There were two very good articles (actually, one is a thread in the forum section) posted on FF recently that I thought had a lot of relevance for traders. What I’d like to do here is expand on both and tie them together because I think there are some very valuable forex trading lessons to be had. The first was an article posted by Piptrain called “How The USD/JPY Can Predict The End Of The Recession” and the thread that caught my attention was called “Giving Up” by Jimmy Jones.

Piptrain made the very astute observation that USD/JPY had gone from being a co-incident to a leading indicator for the S&P. This is incredibly important because if you know the market is setting up to be in either a “risk on” or risk off” trend, you can enter some trades with potentially huge returns.

To review, “risk on” means investors are buying riskier assets like stocks and commodities as they sell the safe ones-the USD and Treasury’s. Risk off is of course the opposite. The market went into severe risk off mode after Lehman Bros. collapsed last September and we’ve now come to the end of the risk on rally that Bernanke ignited in March.

What also happens when the market is in risk on mode is that the yen falls as traders sell it against the (formally) higher-yielding currencies. At least, that was the case until USD/JPY apparently became a leading indicator of the market’s appetite for risk.

USD/JPY (as well as the other yen crosses) had basically been falling right along with the S&P ever since the market peaked in October 2007 and the move into the yen accelerated when global stock markets collapsed through last Fall after the Lehman bust.  But starting at the beginning of 2009, things changed.

USD/JPY started appreciating in January even as the S&P headed lower, making a bullish divergence just as the MACD sometimes does. The way things look now, what USD/JPY was telling us was that the market was setting up to be in risk on mode; the only thing it needed was the right fundamental catalyst which it got on March 15 when Fed Chairman Bernanke went on 60 Minutes and announced the Central Bank was “electronically” printing dollars. Active depreciation of the dollar is a pretty sure way to ignite a stock rally because if the dollar looks set to depreciate, anything you buy with it (like stocks and commodities) has to gain in nominal if not real terms.

Even more interesting is that during most of the recent rally, USD/JPY was going down-in other words, it was making a bearish divergence, signaling that the rally could only go so far because investors were not truly buying risk. All it needed to completely kill it off was perhaps something like the poor NFP report we got 2 weeks ago.

An even stronger indication that the market is moving into full risk off mode is that USD/JPY is continuing to depreciate even as stocks head lower-in other words, it isn’t making a bullish divergence now which is entirely justified especially after all the recent talk about deflation being a bigger concern than inflation along with the G8 saying that now is not the time to begin withdrawing the extraordinary monetary and fiscal policies that have been implemented during the crisis.

So what can be gained from this?

  1. It does indeed look like stocks and commodities are headed lower, which means the dollar will gain against the higher-yielding euro, pound and A$.
  2. If stocks do go down and USD.JPY starts showing a bullish divergence, we’ll know the market is at least prepared to gain given the right set of economic fundamentals.
  3. If stocks eventually gain and USD/JPY shows a bearish divergence, stay ready for an eventual decline
  4. If USD/JPY gains along with stocks, the rally probably has legs.

Giving Up

The exact reason why Jimmy Jones has found it so difficult to trade lately is because the market entered a consolidation period where price moved back and forth but did not trend. Trading is relatively easy when markets are trending because you can “set and forget” or even take profits along the way and buy on dips (in an up-trending, risk on market) or sell on strength in a down trend. But when markets are moving sideways, as they have been over the past few weeks, it’s very easy to see your account get shredded.

Trend following systems like moving average cross-overs all share the same characteristics-they look good in a trending market but fail utterly when markets are moving sideways. They cannot tell you when a trend will end and they certainly can’t tell you when markets will go sideways, which as we know are the most difficult markets to trade. In fact, sideways markets are the main reason why so many forex traders fail.

There are some traders who claim to be good in these types of markets but for the vast majority of us (myself included), they’re just too hard. I basically avoid them like the plague and if that means I don’t have trades for a few days, weeks, or even months-fine. I’ll keep my powder dry for the time when I believe markets can trend. In other words, the decision not to trade is a trade itself.

The only way to avoid this type of price movement is to be an astute observer of what’s happening with the markets in terms of the willingness to buy (or sell) risk and what makes that especially hard is that is that different circumstances create a different set of conditions. For example, what killed the March rally in my opinion was all the talk about deflation from people like Bill Gross of PIMCO, economist Nouriel Roubini and FOMC member Janet Yellen. Why? Because if deflation is truly the risk, the dollar is not likely to depreciate which means the risky assets bought with it (stocks and commodities) are not likely to gain.

I’m not saying this is easy. You have to do your homework. But being aware of what’s going on will help you spot when the trends might start and more importantly, end.