I appreciate the article about the timing strategy and looking back from your previous weekly habits, you have made the analysis about eur/usd.
Habits for Week of December 8, 2013 – December 13, 2013
“Just as the AUD/USD is around 5-10% too high, so too is EUR/USD and GBP/USD. Perhaps not by 1,000 pips overpriced, but around 200-600 pips or so. That is why I am not chasing them higher since the bulls risk macro exhaustion. GBP may be 200-600 pips overpriced. EUR can be 500 – 2,000 pips overpriced, if the ECB does some form of QE or other measures to boost growth.”
My question is, how did you determine that EUR/USD and GBP/USD were exhausted by around 200-600 pips or so? Any general insight will be much appreciated since I really like fading strategy. (either in shorting rallies/buying lows based on prevailing long-term sentiment) … What I don’t get is exhaustion levels (profit taking or macro exhaustion)
I use my overall knowledge of the information flow, news, way the market is responding to things. And my knowledge of the way economies work and what potential changes may occur in the macro situation. That would be the simple answer.
Let me try to elaborate.
The way I see it, assuming that the US econ is experience some stronger growth, enough for the Fed to taper gradually over 2014, then that should help boost the USD slightly. By slightly I don’t expect a 1,000 pip drop in the EUR/USD and GBP/USD purely on USD bullish forces from a gradual taper, because the taper is well, gradual. When QE was enacted, the USD may have gotten hit really hard because the QE was big and fast and overwhelming. And when they did open ended QE, the market was unsure when it would stop. So usually the tapering process of QE for the FED, would be more gradual than the QE starting process.
I also see that USD/JPY has gone up and AUD/USD has gone down. That is from a combo of mostly JPY weakness and AUD weakness, and only very slight USD strength. The USD has been overall flat versus the EUR or GBP to slightly lower with EUR/USD and GBP/USD grinding higher. I am not sure why they went slight higher. For the EUR it could be flows into peripheral debt to take advantage of the perceived bargain yields there. For GBP it could be because people believe the economy is recovering and the BoE is not really considering more QE, while the Fed still is buying 75 bln per month.
That would be my analysis from the USD side and economy. Throughout this process, the U.S. economy has been recovering nicely, but that strength in the econ has not really been factored into in the EUR/USD and GBP/USD.
Now to go onto the EUR and GBP.
The EUR is experiencing low inflation and weak growth. You can tell the weak inflation by the monthly numbers that come out. Last reading was at 0.9% y/y number. That is well below the 2.00% inflation target, and it can remain low due to: Weak / restrained energy and agricultural and commodity prices and due to the sluggish growth in the Eurozone. That is the key insight and principle: If commodity prices are lower / restrained, then that can mean inflation is lower / restrained due to the business input costs are lower, and food inflation is not very high, etc. The next insight would be: If the economic growth is slower, that would put less pressure on inflation, since the consumers and businesses in the Eurozone do not have as much money to spend since growth is slow. If you compare GDP growth at 3.00% per year compared to 0.5% GDP growth, then the countries / zones that have higher GDP growth would tend to experience higher inflation than the countries that have lower GDP growth rates since consumers and businesses would be spending more money and demand growth would be higher. Many Eurozone countries are still trying to recover from the debt restructuring and reduction in govt spending, and if growth is slow, and unemployment is high, that would tend to push inflation lower rather than higher.
So knowing that the inflation is low and the growth is still on the weak side, the EUR shouldn’t be going higher. Another key insight from macro order flow economics is: If a currency goes higher, that can push down inflation, and weaken export growth (and weaken GDP growth). So taking all this into consideration, the EUR rising slightly doesn’t help the Eurozone boost inflation or boost growth. So that is why I am willing and many times fading the rallies in the EUR/USD when it trips topside stops above the daily highs.
It is my perception that the bulls risk macro exhaustion in the EUR/USD when it trips topside stops because of the above analysis I just did.
GBP is in a similar, but slightly different situation that EUR. U.K. has around 2.00% inflation, and they are in stronger growth and recovery mode. However, even the BoE said in their Meeting Minutes that: “Any further substantial appreciation of sterling would pose additional risks to the balance of demand growth and to the recovery.” So the U.K. is fine with their inflation, but the BoE believes that if the GBP continues to rally, it could cause growth to slow. They just use the more elaborate language of “pose additional risks to the balance of demand growth and to the recovery.”
So that is why the GBP/USD bulls risk macro exhaustion if they trip topside stops.
So just based on general slightly overextended positioning, the EUR/USD and GBP/USD can drop 200-300 pips from the highs as disappointed bulls and some slight bullish USD and slight bearish EUR and GBP macro order flow causes the sell off. But any further sell off in EUR/USD and GBP/USD may require either stronger US data and faster taper and/or some weaker econ data and/or policy action from the ECB and BOE.
So GBP/USD dropping 200 – 600 pips can relieve the pressure of the strong GBP hampering the UK recovery. However, the Eurozone is in a bit worse shape with both low inflation and weaker growth. So that is why I believe EUR potential downside is more open ended. ECB adopting QE would be a big game changing event that can cause the EUR to drop 1,000 – 3,000 pips, but that is a long shot and extreme scenario given the current information. The current ECB Governing Council doesn’t want to seriously consider it. They want to let the economy heal on its own and not try to do a QE experiment like U.S., Japan, U.K, etc. Also if the EUR goes down, then the EUR/GBP can go down as well, causing GBP to be supported on the dips.
The exhaustion levels in the form of profit taking/short covering and macro exhaustion of the scenario happen due to my interpretation of the information flow and analysis that I do like the one above. Now granted, it all happens more quickly in my mind. I elaborated it for you above because I wanted to show you the thinking process step by step of what goes on in my head and how I make the connections to the country economy and its effects, etc. I am constantly playing out scenarios in my mind. For example: If a market breaks out higher I am asking myself: What scenario is the person who is buying top tick betting on? Is that scenario exhausted or does it still have room to play itself out? In the case of currencies it is based on my knowledge of the macro economy, of the information flow and news impacts, etc I come up with my answer. If I was analyzing a stock for instance, then I would have to attain an understanding of the various company specific and industry specific scenarios and catalysts that can cause it to move, etc as well as the general macro economy and environment for equities.