NEWS / Foreign Exchange

The Song Remains The Same

By Edward Ponsi

It's been a while since I've written about our old friend, the Japanese Yen. When we last mentioned it, the Yen was in a state of free-fall vs. the stronger currencies, such as the Euro, the Australian Dollar and New Zealand dollar. Trend traders were simply buying the dips, trying to catch a ride on this express train to profit.

Well, I'm happy to tell you that nothing much has changed, as the Euro has continued its dominance over the Japanese currency, reaching a new fourteen-year high this week. This is the time when trend following traders should be cleaning up, because the markets are not always so cooperative. Meanwhile, there are unfortunately those who continue to believe that "it can't go any higher". Someday, these folks will be correct, but how many of them will get flattened in the meantime, trying to fight a runaway trend? This trend will end someday, and maybe soon, but I can't think of a better lesson for trading with the trend. EUR/JPY (Euro/Japanese Yen) has been climbing steadily for months, and consistently rewarding trend followers - and punishing trend fighters - along the way (see figure 1).

Figure 1: EUR/JPY weekly chart reveals the long-term uptrend. Source: Saxo Bank

The New Zealand Dollar continues to roar, also hitting multi-year highs vs. the Yen. In fact, an ascending triangle appears to be forming in the NZD/JPY (New Zealand Dollar/ Japanese Yen) currency pair (see figure 2).

Figure 2: Ascending triangle within the uptrend on NZD/JPY daily chart. Source: Saxo Bank

The trend remains the same because the underlying facts remain the same; Japan has strong growth but has little leeway to raise interest rates because inflation is nonexistent. Japanese officials continue to talk tough about raising rates, but will probably have to wait until after this summer's elections, and even then they will likely be limited to one 25 basis point increase.

This is part of the beauty of the Forex markets; we are trading entire economies, and economies change very slowly. Any of the above analysis could change in the future, but in reality, this situation has been ongoing for some time. I don't have to wake up every day and try to figure out if the Euro is still trending higher vs. Yen, I just need to figure out where to enter or add to my long positions when the pair is pulling back. Simplicity can be a beautiful thing.

Will it all come crashing down at some point? Undoubtedly, the answer is yes. It could happen tomorrow, or next week, or next year. When that finally happens, there will be a great deal of profit taking, even worse than what we saw at the end of February (see figure 3). But if you're using stops on every trade, and adhering to good risk management, you'll be able to take that loss with a smile - especially if you've been making money all the way up.

Figure 3: The USD/JPY pair fell hard when the Yen fought back against the U.S. dollar in late February. Source: Saxo Bank

Just in case you're getting the impression that the Yen currency pairs are the only ones that are trending, have a look at the Euro/ Swiss Franc (EUR/CHF). This pair has been climbing steadily since early March, and last week's pullback - to a key Fibonacci retracement level AND a major trend line AND the 10-day exponential moving average - may create an opening for trend traders seeking to initiate long positions (see figure 4).

Figure 4: EUR/CHF uptrend pulls back to an area of support. Source: Saxo Bank

Meanwhile, the U.S. Dollar is in a screaming downtrend vs. the Canadian Dollar. The buck is hitting new year-to-date lows vs. the loonie nearly every day, and the buying power of the once-mighty greenback is evaporating faster than an ice cube in the desert. Word must've gotten out that I'll be visiting Toronto next week! As of this writing, the USD/CAD pair is trading just about 150 pips above its 27-year low (see figure 5).

Figure 5: USD/CAD plunges toward multi-year lows. Source: Saxo Bank

The beautiful thing is, when these trends finally do come to an end, new trends will begin elsewhere. That's just the nature of the Forex market.

Q) Why does the Chinese central bank not want their currency, the Yuan, to appreciate?

Ed Ponsi) China's economy is heavily geared toward the exportation of goods to the West, and much of the tremendous growth that China is seeing right now (GDP growth in excess of 10% annually) is due to its huge trade surplus with the U.S. and other western countries. Any economy that is heavily focused on exports will benefit from a weak currency, because it makes products cheaper to overseas buyers. As China's exporters create and sell more of these products at a profit, manufacturing production increases and China's economy grows.

One of the side effects of a strong economy can be strength in the currency, but here is the problem - if China's currency strengthens, sales of their exports to the West will fall. This would be harmful to China's economy because of its emphasis on exports. How can China keep its currency weak (and its exports cheap) while simultaneously experiencing strong economic growth? For years, China "pegged" its currency to the U.S. dollar at a fixed rate. One U.S. dollar bought approximately 8.28 Chinese Yuan, a rate maintained by the Chinese central bank until July of 2005. Because the rate was fixed, no amount of strength or weakness in the U.S. dollar would affect that currency's relationship to the Yuan.

U.S. policymakers argued that the cheap Yuan was causing a flood of imports into the U.S. and the European Union, displacing millions of jobs, particularly in the manufacturing sector. Under pressure from the U.S. and other countries about what many considered an unfair trade advantage, China finally released the Yuan from its peg and allowed the currency to appreciate - but it has been a very slow appreciation, carefully managed by China's central bank. Nearly two years after releasing the currency from its peg, the exchange rate has fallen to about 7.70 Yuan per U.S. dollar (see figure 6).

Figure 6: After trading for years at a fixed rate, USD/CNY exchange rate begins to fluctuate as the Chinese Yuan strengthens. Source: Yahoo Finance

U.S. politicians are still pressuring China, contending that while the current level of currency appreciation is a step in the right direction, it is insufficient. The flip side of this coin is that if the Yuan were to appreciate quickly and significantly, it could create inflation in the U.S. because the price of imported goods from China would rise in tandem with the currency. Also, a stronger Yuan would not necessarily lead to a Renaissance in U.S. manufacturing, because any jobs lost by China would likely go to other export-driven countries that supply plentiful, cheap labor. The simple solution of further Yuan appreciation might help reduce the U.S. trade deficit, but it will not be the panacea for U.S. economic growth that some politicians would have us believe.

Have a question about Forex trading? Send an email to eponsi (at) tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.