Prices move for many reasons in the Forex markets.  When U.S. companies build factories overseas, the payroll of the workers must be paid in the local currency.  That means the U.S. dollar is exchanged for units of the local currency.  When the goods manufactured in this factory are sold in foreign countries, the conversion of those currencies back into U.S. dollars eventually takes place.  U.S. companies that extend credit to overseas customers often need to hedge against the risk of currency depreciation to the point of wiping out the expected profit on the sale of the goods before payment is received. These are a few of the basic business reasons for day-to-day movements in the Forex markets. 

Since 2001, the volume of trading in the Forex market has more than doubled as many companies decided to become speculators as well as hedgers in the Forex markets. When considering market participants such as hedge funds and money management firms that speculate, 70% to 90% of the recent movements in the Forex markets are due to speculation. This also accounts for the explosion in the amounts of daily Forex trading. 

Speculators desire to profit from the movement in the price of an asset without the intent of taking delivery of the asset.  They provide necessary liquidity to the party that is attempting to hedge some form of risk. Hedge funds and money management firms also speculate in other markets such as equity and commodities markets. Since the amount of money available for speculation is finite, money tends to flow into and out of various asset classes. Tracking the movement of the so-called hot money into and out of each asset class is possible if a trader understands the reasons for the sudden shifts. Once the reasons are clear, a chart can be constructed to provide the Forex trader a heads-up on which currencies are strengthening for potential long trades and which pairs are weakening for potential shorting opportunities.  If the trader also trades equities or commodities, this information can be used to time trading decisions in those markets, as well. 

In the currency markets, money flows into countries to take advantage of higher interest rates to earn higher returns. This strengthens one currency in the pair and weakens the other currency. If the U.S. dollar is one of the currencies in the pair, assets that move inversely to the U.S. dollar will strengthen as the dollar weakens. Assets that are priced in dollars such as gold, oil and copper will move inversely to the U.S. dollar. 

Producers of these goods need to charge higher prices to compensate for the weak dollar.  The U.S. dollar and the U.S. equities markets have been negatively correlated especially since the credit crisis and start of the recent recession. One reason for this is that exports to growing economies such as China are positives for the U.S. economy during this period of the consumer deleveraging. For exports to continue, the U.S. dollar needs to remain weak. Stocks of companies that are exporting products tend to rise when the dollar weakens. Companies involved in the exports of certain commodities also benefit from a weak dollar. Another term to become familiar with is “risk aversion.”  Risky assets such as equities and commodities have been moving up on days when the dollar is weak. When fear is the dominant sentiment, money flows into safe assets such as U.S. Treasuries and the dollar while moving out of the riskier assets. 

Once this relationship between assets that move inversely to the U.S. dollar is known, a chart that watches the movement of the markets can be constructed.The 5-minute chart in Figure 1 is an example of a small timeframe correlation chart used for timing entries overlaying gold, oil and the Russell 2000 Small Cap index on a chart with the U.S. Dollar index. 

On July 14, 2009, the U.S. dollar index began to sell off around 1:00 PM EST.  At about the same time, the commodities markets represented by gold and oil and the U.S. equity markets represented by the Russell 2000, began to rally. On July 15, 2009, the dollar sell off continued as the U.S. equities market had one of its best days in 2009, rising 3% for the day.  Meanwhile, oil rebounded from recent selling and gold had a similar strong performance. When a trader looks at a chart similar to this one, it is possible to visually track where the hot money is flowing without trying to process all of the reasons for the flows.


This is an excerpt from Aug 2009 issue of Trader's Journal.