned, because in any play in forex, whatever the pair being traded, the USD does affect the momentum flow.
The USD affects every major traded cross pair, for example; EUR/USD x USD/JPY = EUR/JPY. Also, EUR/USD ÷ GBP/USD = EUR/GBP. The synthetic pairs (no USD on one side or the other) can only move as a percentage of the change in the major pair moves against the USD; knowing what the drivers of the USD are doing allows for targets to be realistically set, and lot size accordingly adjusted.
Getting secondary confirmation from inter-related markets is a must-do for any level forex trader, especially when fair value on risk is so hard to find as global markets transition from Trough to Growth.

Reference: The LFB Team

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