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Strategies, analysis, and news for FX traders

December 2011 Volume 8, No. 12

Dollars down under: Aussie and kiwi outlook p. 6

Dollar index deconstruction: Understanding the DXY’s drivers p. 22

The European crisis and the forex market p. 12

Conducting a walk-forward test on an FX volatility breakout system p. 18

CONTENTS

Contributors .................................................4 Global Markets Aussie up, Aussie down .............................6
Analysts argue whether the currencies have put in long-term tops, but all agree risk sentiment remains key to the prospects for the Aussie and New Zealand dollars. By Currency Trader Staff

Global Economic Calendar ........................ 28
Important dates for currency traders.

Events .......................................................28
Conferences, seminars, and other events.

Currency Futures Snapshot ................. 29 International Markets ............................ 30
Numbers from the global forex, stock, and interest-rate markets.

On the Money............................................12 The long, deep game
If it can survive its crisis with only Greece leaving the EMU, Europe will have the gold-standard currency for a whole new generation. To that end, the IMF may end up getting involved. By Barbara Rockefeller

Trading Strategies Walk-forward analysis of a volatility breakout system ...................................... 18
Progressively updating a trading system to recent market data provides insight into how robust the technique is and allows it to adjust to changing market conditions. By Daniel Fernandez

Looking for an advertiser?
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Advanced Concepts Decomposing the Dollar Index ............... 22
Analyzing the DXY shows how all trades involve comparing alternatives — and those alternatives have to be accounted for on a complete cost basis. By Howard L. Simons

Questions or comments?
Submit editorial queries or comments to [email protected]
2 December 2011 • CURRENCY TRADER

CONTRIBUTORS
q Howard Simons is president of Rosewood Trading Inc. and a strategist for Bianco Research. He writes and speaks frequently on a wide range of economic and financial market issues.
A publication of Active Trader ®

For all subscriber services:
www.currencytradermag.com

Editor-in-chief: Mark Etzkorn [email protected] Managing editor: Molly Goad [email protected] Contributing editor: Howard Simons

q Barbara Rockefeller (www.rts-forex.com) is an international economist with a focus on foreign exchange. She has worked as a forecaster, trader, and consultant at Citibank and other financial institutions, and currently publishes two daily reports on foreign exchange. Rockefeller is the author of Technical Analysis for Dummies, Second Edition (Wiley, 2011), 24/7 Trading Around the Clock, Around the World (John Wiley & Sons, 2000), The Global Trader (John Wiley & Sons, 2001), and How to Invest Internationally, published in Japan in 1999. A book tentatively titled How to Trade FX is in the works. Rockefeller is on the board of directors of a large European hedge fund. q Daniel Fernandez is an active trader with a strong interest in calculus, statistics, and economics who has been focusing on the analysis of forex trading strategies, particularly algorithmic trading and the mathematical evaluation of long-term system profitability. For the past two years he has published his research and opinions on his blog “Reviewing Everything Forex,” which also includes reviews of commercial and free trading systems and general interest articles on forex trading (http://mechanicalforex.com). Fernandez is a graduate of the National University of Colombia, where he majored in chemistry, concentrating in computational chemistry. He can be reached at [email protected].

Contributing writers: Barbara Rockefeller, Marc Chandler, Chris Peters Editorial assistant and webmaster: Kesha Green [email protected]

President: Phil Dorman [email protected] Publisher, ad sales: Bob Dorman [email protected] Classified ad sales: Mark Seger [email protected]

Volume 8, Issue 12. Currency Trader is published monthly by TechInfo, Inc., PO Box 487, Lake Zurich, Illinois 60047. Copyright © 2011 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Currency Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

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December 2011 • CURRENCY TRADER

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GLOBAL MARKETS

Aussie up, Aussie down
Analysts argue whether the currencies have put in long-term tops, but all agree risk sentiment remains key to the prospects for the Australian and New Zealand dollars.
BY CURRENCY TRADER STAFF

In early December, the Australian/U.S. dollar pair (AUD/ USD) had been trading at virtually the same level it was at the end of 2010, around 1.0200 (Figure 1). However, that nearly unchanged value doesn’t reflect the major swings

the pair made throughout the year. The AUD/USD rate hit 1.1080 in July — its highest level since January 1982. However, as the Eurozone sovereign debt situation continued to deteriorate in late summer and early fall, AUD/USD plunged below parity to .9387 in early October as risk FIGURE 1: WEEKLY AUSSIE/U.S. DOLLAR aversion swept the globe and money managers rushed back into the perceived safety of the U.S. dollar and U.S. dollar denominated debt (Figure 2). The Aussie dollar clearly was held captive to the risk-on, risk-off outlook in global money swings. “Amongst the G-10 currencies, the Aussie is everyone’s favorite due to its [high] yield and strong fiscal and growth fundamentals,” says Greg Anderson, senior FX strategist at Citi. “But when the markets get into a panic, [money managers] close off long positions in the Aussie.” In early December, risk appetite was at least temporarily back on, which is short-term bullish for Aussie/dollar. As the new year approaches, several questions swirl around the Aussie currency, including whether the latest The Aussie dollar entered December 2011 almost exactly where it ended move by the Reserve Bank of Australia December 2010, but it moved around a lot in between. signals the start of a new monetary Source for all figures: TradeStation
December 2011 • CURRENCY TRADER

6

FIGURE 2: DAILY AUSSIE/DOLLAR policy trend or was it simply a onetime cut? Also, the New Zealand dollar (“kiwi”) often trades in the same manner as the Aussie dollar, but is not as favored by bigger players because of its lower liquidity. Will the kiwi face the same issues as the Aussie dollar?

Fundamentals

Australia weathered the 2008-2009 global financial crisis the best among G-10 nations, escaping the sustained negative growth suffered by virtually every other mature economy. “It was the only major advanced industrialized nation to sidestep recession,” says Wells Fargo economist Tim Quinlan. “They only had one quarter of negative The AUD/USD pair sold off fairly sharply after peaking above 1.1000 in July. GDP growth.” The accepted economic definition of recession is two consecumining boom, which has contributed to a low unemploytive quarters of negative GDP growth. ment rate and solid wage growth. However, a number of challenges and setbacks for the Overall, Australian growth is led by its exports, with Aussie economy emerged in early 2011, including the mascoal accounting for a major portion. Ieisha Montgomery, sive devastation from the floods in the northeast portion associate economist at Northern Trust, says coal representof the country. Also, the Japanese earthquake and tsunami impacted Australian growth because a good deal of Aussie ed 19.8 percent of Australia’s total export basket, with 25 percent of their exports heading to China and 19 percent exports end up in Japan. to Japan. Australia’s top four trading partners are China, “These factors held back the Aussie economy,” Quinlan Japan, South Korea, and India, which leaves the Eurozone says, noting the country’s -3.4 percent GDP figure for and the U.S. having much less influence on their overall the first quarter of 2011. However, Q2 saw the economy growth. Quinlan notes that only 4.1 percent of Australia’s bounce back with a 4.8-percent growth rate. exports head to Europe, with 4.0 percent winding their Overall, bright spots remain, which analysts believe way to the U.S. should keep Australia’s annual GDP in positive terriNonetheless, despite a looser connection between tory. “We expect the Australian economy will grow 1.8 Australia and Western Europe, what unfolds ahead in percent in 2011,” says Katrina Ell, associate economist the Eurozone and U.S. will trickle back to Australia in the with Moody’s Analytics. “We expect GDP will grow 4 permonths ahead. cent in 2012 as mining investment and reconstruction in “Ultimately, all [Australian] exports to China are raw Queensland drive stronger growth. Australia’s economy materials, which are turned into manufactured goods and is showing signs of resilience amid a gloomy global backdrop. The mining boom is pushing full steam ahead, which sold to many places, including Europe,” Quinlan says. The biggest risk to Australia’s economic outlook is a is driving strong expansion in construction and investmarked slowdown in China, which would weigh heavily ment.” Ell adds the entire country is benefiting from the
CURRENCY TRADER • December 2011 7

GLOBAL MARKETS

on demand for Australia’s resources and prompt businesses to abandon investment plans, Ell explains. “The spillover to weaker employment, confidence, and household incomes would cause consumers to pull back,” she says. “Nevertheless, China is headed for a soft landing in 2012, and if this [view] looks at risk, the Chinese government has the capacity to respond swiftly. Meanwhile, if conditions in Europe deteriorate markedly, credit conditions could tighten and trigger a crisis of confidence.” Even if Australia begins to slow, Ell is optimistic the country is well positioned to deal with moderating growth. “If Australia’s growth is hampered, monetary and fiscal policymakers have scope to stimulate the economy,” she says. “Policymakers would lower interest rates to stimulate consumer spending and the housing market. Sound fiscal management and a low debt burden give the government room to provide a fiscal stimulus and still preserve the economy’s long-term prospects.”

remain on the sidelines and keep rates on hold for the foreseeable future, despite market expectations for further cuts,” Ell says. “However, if Europe’s debt situation worsens and impacts Australia and its trading partners, further rate cuts are expected.” Anderson says the interest-rate outlook for Australia hinges on the external environment, because the domestic situation “probably doesn’t warrant a rate cut.”

New Zealand fundamentals

Monetary policy

After a year on hold, on Nov. 1 the Reserve Bank of Australia (RBA) cut its official monetary policy rate by 0.25 percent to 4.50 percent. “The official rate in Australia, now at 4.5 percent, is still the highest rate among the world’s developed economies,” wrote Wells Fargo economists in the Nov. 16 Global Chartbook research note. “The cut reflects a move from a restrictive monetary policy to one that is more accommodative in light of the weaker global growth outlook. While the headline rate of inflation remains slightly elevated, the downtrend in the core inflation rate grants the RBA the scope necessary to pivot its policy to a more supportive stance without concern on engendering runaway inflation.” Why did they ease? “In the months leading up to the meeting there was continued deterioration in the European sovereign-debt situation, which had the IMF and OECD downwardly revise forecasts for emerging [country] growth,” Quinlan says. He adds that with approximately 66 percent of Australia’s exports heading to either Japan or emerging-market economies, slower growth in emerging economies would dampen demand for Australia’s export sector. Most market watchers expect the RBA to take a waitand-see approach in the near term. The bank is scheduled to meet on Dec. 6; most analysts anticipate it will hold steady on rates. “The Reserve Bank of Australia will likely
8

On the New Zealand front, Moody’s Analytics forecasts overall 1.2 percent GDP growth in 2011 and a 1.6 percent forecast for 2012. Overall, the country’s economy is slightly lagging its larger neighbor. “New Zealand’s economy is growing below trend, with persistent household deleveraging contributing to weak private consumption,” says Fred Gibson, associate economist at Moody’s Analytics. “Given the government’s commitment to returning the budget to surplus by 2015, the public sector is providing minimal support to growth. On the upside, soft commodity exports are strengthening as Asia’s growing middle class demands a high quality and reliable source of dairy and meat products.” While Australia’s outlook depends heavily on China and emerging Asia, New Zealand can be viewed as a little sister to Australia, heavily dependent on the country’s economic fortunes. “Australia is New Zealand’s biggest trading partner,” Montgomery explains, noting that 23 percent of New Zealand exports head to Australia, with 11.2 percent going to China. Some of its key exports include forestry products, meat, dairy, and wool. Interestingly, the major earthquake that struck New Zealand in February 2011 should actually contribute to better GDP figures in 2012. “Earthquake reconstruction should ramp up growth in 2012 and should help the real estate sector,” Montgomery says. She’s forecasting 2.8 percent GDP growth in New Zealand next year. New Zealand has several other factors working in its favor. “Sustained Asian demand for New Zealand’s soft commodity exports is helping support growth,” Gibson says. “The recent Rugby World Cup and the influx of some 85,000-plus tourists have helped drive a rise in retail spending. Investment is building gradually as capital imports grow, suggesting firms are gearing up to rebuild
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GLOBAL MARKETS

Christchurch.” The kiwi/dollar rate (NZD/USD) has also come under pressure in the early fall months because of the same factors impacting the Aussie dollar (Figure 3). “The major driver behind the sustained depreciation of the kiwi has been increased risk aversion because of Europe’s sovereign debt crisis,” Gibson says. “Growing uncertainty and volatility in financial markets have prompted investors to shun perceived riskier currencies such as the kiwi in favor of haven currencies such as the yen. This has caused the kiwi to depreciate sharply, despite little change in economic fundamentals since July.” For now, market watchers see the Reserve Bank of New Zealand (RBNZ) on hold at 2.50 percent, after a rate cut in the aftermath of the February earthquake. “We believe that rates will remain on hold until March 2012 to help safeguard growth against a deteriorating global recovery,” Gibson says. “Barring another global credit crunch, we think the RBNZ will start its tightening cycle

from March 2012 by reversing this year’s 50-basis-point insurance cut. A further 25-basis-point hike is expected in the third quarter of 2012.”

Forex action

Risk appetite and prevailing market sentiment will likely drive the Aussie dollar in the near future. “The second risk comes off, people come back in and buy Aussie first,” Anderson notes. “That will continue next year. I expect it to be the star performer in the G-10.” Anderson holds a roughly comparable view for the kiwi/dollar: “It’s similar, but not quite as liquid. It doesn’t have as high a yield, so it’s slightly less attractive,” he explains.

There is some discord among analysts regarding the summer highs scored by the Aussie and kiwi dollars. Some say those could represent major long-term tops for the currencies, while others expect renewed strength later in 2012. FIGURE 3: DAILY KIWI Among those expecting these highs to represent longer-term resistance is Stephen Roberts, chief economist-Australia at Nomura. When asked if the 1.1000 area represented an important high, Roberts says it “probably [will be] a peak for quite a while to come given the likely persistent headwinds to global growth prospects from fiscal consolidation and deleveraging in much of the developed world.” Sean Callow, senior currency strategist at Westpac Institutional Bank, holds a similar view. “It is indeed looking increasingly as though the mid-2011 peaks around 1.1000 were the cycle high for AUD/ USD,” he says. “Since then we have had a sea change in the RBA view, from a firm tightening bias to an The New Zealand dollar also declined after hitting new highs over the summer. It’s fate is actual rate cut, and more to come. largely tied to that of its Australian cousin. AUD has lost some of its high yield
December 2011 • CURRENCY TRADER

Major tops?

10

luster, with the two-year bond spread falling below 300 basis points for the first time since July 2009. As the global economy has cooled, Australia’s commodity prices have fallen about 17 percent from the April highs. Along with heightened equity volatility, such factors produce fair value estimates no higher than the low .90s.” However, Callow adds it’s by no means all doom and gloom for the AUD. “Should the U.S. economy slow enough for the Fed to adopt QE3, AUD would be one of the key beneficiaries — quite possibly the best performer,” he says. “Moreover, Australia’s very strong fiscal position should underpin demand for AUD government bonds.” He explains the Australian government noted in its midfiscal-year update that “the average net debt position of the major advanced economies (G7) is projected to reach 92.9 percent of GDP in 2016, more than 10 times higher than the expected peak in Australia’s net debt of 8.9 percent of GDP.” There has been no sign of slackening in demand for Australian Commonwealth government bonds, he says. “Australia’s trade position should also remain stronger than its historical average, with mining sector investment very robust and the terms of trade holding at elevated levels despite decline in recent months,” Callow says. “So while European turmoil may well knock AUD/USD to, say, 0.93 before year end, we do not expect a slide of anywhere near the magnitude of late 2008.” Turing to the kiwi, he notes that “NZD/USD should swing with global risk sentiment as AUD does, with our one-month target at 0.71.”

Michael Woolfolk, managing director at BNY Mellon, offers a more optimistic scenario. “We expect risk appetite to rebound next year on resolution of the European debt crisis,” he says. Assuming that unfolds, Woolfolk cited his firm’s forecasts for the Aussie/ dollar pair to hit 1.1000 by the middle of 2012 and 1.1500 by the end of the year. Part of that view, Woolfolk explains, includes a generally negative outlook for the U.S. dollar, with U.S. interest rates expected to stay at zero and the belief the U.S. Fed will engage in some form of quantitative easing, he says. “Once we get some type of finality to the European situ-

“Should the U.S. economy slow enough for the Fed to adopt QE3, AUD would be one of the key beneficiaries — quite possibly the best performer.”
—Sean Callow, senior currency strategist at Westpac Institutional Bank

Euro resolution

Brian Dolan, chief currency strategist at Forex.com, says the Eurozone debt crisis will be a pivotal factor for the Aussie dollar in the weeks and months ahead. “Aussie/dollar is still captive to overall risk sentiment, which is dominated by the Eurozone debt crisis,” he says. “Unless the ECB changes its mandate to enable it to buy government debt directly or it steps in to lend to the IMF [so they can buy Eurozone debt], it is likely to keep Aussie and kiwi under pressure.”
CURRENCY TRADER • December 2011

ation, the safe-haven flows will reverse and leave the U.S., which will be favorable for the Aussie, loonie (Canadian dollar) and dollar bloc as well,” Woolfolk says. He highlights targets of 0.8730 for kiwi/dollar by mid-year and 0.9350 for year-end 2012. “Don’t be sucked into the Euro break-up scenario that is being peddled right now,” he adds. “It’s not going to happen. The Eurozone will survive and prosper in the coming years, though maybe with a few less members.” y

11

On THE MONEY ON the Money

The long, deep game
If it can survive its crisis with only Greece leaving the EMU, Europe will have the gold-standard currency for a whole new generation. To that end, the IMF may end up getting involved.
BY BARBARA ROCKEFELLER

Europe seems to be on the financial rocks, with five of 17 governments having fallen this year, peripheral bond yields at eye-watering levels, and even Germany unable to sell bonds. European equity markets are tanking and taking other markets with them. Data indicates a recession is looming; the Bundesbank forecasts 0.5-percent German GDP growth in 2012 at the low end. Nonetheless, Figure 1 shows the Euro/U.S. dollar pair (EUR/USD) is not dramatically below the midpoint (1.3958) of the range from its high of 1.6038 on July 18, FIGURE 1: EUR/USD

2008, to its low of 1.1877 on June 11, 2010. In fact, in April of this year the Euro penetrated upside resistance, and although in September it broke downside support, the secondary support line (gray) in Figure 1 may hold. We can complain about the market’s asymmetrical treatment of the Euro (good news is overvalued and bad news is dismissed or downplayed), but the Euro’s resilience reflects more than a Teflon coating — it’s miraculous. If all these woes befell another currency, it would have depreciated by 20 to 40 percent or more. Somewhere, presumably, there must be long-term investors with an abiding faith in the sustainability of the Eurozone experiment and the principles that underlie the Euro. If we use the two-year note as the correct benchmark during a crisis, we see some distress and divergence between the Euro and German twoyear note, but still a strong correlation (Figure 2). Since the Germans would rather underfund an auction than pay too high a price, the Euro still has a strong foundation.

Europe on the rocks

Despite Europe’s woes, the EUR/USD pair is not dramatically below the midpoint of its July 2008 to June 2010 range.
Source: Chart — Metastock; data — Reuters and eSignal

In late November Germany auctioned €6 billion worth of 10-year bunds but was able to sell only €3.64 billion, or 60 percent, with an average yield of 1.98 percent. The bid-to-cover ratio was a horrible 1.1, compared to a bidto-cover of 3.15 the day before in U.S. five-year notes, which was the highest on record in the past 10 years. The U.S. sold seven times as much, too — $35 billion. In the weeks leading up to the failed German auction, Market
December 2011 • CURRENCY TRADER

12

News International (MNI) reported large Asian players you have been elected; none of you have any democratic were selling European bonds, including bunds. However, legitimacy for the roles you currently hold within this crion many days MNI was also reporting large Asian players sis. And into this vacuum, albeit reluctantly, has stepped were continuing to buy Euros at interim lows, presumably Angela Merkel. And we are now living in a Germanfor reserve diversification purposes. dominated Europe — something that the European projMeanwhile, as political crises swelled and receded in ect was actually supposed to stop. Something that those Greece, Italy, and Spain, the 10-year yield on their bonds who went before us actually paid a heavy price in blood rose above 6 percent and, for Italy, above 7 percent — the to prevent. I don’t want to live in a German-dominated level at which other governments (Ireland, Portugal) had Europe and nor do the citizens of Europe.” (Source: www. fallen. Sure enough, all three governments were replaced. ukipmeps.org/articles_263_Farage-Puppet-governmentsThe new leaders will institute the same reforms and installed-in-Greece-and-Italy.html.) austerity budgets as the already fallen governments, so This speech is a “Holy cow!” moment. Farage is railing economically and financially nothing has changed except as much against a German-dominated Europe as against the names on the doors. In fact, it’s still not clear Greece inadequate leadership. But he is wrong. A Germanwill be getting the €8 billion of bailout money if two new dominated Europe is exactly what Europe has had for government coalition partners continue to refuse to sign more than a century and also exactly what the EMU memthe reform/austerity letter demanded by the European bers states signed on for when they signed the Maastricht Commission — a cliffhanger. Treaty. Everyone recognizes government deficits need to be cut The key components of the Maastricht Treaty are an pretty much everywhere and the financial sector needs independent central bank based on Bundesbank prinrecapitalization. Germany and the new ECB President ciples — specifically, one in which all policy decisions are Mario Draghi insist the ECB not be used as a lender of directed toward low inflation. Hard on the heels of the last resort and that there be no new pan-EMU Eurobond Maastricht Treaty came another German initiative, the issuance, but a viable European Financial Stability Facility Stability and Growth Pact, which limits annual deficits to 3 (EFSF) backstop has yet to be designed. percent of GDP and total government debt to 60 percent of Vitriol abounds. In a recent diatribe, Nick Farage, a GDP. The signatories to these two treaties were willing to British member of the European Parliament, said it was a agree with Germany on these issues for one simple disgrace for the EU to be ousting democratically elected reason — German could reunify East and West sectors on governments in Greece and Italy. Addressing EU President its own terms but would give up the Deutsche mark. Herman Van Rompuy, European Commission FIGURE 2: GERMAN TWO-YEAR NOTE chief José Manuel Barroso, Eurogroup leader Jean-Claude Juncker, and EFSF president Olli Rehn, Farage said, “Here we are on the edge of a financial and social disaster and in the room today we have the four men who are supposed to be responsible. And yet we have listened to the dullest, most technocratic speeches I’ve ever heard ... You are all in denial. By any objective measure the Euro is a failure. And who exactly is responsible, who is in charge out of all you There is still a strong correlation between the Euro and German two-year note. lot? The answer is none Source: www.fxthoughts.com of you because none of
CURRENCY TRADER • December 2011 13

ON THE MONEY

Consider the timeline. Reunification began in 1990, the Maastricht Treaty forming the Eurozone was signed in 1992, and the Stability and Growth Pact was signed in 1997. The Euro was launched Jan. 1, 1999. Why was it worth anything to the other countries that Germany would give up the Deutsche mark? Their currencies had been explicitly pegged to the DM (or at least compared to it) for decades, in the “snake” and the European Rate Mechanism (ERM). The Deutsche mark was the standard for excellence in economic management in the post-war world. The other countries wanted to reduce the influence of Germany (and the Bundesbank) on the other European economies and currencies. Germany giving up the Deutsche mark was a realworld way of doing that, far beyond its symbolic value. In effect, what Germany gave up was its central place in the currency world. And what did the rest of Europe get out of it? By sheltering under the Eurozone umbrella they got lower interest rates than they could have gotten on their own. They got rid of periodic currency crises and painful devaluations. They got capital inflows inspired by relative currency market stability. They also got bigger transfers in the form of agricultural and development subsidies. Whole towns were rebuilt on European money, including the port city of Valencia, Spain, which went on to host the Americas Cup yacht race. To be fair, Germany gave up something it didn’t want in the first place: the potential for the DM to be the target of destabilizing hot-money inflows in crises, much as the Swiss franc is today. But Germany benefits in other ways, too. The German export boom over the past decade is due as much to other EMU members as to emerging markets. Think-tank analyst Sebastian Mallaby, the Paul A. Volcker senior fellow in international economics at the Council on Foreign Relations, wrote in the Nov. 24, 2011 Financial Times: “[T]he currency union that makes adjustment in the periphery so excruciating is the very same currency union that handed Germany its export boom. Rather than con14

The U.S. has had a depreciation policy for most of the 40 years since President Nixon took the U.S. off the gold standard in 1971.

demning lazy southerners, the Germans should share the loot. “Germany has benefited more than it acknowledges through the monetary channel, too. During the Euro’s first decade, interest rates across the Eurozone fell toward German ones, and low-saving southern countries appeared to derive a subsidy from the credit rating of high-saving northern ones. But, far from being a boon to the periphery, centralized monetary policy proved appropriate for the EU’s mature core, but too loose for inflation-prone catchup economies. By an irony that inflation-hating Germans have trouble seeing, Ireland and Spain suffered property and banking busts at least partly because monetary policy was too German. Rather than scorn the losers, Germany should compensate them.” Mallaby is defending the point of view that Germany should be willing to pay more to save the Eurozone. Whether in the form of the ECB “monetizing” debt (like the Fed), backing a Eurobond, or through some other measure, Germany should rebalance its perception of self-interest; it has a lot to lose if the Eurozone were to break up. Eurozone political leaders, especially in France, have baldly stated they want the Euro to supplant the dollar as the world’s reserve currency. Becoming the reserve currency is not a stated goal of any of the treaties, but it’s surely present in the back of everyone’s mind. Another concept at work is that “no country ever prospered by devaluing its currency.” So while academics and technocrats plead for the ECB to become a lender of last resort, possibly going as far as engaging in quantitative easing (as conducted by Japan, the U.S., the UK, and even Switzerland), Germany and the ECB oppose this form of monetization of debt. They say their opposition is to enforce the Stability Pact, but underlying the Stability Pact is the core concept that monetization leads to devaluation. The tactic of monetizing debt flies in the face of the long game, which is to forge a stable currency based on the
December 2011 • CURRENCY TRADER

Consider the assumptions

expectation of no inflation or devaluation, ever. German Chancellor Angela Merkel and the Bundesbank want the Euro to be as well-grounded as the Deutsche mark. Two top Bundesbank officials — President Axel Weber and Vice President Jürgen Stark — went so far as to resign on losing the argument that the ECB should buy a limited amount of sovereign debt. So far the ECB has bought less than €300 billion in sovereign debt in the secondary market — Stark and Weber presumably would have had the amount be zero. Current Bundesbank chief Jens Weidmann has taken upon himself the job as ECBwatcher and enforcer, saying “By assuming the role of lender of last resort for highly indebted member states, the bank would overextend its mandate and shed doubt on the legitimacy of its independence. To follow this path would be like drinking seawater to quench a thirst.” The Germans are accused of selfishness and even sabotage of the Eurozone experiment, but it’s possible to interpret their mulish stubbornness as something else: the desire to sponsor the world’s first bulletproof fiat currency. After all, let us not forget the U.S. has had a policy of depreciation for most of the 40 years since President Nixon took the U.S. off the gold standard in 1971. Sometimes it has been an explicit policy and the U.S. has bullied others into cooperating, such as the Nixon 10-percent import surcharge and trade deficit targets in 1973, as well as the Plaza Accord in 1985. Other times the policy was implicit. Rarely did the U.S. aim for a stable or appreciating currency, one of the exceptions being the Reagan-Volcker regime in the early 1980s. During the Clinton years, Treasury Secretary Robert Rubin declared “a strong dollar is in the U.S.’ best interests,” the so-called strong-dollar mantra, but by the time of the 2007-08 financial crisis and the advent of quantitative easing, the phrase was falling flat, even though current Treasury Secretary Timothy Geithner continues to say it. No one believes him: zero-percent interest rates, quantitative easing, and the “Twist” all point toward a weaker dollar, not a stronger one. The Fed’s fear of deflation is real, but many observers fear the refusal to live with and manage deflation can lead to only one thing — inflation down the road. The Fed asserts it has the means to identify impending inflation and the will to cut it off at the pass, but not everyone has confidence the Fed can deal with another round of the kind of stagflation the U.S. suffered after the first oil shock
CURRENCY TRADER • December 2011

If all these woes befell a currency other than the Euro, it would have depreciated by 20 percent or more.

in 1973. A sense of grim foreboding lies over the land. If the Eurozone can survive the current financial crisis with no more than one country leaving the EMU (Greece), Europe will be in the driver’s seat as the gold-standard currency for a whole new generation. It won’t matter whether the Fed is able to contain inflation, Europe will have the one thing investors want above all else: a rocksolid anti-inflation commitment. This is the long game Merkel and the Bundesbank are playing. At a guess, they won’t win without some help. This will mostly likely come from the International Monetary Fund (IMF), egged on by emerging-market countries such as Brazil, Russia, India, and China, who have already complained bitterly about U.S. policy being selfish and conducting the equivalent of a currency war. However, this term is inappropriate and there is little evidence the U.S. has a grand plan that entails deliberately harming other countries for its own self-interest. It would be more accurate — but no less damning — to say the U.S. is indifferent to hot-money inflows into emerging markets that arise from the quest for yield by investors and speculators. The U.S. has a split attitude toward market intervention: Let the markets rule when it’s global capital flows but hands off U.S. interventionist monetary policy directed toward U.S. institutions and the U.S. economy. What can the IMF do? Its mandate is to act as a lender of last resort to governments in temporary distress. We might think it’s embarrassing for a major player such as the EMU to seek and to accept financial aid from the IMF, although the UK is certainly a major player and has done it. Besides, the IMF insists on getting paid first and promptly (years, not decades), and so far has always succeeded. IMF aid is temporary and intended to restore imbalances in a crisis, which is precisely what exists in the Eurozone today. The IMF generally embraces a monetarist approach and fiscal retrenchment, which is fine with the Bundesbank and ECB. The IMF also usually calls for a devaluation, but that’s not a hard and fast rule. If the IMF could act as the lender of last resort, letting the ECB off the hook, the EMU would be buying time, exactly as it has been doing since Greece confessed to lying about its public finances in fall 2009. Recently the IMF announced it was preparing to expand its short-term lending facility, renamed from the “Precautionary Lending
15

ON THE MONEY

Barbara Rockefeller Currency Trader Mag Dec 2011 Figure 3: Major European Equity Indices

FIGURE 3: MAJOR EUROPEAN EQUITY INDICES
Black—German DAX Gold—French CAC Blue—Madrid Red—Athens

550

500

450

400

350

300

250
x10

2007F MA MJ J A S O N D 2009 A MJ J A S O N D 2010 A MJ J A S O N D 2011 A M J J A S O N D M M

European equity markets would be another beneficiary of a rallying Euro.
Source: Chart — Metastock; data — Reuters and eSignal

Line” to the “Precautionary Lending and Liquidity Line” (PLL). According to the IMF statement, the PLL will be available in “broader circumstances, including as insurance against future shocks and as a short-term liquidity window to address the needs of crisis bystanders during times of heightened regional or global stress and break the chains of contagion. It will be a lending facility designed to provide short-term liquidity to what it calls “crisis bystanders,” rather than just those impacted by natural disasters or rebuilding after a war. The IMF has available lending resources of about $652 billion, which together with €440 billion in the beefedup EFSF might be enough to pull both governments and banks out of the hole they are sliding into. In addition, the ECB could lend to the IMF to increase the amount, and the IMF can turn around and lend to any government seeking aid, such as Greece, Spain, or Italy. Note that almost all of the IMF’s lendable resources come from central banks — which, of course, includes the U.S. Federal Reserve, so the Fed would become a lender once-removed to distressed European governments. In fact, the ECB could borrow directly from the Fed under the central bank swap line and send that money to the IMF, too. You can view this as a neat trick by Germany to avoid responsibility or as a perfectly legitimate fall-back under current international finance rules. An interesting aspect of the IMF bailout idea is that it would allow the BRICs to get involved indirectly. China, for one, has declared support for some countries (including Spain) and for the EFSF, but evidently declined to make a new commitment when EFSF CEO Klaus Regling visited Beijing in November 2011. Note that the EFSF already operates in conjunction with the IMF. Because the
16

IMF demands it be repaid first, that might reassure BRIC members. A fun problem is if China were given the extra votes it “deserves” in the IMF based on population and GDP (as proposed at the Pittsburgh G20 meeting in 2009), it would have more votes than the smallest G7 country, Canada. Europe may have an incentive to stand behind China getting more IMF votes. Today, the single biggest voter and contributor to the IMF is the U.S., at 17 percent. Although the idea purloined from Karl von Clausewitz that finance is “war by other means” is a bit of a stretch, it sometimes seems to come close. At an Asian summit, the U.S. declared itself a “resident Pacific power, as a maritime nation, as a trading nation and as a guarantor of security in the Asia Pacific region.” The U.S. was warning China off from the South China Sea territorial fight it has been waging bilaterally with smaller countries in a grab for undersea resources. China backed down for the moment — territorial claims will be decided by a multilateral process, not by China bullying countries one-by-one. If and when it is announced the IMF has been called in to consult with the Eurogroup, ECB, European Commission, and/or the EFSF, we are at risk of a tremendous rally in the Euro. We don’t know for sure this is the German plan, but kicking the can down the road has worked so far, and in retrospect, has been leading to the IMF all along. Therefore, we do not buy into the scenario that has the Euro falling ever farther. In fact, it may stabilize near the midpoint of the range in Figure 1, around 1.3950. Keep in mind that another beneficiary of a rallying Euro will be European equity markets (Figure 3). y
For information on the author, see p. 4.

December 2011 • CURRENCY TRADER

CURRENCY TRADER • December 2011

17

TRADING STRATEGIES

Walk-forward analysis of a volatility breakout system
Progressively updating a trading system to recent market data provides insight into how robust the technique is and allows it to adjust to changing market conditions.
BY DANIEL FERNANDEZ

FIGURE 1: WALK-FORWARD TESTING

Walk-forward analysis applies optimized parameters from the most recent period (blue rectangles) to the subsequent forward-test periods (green rectangles), re-optimizing the parameters at regular intervals.
18

A frequent question that arises when developing a trading strategy is how to properly determine specific parameters. Because market conditions are constantly changing, it’s unrealistic to expect a system with fixed parameters to perform at a consistently high level over long time periods. But how do you decide if a strategy should use a certain stop-loss, profit target, or indicator period length rather than another? What’s the best way to adjust parameters over time? The answer to these questions usually comes through optimization — the process of testing multiple parameter values on historical data to see which set gives the best results — “best” being something that can be measured in different ways. However, optimization presents another problem: the potential for excessive “fitting” of a system to past market conditions, which is likely to result in far worse results in future trading. For example, say a trading system uses a moving average as one of its inputs and a historical test shows that a length of 24 days produced the highest net profit, but that all other lengths between 20 and 30 days performed poorly. Using a 24-day moving average length would be a poor choice for future trading because it is likely a fluke; this parameter selection is merely fitted to the past data conditions, which are unlikely to be repeated in the future.
December 2011 • CURRENCY TRADER October 2010 • CURRENCY

TABLE 1: STRATEGY STATISTICS
Annualized return 19.65% 32.87% 58% 1.41 10.79 1.94 171 Max. drawdown Win percent Reward/risk ratio Ulcer Index Profit factor No. of trades

Walk-forward analysis is one of the most powerful techniques for evaluating whether a strategy can survive the parameter selection process — that is, whether the idea of optimizing and using a given set of “best” parameters is justified. In this procedure a strategy is optimized for a period of x bars and the results of the optimization are used for y bars in the future, at which point the procedure is repeated to obtain the parameter settings for the subsequent trading period. This process of “walking” the strategy forward through successive sets of new data is designed to keep the system as up to date as possible with changing market conditions. Figure 1 illustrates how this is carried out. The blue rectangles represent the optimization periods and the green rectangles represent the subsequent forward-testing periods to which the optimized parameter settings are applied. By running a 10-year test with constant re-optimization and the use of the “best” parameters through every new forward-testing period, we can get a very good idea of how our strategy handles changing parameter values, and whether doing this makes sense.

The strategy’s performance statistics were solid — an average compound yearly profit of 19.65 percent and a maximum drawdown of 32.87 percent.

bilities (such as volatility adapted indicators). As a result, the only way the system can possibly adapt to evolving market conditions is by changing parameters x (the intraday move threshold that determines trade entry) and/or y (the holding period).

The walk-forward process

The system

To illustrate the walk-forward analysis process, we will use a daily time frame trend-following strategy (based on volatility breakouts) that includes two parameters. Basically, the system takes a position in the direction of the most recent day’s momentum (as determined by whether the close is above or below the open) as long as that momentum exceeds a certain threshold, the logic being that such a move will be followed by more price movement in the same direction:

1. Go long if the most recent day’s close is above the open and the open-to-close range is greater than x pips. 2. Go short if the most recent day’s close is below the open and the FIGURE 2: EQUITY CURVE open-to-close range is greater than x pips. 3. Close a position after it has been open for y days. 4. Only one trade can be open at a time. 5. Trade 0.00001 times the current account balance per signal. This type of strategy is perfect for illustrating walk-forward analysis because it has a limited number of parameters that can be optimized quickly and conveniently. Other than the position-sizing rule (step 5), the strategy has no inherent dynamic capa-

The strategy was applied to the Euro/U.S. dollar pair (EUR/USD) over a 10-year period starting in January 2001 and ending in January 2011, with optimization of parameters x and y conducted every 50 calendar days on the most recent 300 calendar days. Parameter x was optimized from 10 and 500 pips in 10-pip increments (10, 20, 30, 40…500), while y was optimized between one and 50 days in one-day increments (1, 2, 3, 4…50). The best result for each optimization period was defined as the largest net profit; the parameter set that produced this result was used for the subsequent segment of the forward test (the next 50-day period). Trading costs of 2 pips per trade were applied throughout the test. The primary advantage of this analysis is that it eliminates hindsight: Although we don’t know which parameters will be used for each upcoming 50-day period, we have a very clear process for establishing how to derive these values from the previous data. In the end we have a result that tells us how our strategy will behave if we had

The system was profitable overall, with one major drawdown followed by a new equity high at the end of the test window.

CURRENCY TRADER • December 2011

19

TRADING STRATEGIES

FIGURE 3: MONTHLY RETURNS

applied a constant set of rules for the selection of parameters through the whole test. Figure 2 shows the system’s equity curve using the parameters derived from the walk-forward process. The system was profitable overall, indicating the technique has an edge that is maintained in the long-term based on the constant re-optimization of the system’s parameters. Table 1 shows that the strategy’s basic performance metrics were quite good, with an average compound yearly profit of 19.65 percent and a maximum drawdown of 32.87 percent. The maximum drawdown length was 644 days, in line with what we would expect for a trend-following system on the daily time frame. The monthly returns in Figure 3 show the best-performing conditions for this system have actually developed within the past three years (despite the most significant drawdown also occurring during this period). This highlights how re-optimization allowed the strategy to function during the financial crisis even though such extreme conditions had not previously appeared in the test period. When a strategy fails to produce profitable results in walk-forward analysis, it implies the strategy’s best parameter choice always lagged the changes in market conditions. Such systems have a high probability of always giving curve-fitted results and there’s a high chance their profitability is entirely based on hindsight. It’s also interesting how the optimum parameters evolved over time. These changes show us how market conditions have changed and if the system has actually adapted. Figure 4 shows the entry (x, bottom) and exit (y, top) parameters oscillated
December 2011 • CURRENCY TRADER

Results

Re-optimization helped the strategy continue to perform during the financial crisis.

FIGURE 4: EVOLVING PARAMETER VALUES

The exit (top) and entry (bottom) parameters oscillated significantly over the course of the test.

20

TABLE 2: PARAMETER RANGES
x (entry) Max. 150 50 65 60 50 50 y (exit) 49 1 18 15 6 9

substantially throughout the test period, implying that the strategy’s character has varied significantly in response to changing market conditions. Table 2 shows the entry parameter ranged from 50 to 150 pips, had a median value of 60, and a mode (most frequently occurring value) of 50. (The estimated mode, which derives a hypothetical mode value based on a data set’s median and average values, was also 50.) The exit parameter (number of days until exit) ranged from 1 to 49, with a median of 15 (average 18) and a mode of 6 (estimated mode of 9). When extreme drastic market changes occurred (e.g., during the financial crisis) the system adapted by drastically reducing the time to exit trades (from 30 to six days between July 2007 and March 2009) and increasing the threshold for opening a trade (from 50 to 100 pips over the same period) — in essence adapting the system to the fact that larger, shorter-term moves were the best bet. Walk-forward analysis offers a way to build a trading strategy without any parameter-selection bias. You can

Min. Avg. Med. Mode Est. mode

Over time, the optimum value for the entry parameter (x) was a little more stable than the optimum exit parameter (y).

evaluate a strategy over a long-term period using a defined set of rules for choosing parameters, removing much of the potential hindsight and curve-fitting inherent in regular trading system creation. Using simple trading techniques, such as the one described here, and evaluating them through walk-forward analysis is an excellent way to determine their level of robustness. y
For information on the author, see p. 4.

CURRENCY TRADER • December 2011

21

ADVANCED CONCEPTS TRADING STRATEGIES

Decomposing the dollar index
Analyzing the DXY shows how all trades involve comparing alternatives — and those alternatives have to be accounted for on a complete cost basis.

BY HOWARD L. SIMONS
One of the cultural annoyances new traders have to overcome is the difference between the interbank and Chicago Mercantile Exchange’s International Monetary Market (IMM) conventions. The interbank market, with certain prominent exceptions such as the Euro, British pound, and both the Australian and New Zealand dollars, quotes currencies in “per USD” terms. The IMM convention is to quote everything in “USD per” terms. One writer was told back in the 1970s the IMM convention was necessary for purposes of clearing and margining, and this does, in fact, make sense: a customer’s account could hold just a single currency, the U.S. dollar, and be managed accordingly. A more cynical answer was proffered in the 1980s: When currency futures started during the early 1970s, the sentiment was FIGURE 1: INTEREST-RATE SPREAD RETURN FOR Components INDEX DOLLAR overwhelmingly dollar-bearish, Interest Rate Spread Return For Dollar Index and by quoting the futures in 115 terms that rose when the dollar 110 weakened, a bullish bet on the yen or Deutsche mark would be 105 accompanied by a rising number 100 if successful. Why the introduction? The 95 answer, for purposes of this 90 article, is simple: We will be discussing carry trade returns into 85 the dollar index’s six components JPY 80 GBP and summing those returns in EUR an index. Thus a successful bullCHF 75 SEK ish bet on the dollar index’s CAD 70 components will have a rising number meaning a successful 65 bullish outlook on a dollar index (DXY) position itself is expressed as a bearish opinion on the DXY Of the dollar index’s six components, only the return into the British pound has been and produces a lower number. A significantly positive. higher carry return into the six
January 4, 1999 = 100 Oct-04 Oct-05 Apr-06 Jan-11 Feb-09 Feb-10 May-02 May-03 Sep-06 Sep-07 Sep-08 Aug-09 Aug-10 Nov-03 Apr-04 Apr-05 Mar-07 Dec-99 Dec-00 Nov-01 Nov-02 Mar-08 Jan-99 Jun-99 Jun-00 Jun-01 Jul-11

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December 2011 • CURRENCY TRADER

FIGURE 2: INTEREST-RATE SPREAD RETURN Interest INDEX (INDEX-WEIGHTED”) FOR DOLLAR Rate Spread Return For Dollar Index Components
(Index-Weighted) 102.5 100.0 97.5 95.0 92.5

components and a lower DXY index reading are two ways of expressing the outcome, but they can be confusing. As an aside, futures traders who think of bonds in terms of price often stumble when they enter the cash market and are forced to think in terms of yield.

90.0 87.5 January 4, 1999 = 100 85.0 82.5 80.0 77.5 75.0 72.5 70.0 67.5 65.0 62.5 60.0 57.5 55.0 Oct-04 Oct-05 Jan-11 Feb-09 May-02 May-03 Nov-03 Sep-06 Sep-07 Sep-08 Aug-09 Feb-10 Mar-07 Mar-08 Apr-04 Apr-05 Apr-06 Aug-10 Jan-99 Jun-99 Jun-00 Dec-99 Dec-00 Jun-01 Nov-01 Nov-02 Jul-11 52.5
CHF SEK CAD GBP JPY EUR

Carry components

The dollar carry trade (see “The short, awful life of the dollar carry trade,” August 2008) can be broken into two components: the net interest-rate spread from borrowing the USD and lending into another currency, and the spot rate return. Over time, the interest-rate spread for high-yielding currencies such as the Argentine peso or Turkish lira can overwhelm their negative spot rate returns and make them good investments for dollar-domiciled investors. Figure 1 shows the interestrate spread returns since the January 1999 advent of the Euro. Surprisingly, only the return into the British pound has been significantly positive. (March 18, 2009, the date when quantitative easing began, is marked with a vertical line in all accompanying charts.) Now let’s weight these spread returns by the fixed weights of the DXY’s components, which are: EUR 57.6 percent, JPY 13.6
CURRENCY TRADER • December 2011

The combined net interest-rate spread for borrowing the dollar and lending into the DXY components has been negative over time.

FIGURE 3: SPOT RATE RETURN FOR DOLLAR INDEX COMPONENTS Spot Rate Return For Dollar Index Components
200 190 180 170 160 January 4, 1999 = 100 150 140 130 120 110 100 90 80 Oct-04 Oct-05 Apr-04 Apr-05 Apr-06 Feb-09 May-02 Nov-02 May-03 Dec-99 Sep-06 Sep-07 Sep-08 Aug-09 Feb-10 Mar-07 Mar-08 Jan-99 Jun-99 Jun-00 Aug-10 Dec-00 Jun-01 Nov-01 Nov-03 Jan-11 Jul-11 70
JPY GBP EUR CHF SEK CAD

On an unweighted basis, five of the six components have gained on the USD over time, with the GBP being the one exception.

23

ADVANCED CONCEPTS ON THE MONEY

FIGURE 4: SPOT RATE RETURN FOR DOLLAR INDEX COMPONENTS (INDEX-WEIGHTED)
135 130 125 120 115 110 105 January 4, 1999 = 100 100 95 90 85 80 75 70 65 60 55 50 45 40 Jan-11 Sep-06 Sep-07 Sep-08 Aug-09 May-02 May-03 Aug-10 Apr-04 Apr-05 Jan-99 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Nov-01 Nov-02 Nov-03 Apr-06 Oct-04 Oct-05 Mar-07 Mar-08 Feb-09 Feb-10 Jul-11 35
CHF SEK CAD GBP JPY EUR

Applying the index weights shows the combined spot rate return over time has been less impressive than we have been led to believe.

FIGURE 5: EXCESS CARRY RETURN FOR Dollar Index Components Excess Carry Return For DOLLAR INDEX COMPONENTS
170 160 150 140 January 4, 1999 = 100 130 120 110 100 90 80 70 60

JPY GBP EUR CHF SEK CAD

The actual economic return of going short the dollar and long the six components has been a struggle.

percent, GBP 11.9 percent, CAD 9.1 percent, SEK 4.2 percent, and CHF 3.6 percent. The combined net interest-rate spread for borrowing the dollar and lending into the DXY components has been negative over time, which is hard to imagine today given the Bernanke Federal Reserve’s money-printing proclivities (Figure 2). Figure 3 repeats the exercise with the spot rate returns. On an unweighted basis, five of the six components have gained on the USD over time, with the GBP being the one exception. Once we apply the index weights, the combined spot rate return over time has been less impressive than we have been led to believe — indeed, the peak occurred just before the 2008 financial crisis hit (Figure 4). Finally, let’s re-integrate the interest-rate spread and spot rate components, first on an unweighted basis (Figure 5) and later on a weighted basis (Figure 6). While many believe the bet against the dollar has been a oneway affair for 40 years, the actual economic return of going short the dollar and long the six components has been a struggle. By September 2011, the net return on the trade was about the same as it was in November 2007.

Oct-05

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December 2011 • CURRENCY TRADER

Excess RETURN For Dollar Index Components FIGURE 6: EXCESS CARRY Carry Return FOR DOLLAR INDEX COMPONENTS
125 120 115 110 105

January 4, 1999 = 100

Net carry returns and other markets

100 95 90 85 80 75 70 65 60 55 50 45 40 Oct-04 Oct-05 Apr-04 Apr-05 Apr-06 Sep-06 Sep-07 Mar-07 Jan-99 Jun-99 Jun-00 Dec-99 Dec-00 Jun-01 Nov-01 Nov-02 May-02 May-03 Nov-03 35
CHF SEK CAD GBP JPY EUR

Finally, as many traders regard the linkages between the DXY and key commodity markets such as crude oil or gold or between the DXY and U.S. equities as constant, let’s look at the rolling three-month correlations of returns involved. In the case of crude oil and gold, we will use the Dow JonesUBS total return sub-indices for each commodity; these include the effects of roll yield and the return on collateral. The correlation of returns between the DXY carry index constructed here and gold is not only much lower than commonly believed, but it peaked in April 2005 and has gone negative thrice since then. The DXY and crude oil never had much of a link between them prior to the widespread adoption of longonly commodity index trading in the 2003-2004 time frame, and that stands out in Figure 7. If we repeat the exercise for large- and small-capitalization U.S. equities as measured by the Russell 1000 and Russell 2000 indices, respectively, we see a similar time-dependent relationship (Figure 8). The carry returns for the DXY against both stock indices had been negative until 2004 and only climbed into strongly positive ground during and after 2009, with a prominent
CURRENCY TRADER • December 2011

Feb-09

Feb-10

Aug-10

Jan-11

Mar-08

Sep-08

By September 2011, the net return on the trade was about the same as it was in November 2007.

FIGURE 7: THREE-MONTH ROLLING CORRELATION OF RETURNS: Three-Month Rolling Correlation Of Returns: DXY VS. GOLDDXY Vs. WEST TEXAS INTERMEDIATE AND Gold And West Texas Intermediate
0.9 0.8 0.7 0.6 0.5 0.4 Correlation 0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3 Feb-02 Feb-03 Apr-99 Mar-01 Sep-99 Sep-00 Aug-01 Mar-00 Aug-02 Aug-03 Jan-04 Jan-05 Jul-04 Jul-05 -0.4
Crude Oil Gold

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The correlation of returns between the DXY carry index and gold peaked in April 2005 and has gone negative three times since. The DXY and crude oil never had much of a link prior to the widespread adoption of long-only commodity index trading in 20032004.
25

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ADVANCED CONCEPTS ON THE MONEY

detour to the downside during the QE2 era. In all cases, traders should be careful about assuming relationships where none may exist outside of a momentary fashion in the markets created by policies such as quantitative easing or a stampede by institutions into vehicles such as long-only commodity index funds.

Covering all bases

It is understandable so many traders look at

the spot rate return of going into the DXY basket and never stop to ask, “What is the opportunity cost? Am I incurring net interestrate spread losses as part of this trade? Which DXY components are contributing to what aspects of the total return picture?” While understandable, this is not excusable, however. All trades involve the comparison of alternatives, and those alternatives have to be accounted for on a complete cost basis. y For information on the author, see p. 4.

FIGURE 8: THREE-MONTH ROLLING CORRELATION OF RETURNS: Three-Month INDICES DXY VS. RUSSELL STOCKRolling Correlation Of Returns:
DXY Vs. Russell Stock Indices 0.7 0.6 0.5 0.4 0.3 0.2 Correlation 0.1 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 Feb-02 Sep-99 Sep-00 Aug-01 Aug-02 Feb-03 Apr-99 Mar-00 Mar-01 Aug-03 Jan-04 Jan-05 Jul-04 -0.7
Russell 2000 Russell 1000

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The carry returns for the DXY against both stock indices were negative until 2004 and only climbed into strongly positive ground during and after 2009 (with a prominent downside detour during the QE2 era).

26

December 2011 • CURRENCY TRADER

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GLOBAL ECONOMIC CALENDAR
CPI: Consumer price index ECB: European Central Bank FDD (first delivery day): The first day on which delivery of a commodity in fulfillment of a futures contract can take place. FND (first notice day): Also known as first intent day, this is the first day on which a clearinghouse can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillment of a futures contract. The clearinghouse also informs the seller. FOMC: Federal Open Market Committee GDP: Gross domestic product ISM: Institute for supply management LTD (last trading day): The final day trading can take place in a futures or options contract. PMI: Purchasing managers index PPI: Producer price index Economic release (U.S.) GDP CPI ECI PPI ISM Unemployment Personal income Durable goods Retail sales Trade balance Leading indicators Release time (ET) 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 10:00 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 10:00 a.m.

1 2 3 4 5 6 7

U.S.: November ISM manufacturing report France: Q3 employment report U.S.: November employment report Canada: November employment report

December

19

20 21

8

9

10 11 12 Japan: November PPI 13 14 15 16 17 18

Canada: Bank of Canada interestrate announcement Brazil: Q3 GDP Australia: Q3 GDP Brazil: November PPI Australia: November employment report Brazil: November CPI Mexico: November PPI and Nov. 30 CPI UK: Bank of England interest-rate announcement ECB: Governing council interest-rate announcement U.S.: October trade balance Germany: November CPI UK: November PPI LTD: December forex options; December U.S. dollar index options (ICE)

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23 24 25 26 27

Hong Kong: Sept.-Nov. employment report LTD: December forex futures; December U.S. dollar index futures (ICE) Canada: November CPI Germany: November PPI Hong Kong: November CPI Japan: Bank of Japan interest-rate announcement FDD: December forex futures; December U.S. dollar index futures (ICE) U.S.: Q3 GDP and November leading indicators Brazil: November employment report Mexico: November employment report and Dec. 15 CPI UK: Q3 GDP U.S.: November personal income and durable orders France: Q3 GDP and November PPI

28 Japan: November employment report and CPI 29 30 India: November CPI January 1 2 3 4 5 6

The information on this page is subject to change. Currency Trader is not responsible for the accuracy of calendar dates beyond press time.

U.S.: November retail sales and FOMC interest-rate announcement France: November CPI Hong Kong: Q3 PPI UK: November CPI India: November PPI South Africa: November CPI UK: November employment report South Africa: November PPI U.S.: November PPI U.S.: November CPI

U.S.: December ISM manufacturing report Germany: November employment report Canada: November PPI U.S.: December employment report Brazil: December CPI LTD: January forex options; January U.S. dollar index options (ICE)

EVENTS

Event: The World MoneyShow Orlando Date: Feb. 9-12 Location: Gaylord Palms Resort For more information: Go to www.moneyshow.com/tradeshow/orlando/world_moneyShow/?scode=013104 Event: The International Traders Expo New York Date: Feb. 19-22 Location: Marriott Marquis Hotel, New York For more information: Click here.

Event: CBOE Risk Management Conferenc Date: March 11-13 Location: Hyatt Regency Coconut Point Resort and Spa at Bonita Springs, Fla. For more information: Go to www.cboermc.com Event: The International Traders Expo London Date: March 23-24 Location: Queen Elizabeth II Conference Centre, London For more information: Click here.

28

December 2011 • CURRENCY TRADER

CURRENCY FUTURES SNAPSHOT as of Nov. 29
Market EUR/USD AUD/USD GBP/USD JPY/USD CAD/USD MXN/USD U.S. dollar index CHF/USD NZD/USD E-Mini EUR/USD Sym EC AD BP JY CD MP DX SF NE ZE Exch CME CME CME CME CME CME ICE CME CME CME Vol 315.7 133.7 97.2 82.4 79.1 34.3 27.8 23.9 6.1 5.6 OI 237.5 133.1 163.3 148.4 117.7 91.5 60.0 27.3 25.3 6.2 10-day move / rank -2.06% / 53% -1.25% / 13% -1.79% / 62% -1.06% / 8% -1.18% / 33% -2.82% / 60% 1.40% / 29% -1.33% / 13% -1.87% / 25% -2.06% / 53% 20-day move / rank -4.24% / 55% -5.03% / 54% -3.25% / 49% 0.13% / 13% -3.46% / 56% -4.92% / 50% 2.28% / 37% -5.14% / 48% -5.97% / 60% -4.24% / 55% 60-day move / rank -6.02% / 87% -5.82% / 70% -3.72% / 87% -1.49% / 84% -4.45% / 69% -10.90% / 69% 4.07% / 65% -14.33% / 95% -9.90% / 89% -6.02% / 87% Volatility ratio / rank .29 / 10% .44 / 32% .41 / 50% .49 / 87% .31 / 23% .23 / 43% .30 / 12% .07 / 0% .30 / 13% .29 / 10%

Note: Average volume and open interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity is based on pit-traded contracts.

The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields. Note: Average volume and open interest data includes both pit and side-byside electronic contracts (where applicable). LEGEND: Volume: 30-day average daily volume, in thousands. OI: 30-day open interest, in thousands. 10-day move: The percentage price move from the close 10 days ago to today’s close. 20-day move: The percentage price move from the close 20 days ago to today’s close. 60-day move: The percentage price move from the close 60 days ago to today’s close. The “% rank” fields for each time window (10-day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the % rank for the 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, it shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, it shows how the most recent 60-day move compares to the past one-hundred-twenty 60-day moves. A reading of 100% means the current reading is larger than all the past readings, while a reading of 0% means the current reading is smaller than the previous readings. Volatility ratio/% rank: The ratio is the shortterm volatility (10-day standard deviation of prices) divided by the long-term volatility (100-day standard deviation of prices). The % rank is the percentile rank of the volatility ratio over the past 60 days.

BarclayHedge Rankings: Top 10 currency traders managing more than $10 million
(as of Oct. 31 ranked by October 2011 return) October return 13.08% 10.74% 5.51% 4.07% 3.99% 2.07% 1.74% 1.37% 1.18% 0.98% 7.23% 6.90% 4.76% 4.37% 3.39% 2.53% 2.40% 1.40% 1.14% 0.98% 2011 YTD return -10.84% 73.78% 32.50% 22.66% 23.18% 18.69% 1.90% -5.36% 7.89% 0.74% 35.47% 46.11% 3.14% 29.92% -9.70% 2.71% 0.43% 3.58% 4.36% 29.10% $ Under mgmt. (millions) 16.3 45.0 19.5 36.6 18.8 20.0 90.0 174.0 30.0 27.6 1.7 3.2 4.0 2.1 2.3 1.8 2.0 9.3 1.9 6.5

Trading advisor 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Silva Capital Mgmt (Cap. Partners) MIGFX Inc (Retail) CenturionFx Ltd (6X) Regium Asset Mgmt (Ultra Curr) Gedamo (FX Alpha) ACT Currency Partner AG Cambridge Strategy (Emerging Mkts) IPM Global Currency Fund (C) Olsen (Olsen Invest - AF) Gain Capital Mgmt (MAC 4X) Adantia (FX Aggressive) Iron Fortress FX Mgmt Greenwave Capital Mgmt (GDS Beta) Valhalla Capital Group (Int’l AB) Armytage AAM (Asian Currency) Four Capital (FX) BEAM (FX Prop) Blue Fin Capital (Managed FX) Basu and Braun (Everest) Halion Capital (Conservative)

Top 10 currency traders managing less than $10M & more than $1M

Based on estimates of the composite of all accounts or the fully funded subset method. Does not reflect the performance of any single account. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.

CURRENCY TRADER • December 2011

29

INTERNATIONAL MARKETS
CURRENCIES (vs. U.S. DOLLAR)
Rank Currency 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Hong Kong dollar Chinese yuan Taiwan dollar Japanese yen Thai baht Great Britain pound Russian ruble Singapore dollar Canadian dollar Indian rupee Euro Swiss franc Brazilian real Australian Dollar Swedish krona South African rand New Zealand dollar Nov. 28 price vs. U.S. dollar 0.128265 0.156605 0.032875 0.01287 0.03186 1.54446 0.031615 0.76169 0.95553 0.019055 1.3246 1.075735 0.529855 0.97196 0.14274 0.11732 0.741105 1-month gain/loss -0.33% -0.34% -1.10% -2.24% -2.37% -3.63% -4.27% -4.38% -4.71% -5.46% -5.65% -6.20% -7.58% -8.08% -8.10% -8.21% -8.60% 3-month gain/loss -0.01% -0.08% -4.59% -1.30% -4.55% -5.64% -8.94% -8.37% -6.22% -12.09% -8.64% -13.26% -14.74% -8.07% -10.15% -16.13% -11.74% 6-month gain/loss -0.18% 1.66% -5.04% 4.29% -3.28% -6.04% -11.11% -5.69% -6.61% -13.76% -6.91% -7.72% -14.53% -8.96% -10.22% -18.66% -9.12% 52-week high 0.1288 0.1578 0.03510 0.0132 0.0336 1.6702 0.0366 0.832 1.059 0.0226 1.4842 1.3779 0.65 1.1028 0.1662 0.1518 0.8797 52-week low 0.1281 0.1496 0.0321 0.0117 0.0314 1.5407 0.0306 0.7572 0.9467 0.0189 1.2901 0.996 0.5288 0.9478 0.1422 0.1166 0.7207 Previous 15 12 14 13 16 5 3 10 11 17 7 9 2 1 4 8 6

GLOBAL STOCK INDICES
Country 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Mexico South Africa Switzerland Brazil Australia UK Canada U.S. Singapore Japan India Germany Hong Kong France Italy Index IPC FTSE/JSE All Share Swiss Market Bovespa All ordinaries FTSE 100 S&P/TSX composite S&P 500 Straits Times Nikkei 225 BSE 30 Xetra Dax Hang Seng CAC 40 FTSE MIB Nov. 28 35,558.18 31,829.34 5,522.70 56,017.00 4,125.80 5,312.80 11,640.21 1,192.55 2,694.43 8,287.49 16,167.13 5,745.33 18,037.81 3,012.93 14,578.23 1-month gain/loss -3.13% -3.24% -5.64% -5.87% -6.47% -6.83% -7.02% -7.20% -7.27% -8.43% -9.20% -9.47% -9.90% -10.02% -12.46% 3-month gain/loss 1.55% 5.07% 1.40% 2.11% -4.80% 0.84% -6.91% -1.45% -0.25% -6.37% -1.52% 1.33% -9.20% -4.48% -3.72% 6-month gain loss -0.23% -1.73% -14.65% -12.41% -13.07% -11.31% -15.83% -11.35% -14.73% -12.81% -11.33% -19.76% -22.20% -23.58% -29.88% 52-week high 38,876.80 32,894.11 6,739.10 71,924.00 5,069.50 6,105.80 14,329.50 1,370.58 3,280.77 10,891.60 20,664.80 7,600.41 24,468.60 4,169.87 23,273.80 52-week low 31,659.30 28,391.18 4,695.30 47,793.00 3,829.40 4,791.00 10,848.20 1,074.77 2,521.95 8,135.79 15,478.70 4,965.80 16,170.30 2,693.21 13,115.00 Previous 8 10 12 11 5 6 15 9 14 13 7 2 4 3

30

December 2011 • CURRENCY TRADER

NON-U.S. DOLLAR FOREX CROSS RATES
Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Currency pair Yen / Real Pound / Aussie $ Canada $ / Real Pound / Franc Euro / Aussie $ Euro / Real Pound / Canada $ Euro / Franc Aussie $ / New Zeal $ Aussie $ / Real Euro / Canada $ Pound / Yen Franc / Canada $ Aussie $ / Franc Euro / Pound Canada $ / Yen Euro / Yen Aussie $ / Canada $ Franc / Yen Aussie $ / Yen New Zeal $ / Yen Symbol JPY/BRL GBP/AUD CAD/BRL GBP/CHF EUR/AUD EUR/BRL GBP/CAD EUR/CHF AUD/NZD AUD/BRL EUR/CAD GBP/JPY CHF/CAD AUD/CHF EUR/GBP CAD/JPY EUR/JPY AUD/CAD CHF/JPY AUD/JPY NZD/JPY Nov. 28 0.024285 1.589015 1.8034 1.43593 1.36319 2.49996 1.616335 1.23223 1.311485 1.83441 1.386245 120.04 1.1258 0.90353 0.85739 74.25 102.95 1.017195 83.600 75.41 57.59 1-month gain/loss 5.75% 4.83% 3.11% 2.76% 2.66% 2.09% 1.13% 0.67% 0.57% -0.54% -0.99% -1.39% -1.57% -2.00% -2.12% -2.51% -3.46% -3.53% -4.04% -6.10% -6.49% 3-month gain/loss 15.75% 2.64% 10.00% 8.80% -0.60% 7.16% 0.62% 5.41% 4.17% 7.83% -2.58% -4.37% -7.50% 5.98% -3.20% -4.99% -9.04% -1.97% -12.11% -6.96% -10.59% 6-month gain loss 22.00% 3.21% 9.26% 1.84% 2.28% 8.91% 0.62% 0.95% 0.18% 6.51% -0.32% -9.88% -1.18% -1.35% -0.96% -10.45% -10.72% -2.51% -11.50% -12.84% -12.85% 52-week high 0.0246 1.6373 1.8282 1.5639 1.4228 2.5367 1.6354 1.3283 1.3746 1.8452 1.4316 139.19 1.3569 0.9749 0.9038 88.95 122.63 1.0612 105.79 89.46 67.97 52-week low 0.0186 1.4806 1.5997 1.1778 1.2947 2.1692 1.5302 1.0376 1.2354 1.6066 1.2811 117.7 1.0124 0.7477 0.8297 72.63 101.41 0.9708 82.68 72.72 56.86 Previous 21 18 20 13 19 17 10 15 4 12 11 5 14 3 16 9 7 2 8 1 6

GLOBAL CENTRAL BANK LENDING RATES
Country United States Japan Eurozone England Canada Switzerland Australia New Zealand Brazil Korea Taiwan India South Africa Interest rate Fed funds rate Overnight call rate Refi rate Repo rate Overnight rate 3-month Swiss Libor Cash rate Cash rate Selic rate Korea base rate Discount rate Repo rate Repurchase rate Rate 0-0.25 0-0.1 1.25 0.5 1 0 4.5 2.5 11 3.25 1.875 8.5 5.5 Last change 0.5 (Dec. 08) 0-0.1 (Oct. 10) 0.25 (Nov 11) 0.5 (March 09) 0.25 (Sept 10) 0.25 (Aug 11) 0.25 (Nov 11) 0.5 (March 11) 0.5 (Nov 11) 0.25 (June 11) 0.125 (June 11) 0.25 (Oct 11) 0.5 (Nov.10) May 2011 0-0.25 0-0.1 1.25 0.5 1 0.25 4.75 2.5 12 3 1.75 7.25 5.5 Nov 2010 0-0.25 0-0.1 1 0.5 1 0.25 4.75 3 10.75 2.5 1.5 6.25 5.5

CURRENCY TRADER • December 2011

31

INTERNATIONAL MARKETS
GDP AMERICAS
Argentina Brazil Canada France Germany UK S. Africa Australia Hong Kong India Japan Singapore Argentina Brazil Canada France Germany UK Australia Hong Kong Japan Singapore

Period
Q2 Q2 Q3 Q2 Q3 Q2 Q3 Q2 Q3 Q3 Q3 Q3

Release date
9/16 9/6 11/30 9/28 11/15 10/5 11/29 9/7 11/11 11/30 11/14 11/25

Change
26.1% 8.7% 1.1% 0.4% 0.8% 0.5% 2.7% 2.7% 6.5% 1.0% 3.4% 2.0%

1-year change
20.1% 9.0% 5.9% 3.2% 2.5% 4.5% 10.8% 6.3% 4.3% 16.0% 14.5% 6.1%

Next release
12/16 12/6 3/2 12/23 2/15 12/22 2/28 12/7 2/1 2/29 2/13 2/24

EUROPE AFRICA ASIA and S. PACIFIC

Unemployment AMERICAS

Period
Q3 Oct. Oct. Q2 Oct. July-Sept. Oct. Aug.-Oct Oct. Q3

Release date
11/21 11/24 11/4 9/1 11/30 11/16 11/10 11/17 11/29 10/31

Rate
7.2% 5.8% 7.3% 9.1% 5.6% 8.3% 5.3% 3.3% 4.5% 2.0%

Change
-0.1% -0.2% 0.2% -0.1% -0.1% 0.2% 0.0% 0.1% 0.4% -0.1%

1-year change
-0.3% -0.3% -0.5% -0.2% -1.2% 0.6% 0.1% -0.9% -0.6% -0.1%

Next release
2/22 12/22 12/2 12/1 1/3 12/14 12/8 12/19 12/28 1/31

EUROPE

ASIA and S. PACIFIC CPI

Period
Argentina Oct. Oct. Oct. Oct. Oct. Oct. Oct. Q3 Oct. Oct. Oct. Oct. Brazil Canada France Germany UK S. Africa Australia Hong Kong India Japan Singapore

Release date
11/11 11/11 11/18 11/10 11/10 11/15 11/23 10/26 11/22 11/30 11/25 11/23

Change
0.7% 0.4% 0.2% 0.2% 0.0% 0.1% 0.5% 0.6% 3.1% 1.5% 0.1% 0.5%

1-year change
9.7% 5.4% 2.9% 2.3% 2.5% 5.0% 6.0% 3.5% 5.8% 10.1% -0.2% 5.4%

Next release
12/16 12/8 12/20 12/13 12/9 12/13 12/14 1/25 12/20 12/30 12/28 12/23

AMERICAS

EUROPE AFRICA ASIA and S. PACIFIC

PPI AMERICAS EUROPE AFRICA ASIA and S. PACIFIC
Argentina Canada France Germany UK S. Africa Australia Hong Kong India Japan Singapore

Period
Oct. Oct. Oct. Oct. Oct. Oct. Q3 Q2 Oct. Oct. Oct.

Release date
11/11 11/30 11/30 11/18 11/11 11/24 10/24 9/15 11/14 11/11 11/29

Change
0.9% -0.1% 0.5% 0.2% 0.0% -0.3% 0.6% 2.8% 0.6% -0.7% 1.7%

1-year change
12.7% 4.7% 5.8% 5.3% 5.7% 10.6% 2.7% 8.9% 9.7% 1.7% 11.6%

Next release
12/16 1/5 12/23 12/20 12/9 12/15 1/23 12/13 12/14 12/12 12/29

As of Nov. 29 LEGEND: Change: Change from previous report release. NLT: No later than. Rate: Unemployment rate.

32

December 2011 • CURRENCY TRADER

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