Deriving a forex signal is first of all dependent on the creation of a powerful yet simple strategy combining different aspects of analysis. But analysis is not all of the picture. A successful forex strategy is above all about the balancing of risks, evaluation of the risk/reward ratio inherent in the planned trade, independent of the analytical tools used. In other words, money management must always be made a major part of the formation process which results in the employed trading strategy. If one understands and recognizes that no forex strategy can be applied to the market for consistent gains, and that the markets operate on different dynamics at different time periods, it is only too easy to recognize as well that a forex strategy is only useful as a temporary compass of our path with which we determine our destination, but never points directly to the destination itself.

How should we formulate a forex strategy?

1. Keep it as simple as possible

Keep your strategies simple. Avoid over-interpreting, over analyzing market phenomena. It is almost certain that the tools that you use are not sufficient to establish a truly reliable analytical picture of the market. So do not waste your time trying to reach at the holy grail of technical analysis.

1. Only use the methods that you understand well

In order to have clarity of mind as you make decisions, use only the tools that you understand well, and are capable of interpreting with fluency and confidence. Recall that there’s no special indicator that will do particularly well in a market, (or, more precisely, that it is impossible to know which indicator will work in advance in a particular market configuration). So do not obscure your analysis by wasting time trying to understand obscure and esoteric methods.

1. Focus on money management, not analysis

Any strategy may fail, but you should make sure that you never fail so severely that you suffer severe results from which you can not recover. Make sure that your plans depend on risk management, the careful balancing of positions, modest leverage, and sensible commitment of capital. Always keep in eye on volatility. Do not hesitate to liquidate a position if your basic assumptions are proven to be false.

1. Make a plan, and follow it

Discipline is the essence of trading. Make sure that your trades follow your original plans carefully, and that you never make arbitrary decisions. It is impossible to be arbitrary in your decisions, and successful in your trading. Your trade sizes, stop-loss/take profit orders, leverage, must all follow well-established principles that emphasize conservatism over risk taking.

If you follow these rules, you may do well even with a less-than-perfect forex broker. If you don’t follow them, the chances of success are very limited indeed. To ensure that you get the greatest benefit from your trades, make sure that you adopt a disciplined, rigorous approach to trading from the very first day. Then you can succeed with just about any strategy.

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FX Crossroads: EUR/USD – Will History Repeat Itself?

Summary and conclusions

• EUR/USD rallied sharply from October 2000 to January 2001, but then spent 18 months trying to clear the January high. While we do not necessarily expect history to repeat itself, a dollar rally may still take longer to materialise than many now seem to expect. We show that while valuation argues in favour of USD strength, as it argued in favour of EUR strength in 2000, fair value estimates are only a long-term anchor for currency markets. Monetary policy cycles seem better in terms of setting the medium-term framework for a currency pair: If we are correct in expecting a turn from the Fed easing to the ECB easing during the summer, this suggests further downside for the euro. However, considering the risk of a prolonged downturn in the US as well as the present hawkishness of the ECB, we could well be in a policy vacuum for several months. Further, though EUR/USD bottomed out in 2000, an uptrend did not really get underway until capital flows turned in favour of the euro in 2002. Presently, net capital flows on both sides of the Atlantic remain supportive of the euro.
• We currently have four open trading recommendations in the G10 space, all established during the past week. We are long EUR/GBP, short EUR/CHF, short EUR/NOK and short NZD/USD.
• FX Crossroads is published every second Wednesday. Next publication date is 28 May 2008

EUR/USD – Two cycles compared

Basic balance and EUR/USD

EUR/USD – Will History Repeat Itself?

Arguments not yet in place for sharp dollar rally

This article considers the outlook for EUR/USD seen from the perspective of the turning point in 2000. EUR/USD rallied sharply from October 2000 to January 2001, but then spent 18 months trying to clear the January high. While we do not necessarily expect history to repeat itself, a dollar rally may still take longer to materialise than many now seem to expect. We show that while valuation argues in favour of USD strength, as it argued in favour of EUR strength in 2000, fair value estimates are only a long-term anchor for currency markets. Monetary policy cycles seem better in terms of setting the medium-term framework for a currency pair: If we are correct in expecting a turn from Fed easing to ECB easing during the summer, this suggests further downside for the euro. However, considering the risk of a prolonged downturn in the US as well as the present hawkishness of the ECB, we could well be in a policy vacuum for several months. Further, though EUR/USD bottomed out in 2000, an uptrend didn’t really get under way until capital flows turned in favour of the euro in 2002. Presently, net capital flows on both sides of the Atlantic remain supportive of the euro.

Our present forecast profile sees EUR/USD at 1.55 in 3m, 1.50 in 6m and 1.50 also one year from now. We are biased for a stronger dollar, but also see clear risks toward dollar weakness should the US economy fail to develop sustainable momentum once the impact of the fiscal stimulus package fades in the autumn.

Technically, EUR/USD is seen moving towards 1.49 – 1.51 in the coming month before resuming the uptrend. Only a break of 1.45 would suggest that downside momentum is building.

From a low in 2000 to a high in 2008

EUR/USD fell to a historical low of 0.8248 on 25 October 2000. Less than three months later, the pair had risen to 0.9580, a gain of 13 big figures. Since the euro was at the time substantially undervalued, many believed that a secular turning point had arrived.

With the benefit of hindsight, we now know that October 2000 was indeed the all-time-low. However, the “high water-mark” from January 2001 would remain unbroken until June 2002, 18 months later. As the chart below shows, the journey higher turned out to be a laborious one. The initial wave higher from October 2000 to January 2001 was followed by a 6-month decline to 0.8338 (wave 2). Wave three was another 3-month sprint to 0.9270 in September 2001, followed by wave 4, a 5-month glide to 0.8614 in January 2002.

The rise to a peak in 2008 is not too different from the fall to a low in 2000, as the chart below shows.

While history is unlikely to repeat itself, it may nonetheless be instructive to contemplate how a development similar to 2000 – 2002 would look like today. If this cycle should turn out to be the exact opposite, then EUR/USD should fall to 1.38 in July, rise to 1.54 in January 2009, fall to 1.43 in March, rise to 1.52 in July and then only fall below 1.43 in October 2009.

Valuation lends support to USD

Our fair value PPP estimate of EUR/USD is 1.20, leaving the euro some 30% overvalued. In 2000, the euro was 27% undervalued, so in that regard the two episodes share some resemblance (see chart below). Unfortunately, PPP only serves as a long-term anchor and turning points cannot be determined with any great precision, as the 2000 – 2002 episode also revealed. In short, we know that the euro is overvalued, not when the misalignment will be corrected.

Even if there is some symmetry around the valuation of EUR/USD in 2000 and in 2008, the circumstances differ considerably. As the above chart also shows, the euro was as it weakest when the US economy was last in recession. Today, the euro is at it strongest when the US could be on the verge of a recession. If nothing else, it does suggest that currency trends often diverge from the obvious cyclical signals.

Monetary policy cycles and EUR/USD

If the business cycle gives only imprecise guidance to EUR/USD, the pair does seem to correlate well with the monetary policy cycle, however. For instance, Fed funds fell below the ECB repo rate in April 2001, not long after EUR/USD had reached its low point. Fed funds remained below the ECB repo up until December 2004, when EUR/USD reached a high of 1.36. The Fed went on hold again in July 2006 and the ECB began raising rates in November 2005. In between, EUR/USD once again began moving higher.

In recent months, the Fed has cut rates well below the ECB repo, highlighting the rate advantage that the euro currently enjoys. However, our economics team expects another policy turning point to arrive within the coming months: the Fed is expected to cut rates one final time in June and the ECB is seen initiating an easing cycle in September. If correct, the orientation of monetary policy would be consistent with a move lower in EUR/USD further into 2008.

What if?

An alternative scenario worth considering has the Fed cutting rates further as the economy struggles close to a recession. Here, the fed funds rate would probably fall close to the 1% low from the previous cycle. While the near-term economic outlook may brighten thanks to the USD 150bn fiscal package about to hit the US consumer, there is reason to be more concerned when considering the outlook further out. A prolonged downturn, driven by a housing recession and financial deleveraging, would most likely result in additional dollar weakness.

In Europe, we think that the slowdown is already unfolding. Countries such as the UK, Spain and Ireland seem particularly vulnerable to the same sort of economic troubles as have been seen in the US. Yet, for the euro-area as a whole, the risk of recession still seems smaller than for the US.

A final scenario worth contemplating is the one that seems to be discounted in global equity markets presently, namely a short, mild “nonrecession “. If such a scenario comes true, at the same time as the ECB starts cutting rates, the dollar could rally significantly, taking us well below our 1.50 forecast for EUR/USD in 12 months.

Capital flows have yet to turn

An all-important part of the decline in the euro from its birth in 1999 was a massive outflow of capital. The basic balance (the sum of the current account, net direct investments and net portfolio flows) was in deficit by EUR 200 – 400bn in the first couple of years, partly explained by a structural adjustment of portfolios. The rise in EUR/USD did not materialise until net flows turned positive in 2002. The most recent rise in EUR/USD from 2007 has also coincided with a sharp rise in capital inflows. In contrast, the US saw a widening of its basic balance deficit from 2002 an onwards. Flows turned for the better in 2005, helped by net direct investment flows following from the Homeland Investment Act, but have since deteriorated sharply. As can be seen from the chart below, net capital flows have yet to turn in favour of the dollar.

In conclusion, an outcome close to our expectations for monetary policy would be consistent with increasing support to the dollar in the coming year. However, not only could we be in a vacuum as regards monetary policy as both central banks stay on hold until the early autumn, one should also consider that the Fed may have to cut rates well below current pricing. Further, a sustained rally in the dollar is likely to include investors rotating out of EUR assets in favour of USD assets, in a reversal of what happened in 2001 – 2002, something that has yet to arrive.

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