Tag: Forex Theory

Categories
Forex Market

Purchasing Power Parity Theory

Traders, who operate in the foreign exchange market, read such news every day as: “the consolidation of the dollar led to the fall in the price of gold” or “the price of the euro backed the price of oil”. Although this news is usually published after an event, the relationship between the goods market and […]

Traders, who operate in the foreign exchange market, read such news every day as: “the consolidation of the dollar led to the fall in the price of gold” or “the price of the euro backed the price of oil”. Although this news is usually published after an event, the relationship between the goods market and […]

Traders, who operate in the foreign exchange market, read such news every day as: “the consolidation of the dollar led to the fall in the price of gold” or “the price of the euro backed the price of oil”. Although this news is usually published after an event, the relationship between the goods market and the foreign exchange market is felt independently whether we trade in the foreign exchange market or have nothing to do with it.

Theoretically, inflation serves as a correlation between the value of money and the prices of goods, and in this case, the currency does not matter (whether dollars, euros, rubles, British pounds, or Indian rupees). If a week ago the price of gasoline cost 40 rubles per liter and now it is 50 rubles, this means that the ruble in a week was lowered by 25% and the gasoline, on the contrary, increased in price. If gold cost $ 30 per gram in June 2009 and in June 2019 was $ 43, this shows that in 10 years the value of gold in US dollars increased 43% and the dollar, the other way around, fell in price.

Correlation between the goods market and the foreign exchange market. How does it work? They are simple and easy to understand (and also applicable to trading) examples of how money and goods are related and why the correlation between the goods market and the foreign exchange market is a fundamental rule that determines the price of a currency. Let’s try to decipher this theory.

Purchasing Power Parity Theory

Purchasing power parity theory states that the cost of goods in one country should not exceed the cost of goods in another country more than the price of the transport of goods between the two countries. The price of transportation also includes the profit margin of the trader and the change of the standards of one country by the standards of the other. It is also theoretically assumed that there are no artificial trade barriers.

When most of Europe and Asia, back in 1944, were in ruins, a conference was held at the Bretton Woods spa where, for the next twenty-five years, the fate of all the world’s currencies was determined, among which the United States was chosen as the international reference currency. The currencies of other countries were beginning to be traded in dollars, the same dollar was convertible into gold and the troy ounce was worth $ 35. That agreement at that time seemed fair, as the US had 70% of all world reserves and, thanks to the Second World War, it had an international advantage.

The Bretton Woods monetary system existed until 1971 when United States President Richard Nixon unilaterally terminated the agreement, and on 16 March 1973, the treaty is known as the “Jamaica agreement” was signed, which formed the Forex currency market. According to the “Jamaica agreement”, exchange rates would be set in the market on the basis of supply and demand. Since then and to this day the dollar is the main reserve currency, occupies a leading position in the calculation of energy, goods, and gold, and is the main currency used in many financial instruments.

At present, the US dollar position is well described with the word “petrodollar”, and the main volumes of trade in goods, including oil and gold, take place on US exchanges such as NYMEX, COMEX, CME, and ICE. The United States leads in the trade of oil, gold, grains, and many other goods, and the quotations of productive resources are valued in US dollars: gold/dollar (GOLD/$), oil/dollar (WTI/$), corn/dollar (Corn/$), wheat/dollar (Wheat/$), coffee/dollar (Coffee/$), etc.

For the determination of the value of the market of goods or a group of goods there are different indices of raw materials. The best known among them are: Thomson Reuters/CoreCommodity CRB Index (CRY) and Deutsche Bank Commodity Index, which are calculated based on parameters of futures traded on the exchanges indicated above. The exception is for aluminum and nickel prices, which are based on quotations from the London Metal Exchange, calculated in US dollars. Gold prices are also valued in US dollars.

The quotations of foreign currencies are also translated through the value of the dollar: pound/dollar (GBP/USD), euro/dollar (EUR/USD), dollar/ruble (USD/RUB), dollar/franc (USD/CHF), dollar/yen (USD/JPY), etc.

The best known of these is the US dollar index (USDX) measured in relation to the value of a basket of six currencies: the euro (57.6%), the Japanese yen (13.6%), the pound sterling (11.9%), the Canadian dollar (9.1%), the Swiss franc (3.6%) and the Swedish krona (4.2%). The index began in 1971 with a base of 100, and values since then are relative to this base. Therefore, the current rate of index 97 indicates that the exchange rate of the US dollar, relative to the basket of previous currencies, represents 97% of the level of 1971. ¡ A completely insignificant change in 48 years!. But the reality is that it hasn’t always been like this, and in recent years the index has changed considerably from the level of 70 percent in 2009 to the level of 128 percent in 1985.

Do we say “oil,” but do we really mean “dollar”?

As we have already mentioned, the US dollar is used in goods and currencies; the exception is inverse currency pairs, but it is only a mathematical casuistry for the ease of quotation of these currencies. It is very logical to think that at the moment when the dollar rises, the exchange rate of goods decreases, and vice versa, the depreciation of the dollar leads to the rise of currencies and goods markets.

Between July 2014 and July 2017, oil and the dollar correlated with each other with a coefficient of -0.75, that is, they were inversely correlated. Thus, at that time the linear correlation between EUR/USD pair and Brent-type oil in certain periods of time can reach the coefficient of 0.9, that is, it can be very high.

In the preceding paragraph, I purposely emphasized the phrase “in certain periods of time”. The ability to detect periods, in which one or the other factor impacts on quotes, depends on the competition between traders and the level of his training. In this case, there are no clear examples and schemes, everyone has to take this path on their own. But what we do have to warn about is the effects of oil prices on foreign exchange rates increases over time, when the difference in interest rates is small, as in the years 2014-2017, and decreases, when interest rate potential increases, as in the years 2018-2019.

Analysing the correlation between the prices of goods, oil, and the foreign exchange market, it should be noted that the study of the correlation between these assets has a low efficiency. It is better that traders, who ultimately decide to study the issue on their own, focus on monitoring quotes by oscillators, for example, the stochastic indicator or RSI that allows absolute values to be left by the percentage change of some assets compared to others.

We live in the era of hydrocarbons, and oil and its derivatives are the main product whose price affects all other sectors of the economy, which is reflected in the indices. Energy carriers account for 33% of the composition of the Thomson Reuters/CoreCommodity CRB index, regardless of natural gas. As a major part of the Deutsche Bank’s commodity index, petroleum products, and oil amount to 50 percent.

In this way, the change in the price of oil leads to changes in the entire market of goods, from which some dependencies can be deduced: the decline of the dollar leads to the growth of the price of oil and foreign currencies; and vice versa, the rise of the US Dollar contributes to the depreciation of the price of oil and foreign currencies.

It is impossible to predict the beginning and the end of this correlation. For example, the price of the euro may fall, causing the rise of the US dollar, which in turn will contribute to the fall in the price of oil; or if the price of oil begins to rise, the price of the dollar begins to fall, which in turn causes the growth of the euro.

Purchasing Power Parity Assumptions

Purchasing power parity theory takes into account a world in which there is no single reserve currency, assuming many world trade points, which is not in keeping with the current situation. However, the crisis of the world’s dollar-based currency and the trade wars that have been unleashed as a result of Donald Trump’s presidency have forced the governments of major emerging power centers to try to find a gradual replacement of the US dollar as a universal equivalent value.

Thus, for example, in the calculations of Asian goods, the Chinese yuan has already left the Japanese yen behind and is gradually displacing the US dollar from trade. At the St Petersburg Economic Forum in early June, China and Russia agreed to eliminate the US dollar from reciprocal payments and arrangements; Iran and Turkey take the same path.

The tendency to renounce the dollar is barely growing, but it already seems impossible to stop it. The more trade tariffs the US applies, the more the dollar will shift in financial calculations and the faster the US currency will lose its position as the dominant global currency. Trade wars will inevitably lead to the fragmentation of the world economy in several monetary and customs zones, where the theory of purchasing power parity will be in force in a forceful manner, avoiding the intermediate link that is the US dollar. Of course, there is no one who knows for sure when it will happen, but there is no doubt that one day it will happen.

Purchasing power parity theory, like interest rate parity theory, is the fundamental basis of the currency market. In turn, the study of the relationship between the goods market and the foreign exchange market is an important element in the “authentic” fundamental analysis, unlike the studies of different “relevant” economic indicators or informative, which are very often difficult for private traders to analyse due to a lack of their knowledge and resources. However, knowing how it works and thinking nimbly, we will always find a way to apply the basic rules of the currency market to make a profit, even in complicated situations. He who seeks finds!

Categories
Forex Market

What Is the The Theory of the Dollar Smile?

In times of recession, the US currency acts in the same way. The global economy is cyclical. And whether in periods of GDP expansion or recovery, the US dollar allows other competing currencies to take the lead, but in times of recessions, the dollar grabs the blanket. The main reason is that the US economy […]

In times of recession, the US currency acts in the same way. The global economy is cyclical. And whether in periods of GDP expansion or recovery, the US dollar allows other competing currencies to take the lead, but in times of recessions, the dollar grabs the blanket. The main reason is that the US economy […]

In times of recession, the US currency acts in the same way. The global economy is cyclical. And whether in periods of GDP expansion or recovery, the US dollar allows other competing currencies to take the lead, but in times of recessions, the dollar grabs the blanket.

The main reason is that the US economy is too important and the dollar plays a major role in international payments, gold and foreign exchange reserves, Forex trading volumes, and cross-border loans. A global recession makes investors forget the influence of European macro statistics on the euro rate or the influence of the Bank of Japan’s monetary policy on the yen rate, the pressure of political risks on the exchange rate of the pound sterling. All eyes are on a single coin. The US dollar.

Interestingly, the dollar behaves very similarly in the course of recessions, and this may have become the beginning of the dollar smile theory, which was developed by Stephen Jen, a famous currency strategist for Morgan Stanley. There are three obvious steps in the dynamics of the USD index:

– The Dollar Is Actively Bought Since the US Economy Is Very Stable.

– USD is sold in the midst of the Fed’s aggressive monetary expansion.

– The dollar is bought back amid expectations that the US GDP will recover faster than other countries’ GDP.

As a result, a smile-like image appears.

Let’s look at the dynamics of the USD index in more detail. In the first stage, the dollar is in high demand as the United States economy is strong. It looks better than others, increasing demand for US stocks and bonds and leading to increased investment flows. In 2019 and early 2020, the USD index actually grew in the midst of trade wars, which are the reason for an impressive rebound of the S&P 500 and high demand for treasury bonds.

The first stage always ends with a correction of US stock indices that ultimately makes the bearings the dominant force in the stock market. The dollar manages to reach its peak, “the left side of the smile”, as investors prefer “flight to quality”. It acts as the main safe-haven currency. At the end of February, due to the coronavirus, the S&P 500 moves to bear territory in the shortest possible time, 16 days. The correlation between the stock index and the USD index becomes an inverse relationship. In the first phase of the previous global economic crisis, the dollar consolidated at 24 percent from March to November 2008.

In the second stage, which Stephen Jen decided to call the “smile fund,” there is a sale of the dollar due to the Fed’s aggressive monetary expansion. Cutting the federal funding rate to near zero, unlimited asset purchases, and the White House’s large-scale fiscal stimulus reverse the bearish trend of the S&P 500 at the end of March. Increased demand for risky assets contributes to the closure of long positions on the green note. A similar situation occurred in the last months of 2008, when the Fed through aggressive monetary expansion, including the launch of QE of $700 billion, tried to reverse the bearish trend in the US stock market and bring USD fans to a fixed point. For a while, there was even a sense that it did: the USD index fell in December.

In the third stage, the dollar rises again, as investors begin to believe that the US economy will recover faster than its foreign counterparts. US stocks seem cheap, while low borrowing costs, the Fed’s ultra-soft monetary policy, that gradually recovers GDP and hopes that corporate earnings growth will rekindle the interest of non-residents in US assets.

So, if we follow the dollar smile theory, it’s time to buy the dollar. At the same time, it is not the fact that the US economy can recover faster than China’s global GDP, and the Fed’s strong desire to prevent the strengthening of the dollar from seriously changing the rules of the game.

Categories
Forex Education

The True Story Behind the Elliot Wave Theory

There are few technical analysis components that can credit a single person, but Elliott’s wave theory has that distinction. The founder of the theory is Ralph Nelson Elliott, who was born in Marysville, Kansas, in 1871 and then moved to San Antonio, (Texas state).

There are few technical analysis components that can credit a single person, but Elliott’s wave theory has that distinction. The founder of the theory is Ralph Nelson Elliott, who was born in Marysville, Kansas, in 1871 and then moved to San Antonio, (Texas state).

There are few technical analysis components that can credit a single person, but Elliott’s wave theory has that distinction. The founder of the theory is Ralph Nelson Elliott, who was born in Marysville, Kansas, in 1871 and then moved to San Antonio, (Texas state).

Elliott began his career as an economist in the middle of 1890. After holding executive positions in private companies and a successful consulting business, the United States State Department wanted Elliott to be the candidate for the post of Chief Accountant of Nicaragua (a country that was then under US control).

During his stay in Central America, Elliott contracted a debilitating illness, which forced him to retire early at the age of fifty-eight. Around this time, he decided to devote himself to the study of the American stock market.

When Elliott began his study of markets, it was generally believed that markets were chaotic and random. Elliott, after many studies, was convinced that there was some sort of underlying order in the way they moved and proposed that market prices develop into specific patterns and trends. This was considered a revolutionary idea at the time.

It began its study by studying more than 75 years of historical data from stock markets using annual, monthly, weekly, daily, hourly, and half-hour charts. Remember, this was in the 1930s before there was computing capacity available to help review graphs and keep records. All these analyses were done manually and to carry it out without help was an achievement in itself.

As his research progressed, he began to establish rules that he could apply. The greater his confidence, the more frequently he began to spread his ideas publicly. In March 1935, an ordinary day, he sent a telegram after the closing of the market indicating that the US stock market is coming to an end.

The next day, Thursday, March 14, 1935, the Dow Jones Industrial Average reached its lowest closing price for the whole year. In fact, the market began an increase which lasted nearly two years and doubled the value of the Dow. Elliott, using its own market rules that he himself had developed, had set the bottom of the market within a trading day.

What makes this most notorious was the moment in history that Elliott made the prediction. In 1935, the United States was in the midst of the Great Depression, and the idea that markets could grow seemed unthinkable.

A few months after predicting the decline in March 1935, Elliott wrote “The Elliott Principle” with Charles J. Collins. Collins himself received Elliott’s telegram on Wednesday afternoon, predicting the decline of the market.

With the book, Wave Theory Elliott was officially born.

After Elliott’s death in 1948, many renowned financiers continued to make predictions based on Elliott Wave’s studies. In the early 1970s, a novice analyst at Merrill Lynch, Robert Prechter, was impressed with Elliott’s work and introduced it to the public through his own books.

Prechter won the US Trade Championship in 1984 with Elliott Wave, with a yield of 444% in four months on a real-money options trading account. Prechter also successfully predicted America’s long-term bullish market that began in 1982 and the October 1987 crash. The CNBC in 1989 named him “Guru of the Decade”.

Today, Prechter is considered the world’s best known Elliott The Wave Analyst, and the book, called “The Beginning of the Elliott Wave”, is considered today as the modern Bible for understanding this topic.

There’s a lot of criticism of the Elliott Wave and Prechter himself has made the wrong predictions. That said, Elliott’s wave theory is considered an important part of the technical analysis and is part of the curriculum of the authorized market technician designation.