Back to Basics
Simpler is better!
This is true in life, and it’s true in investing. The key to making huge profits is to get one big idea right, and then invest on that idea. Ignore the noise. You can rest easy as that one idea plays out. Let everyone else fret about the news, and sweat the daily bumps in the road.
You can make profits from the one big idea.
Golfers are notorious for fixing one problem by creating another. Let’s say a golfer has a bad slice; that’s where the ball heads away from the golfer and off the fairway, instead of going straight. This is caused by an improper grip on the club.
Instead of fixing the grip, the golfer turns his stance away from the centre of the fairway, and twists the clubface toward him to compensate for the slice. Now, instead of doing one thing wrong (the grip), the golfer is doing three things wrong (grip, stance and club face).
This process continues, with more defects leading to more bad habits. Eventually the golfer ends up twisted like a pretzel, and still hitting the ball off the fairway!
Investors can be similar to golfers. They start with an idea, only to find out they’re losing money. The market tells them they’re wrong. So they quickly move in the opposite direction, only to find that the market has moved too. Wrong again! Before long, their portfolios are underwater, and they’re flailing like the golfer who started with a bad slice.
Interest rate markets, in addition to Federal Reserve policymaking, have left many investors flailing over these past two years. In late 2014, markets were certain that the Fed would raise interest rates in 2015. Investors positioned themselves by shorting 10-year Treasury notes. Wall Street economists said the Fed would raise rates at the March 2015 FOMC meeting. March came and went, then June, then September, and still there was no rate hike.
Finally, in December 2015, the Fed did achieve ‘lift-off’ with a tiny 0.25% increase in the target rate for Fed funds. But, by then, investors had missed a huge rally in 10-year notes due to the commodity price collapse, weak growth, and declining inflation expectations.
Once the Fed did raise rates, investors again positioned for a series of rate increases throughout 2016, beginning in March.
But the Fed’s lift-off led to a stock market meltdown in January and early February. This spooked the Fed, and was a contributing factor to the secret Shanghai Accord reached by major central banks in Shanghai, China on 26 February.
Under this secret accord, China and the US would maintain the link between their currencies, but the US would ease policy. This meant that China would ease also because it was linked to the US. Since the Sino-US cross-rate was unchanged, stock markets did not panic. The big losers were Japan, which got a stronger yen, and Europe, which got a stronger euro. Japan and Europe combined are the biggest trading partners to the US and China.
The idea behind the Shanghai Accord was to give the world’s two largest economies — the US and China — some relief by strengthening the currencies of their two largest trading partners, Japan and Europe.
It worked! China and the US are both seeing early effects of cheap currency stimulus, while US stock markets have not fallen out of bed — in fact, they’ve rallied.
Once again, investors were wrong-footed, just like the golfer with a slice. They were looking for rate hikes; what they found instead was that the Fed is on indefinite hold.
Hedge funds are floundering
With the US first quarter growth coming in weaker than expected, and an election cycle looming, the Fed may not raise rates before December, and maybe not even then.
This pattern of making bad moves, based on policy zig-zags, is not affecting retail investors alone. The big guys are on the wrong side of these trades also. Hedge fund returns are the worst since 2008, and institutions are lining up to pull their money out of the hedge funds. Institutions are tired of paying high fees for poor performance.
The problem is that markets and central banks are staring at each other waiting for the other to blink first.
Markets form a belief that the Fed will tighten, and they go into a tailspin. The Fed then loses its nerve, signalling that it won’t tighten after all.
The markets see that the Fed won’t tighten and start to rally. The rally gathers steam, which the Fed sees as ‘easing’ financial conditions due to the wealth effect.
Now the Fed sounds the all-clear, signalling that they will tighten after all because markets are rallying.
Then the markets panic again, and start to crash.
Wash, rinse, repeat.
You get the idea. Markets and central banks are each responding to the other, but neither one really knows what the other will do next.
Markets are supposed to be independent barometers of economic health. Central banks are supposed to be independent guardians of sound money. Instead, markets and central banks are akin to a deer caught in the headlights, not knowing whether to leap for safety or just stand there and hope for the best.
If policy zig-zags are the problem, what’s the solution?
Get this right…and rest easy
The solution is to keep it simple. Just try to get one big thing right, like a golfer who improves his grip, instead of picking up 10 bad habits.
So, what’s the one big idea we can get right and rest easy on the outcome? It’s this: The US dollar has to get weaker against other major trading currencies.
At Currency Wars Trader, we use our proprietary IMPACT method to spot major turning points in exchange rates. We do this by looking for indications and warnings that tell us whether existing trends are continuing, or whether new trends are emerging.
Right now, the secret Shanghai Accord described above is the most powerful indicator of currency trends.
Trading currencies is different from trading stocks and bonds. A stock can go to zero if the company files for bankruptcy. A bond can go to zero if the issuer defaults. Major currencies don’t go to zero; they just go up and down relative to each other. Currency prices — measured in other currencies or indices — are not absolute values; they are relative values.
Picture a currency cross-rate as two kids on a playground seesaw. At any point in time, one will be up and one will be down. If the seesaw is in motion, the partner in the air is coming down, and vice versa. But they can’t both be up and down at the same time. That’s impossible.
Currency cross-rates reflect many factors. Among these are fundamental factors such as the terms of trade — based on inputs such as productivity and natural resources — and the balance of trade. Other factors include policy interventions, which can range from short term adjustments to full-scale currency wars.
Among other factors, these can cause currencies to rise or fall against each other — like the kids on the seesaw. But not forever. Eventually, the nation with a cheap currency achieves some level of desired growth, its export sector expands, and its currency gets stronger.
Conversely, the nation with a stronger currency imports deflation, while hurting its export sector and seeing its currency weaken. The strong go down, and the weak go up. It’s the seesaw in action.
This long term US dollar index chart illustrates these points perfectly.
Source: Trading Economics
[Click to enlarge]
First we observe dollar price stability under the gold standard from 1967 to 1971. Then comes the seesaw effect.
The US dollar rallied from 1980 to 1985 under the Volcker-Reagan ‘King Dollar’ policy of high interest rates and low taxes. The dollar sank from 1985 to 1992 after Treasury Secretary James Baker engineered the Plaza Agreement and the Louvre Accord.
Another rally ensued from 1994 to 2001 under the Bob Rubin strong dollar policy — supported by Bill Clinton and Newt Gingrich’s ‘Contract with America’. Then came another weak dollar period under Greenspan’s low rate polices from 2002 to 2007 — the so-called ‘Greenspan Put’.
Finally, another strong dollar period emerged after Ben Bernanke started the ‘taper talk’ in 2013, and followed through with the QE taper in 2014.
Up, down, up, down, up again. It’s the exchange rate seesaw.
But there’s another powerful trend here that can only be seen from a long term perspective. Despite the ups and downs, the overall trend is down. Each cycle is characterised by lower highs, and lower lows.
Taking all of these cycles and trends together, the dollar’s path is easy to see. The US dollar is going lower; in fact, that lower trend started on 26 February, following the secret Shanghai Accord. The new low will be lower than the previous all-time low of August 2011.
This will not happen in a straight line, and it will not happen right away. There will be ups and downs, and the bigger trend will take a few years to play out.
You can read more about specific recommendations to profit from these trends, and our Currency Wars Trader strategy, here.
Strategist, Currency Wars Trader
Editor’s Note: This article was originally published in Currency Wars Trader.