Monday, May 2, 2016

Forex Moves Prompt a Change in the Immediate Outlook for Stocks

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Ask any of my Energy Trader Team members or, for that matter, anybody with whom I have ever discussed trading in depth, and they will tell you that, at times, I can seem a bit obsessive about certain things. I constantly harp on about the psychological and emotional side of trading, for example, as I see that as far more important than technical factors, which are really just an analysis of historical price action. I can get a bit boring about risk/reward analysis too, but the area where I repeat myself most of all is the importance of foreign exchange when it comes to all of the other, more widely followed markets.

That belief that currencies always lead and must be tracked pretty closely by anybody who is serious about trading anything is probably in part down to the natural bias I have from starting in the interbank forex world, where a peculiar product pride reigns. It is also, however, the result of decades of observation.

It could be, as the forex market would have you believe, that players in that market are just smarter than anybody else, or it could be that the first step to any change in investment strategy by the mega funds that really control capital flows is to exchange currency; but either way currency markets are usually the first to indicate a trend.

This morning's action in oil futures gives a good example. Over the weekend the news that OPEC production was higher than expected should have put enormous pressure on crude. I mean, hasn't the whole collapse thing been about a supply story?

Obviously, if the world's major producers are still cranking out more and more crude we should be heading back to around $30 for WTI, or at least dipping back towards $40, right? Well, in some circumstances I am sure we would be doing that, but instead we see oil opening a little lower and then recovering those losses in early U.S. trading.

The reason for that seemingly inexplicable strength is simple: the dollar is showing signs of weakness.

In fact, looking at the above chart for the dollar index, you could go further than that and say that the greenback is collapsing. Once important support levels between 94 and 93.50 were broken we dropped immediately to challenge the 52 week lows around 92.50. In currency terms, especially in a weighted index, these are dramatic moves, but given the current global situation they are even more remarkable.

Both the BOJ and the ECB are pursuing very loose monetary policy right now and the resultant increased supply of currency and negative interest rates should, in theory, make their currencies weaker and therefore, by default, the dollar stronger.

What we are seeing, however, is the opposite, and it is a trade based on expectations. With every other major central bank still adding huge amounts of liquidity, the argument goes, it is almost impossible for the Fed to pursue their stated aim of "normalizing" interest rates. In other words, currency traders, who generally have a feel for this kind of thing, are betting that the Fed will not hike rates in the near future and even another cut may be on the cards.

If they are right, then those, like me, who have felt that a correction based on fundamental weakness is likely from these levels, have to adjust our expectations and accept that the drop to around 2050 on the S&P is as far as it goes. The upward pressure that comes with a better environment for exporters and the prospect of continued ultra low rates from the Fed will, in this central bank obsessed market, easily outweigh even disappointing earnings and revenues for last quarter. Add to that the worry reducing influence of higher oil that comes with a lower dollar and a test of the stock market highs is probably on the cards.

Eventually, of course, fundamental factors always win out, so unless there is evidence that the lower dollar is having an immediate positive effect on corporate America then the S&P 500 above 2135 will be a prelude to an even sharper correction. When and if that time comes, though, one thing is for sure. I will be looking to the forex market for clues.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.




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