No Rest for the Currency Markets!

After a long week full of action, I’m ready to relax a bit. Too bad the currency markets don’t look like they’re ready to take a breather. In fact, I expect the market will open tomorrow in Asia just how it finished Friday — with major volatility.

We’re at a pivotal point, and pinpointing a clear direction isn’t easy. Chances are good that many market participants are confused. And that’s precisely where the volatility is coming from.

Often times, this is when we see significant longer-term trend changes. Such instances arise when players in one camp — bulls or bears — begin to reassess their position and shift towards the other camp. We can refer to this as “conversion flow.”

Today, I want to explain how you can monitor these shifts, and determine when major trends are about to change.

But first, let’s talk about …

Cracking the Code on the G7 Communiqué

The Group of Seven finance ministers met last weekend to discuss business. And given the severity of the credit crunch, I expected more than the usual wine and cheese tasting going on. But I didn’t know whether they’d discuss exchange rate fluctuations — or more specifically, dollar weakness.

Well, they did. Here’s a key excerpt from the G7 comments:

“Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability. We continue to monitor exchange markets closely, and cooperate as appropriate.”

The comment sparked traders’ concern and some of them rushed out to buy dollars. Alas, after rallying sharply to start this week’s trading, the buck couldn’t hold onto those gains for more than a couple hours.

So even though the euro gapped down more than 100 PIPs against the dollar, it didn’t take long before those losses were recouped. And what came after that was just more of what we’re used to seeing.

The dollar was dragged lower when the tough guys at the G7 took a crack at verbal intervention because traders quickly called their bluff. Very little in the G7 communiqué led the market to believe that honest to goodness intervention is a possibility.

It begs the question …

Could Mere Comments Actually
Be the Difference Maker?

Successful traders use similar measuring sticks when attempting to profitably forecast currency moves.

Monitoring open interest levels on currency futures helps. Observing price action on key news releases helps, too.

And traders were privy to several important market-moving events this week:

• The aforementioned G-7 talk is a not-so-veiled threat that they will act if the dollar goes much lower. That should help support the dollar.

• Thursday, there were very hawkish statements about inflation made by some of the Federal Open Market Committee members. The bond market reacted by selling off, pushing yields higher. This may be a warning that Fed rate cuts are nearing an end. Again, that is dollar bullish.

• On Friday, a strong move in U.S. stocks suggested that, at least over the near-term, confidence may be returning to the U.S. market. That is dollar bullish at this stage of the game.

As a result, the buck hit a rubber floor, bouncing solidly higher against its major counterparts — putting some fear into the perpetual dollar bear camp.

When the dust had settled, the greenback finished off the week little changed. As I mentioned earlier, this volatility, among other things, signifies the lack of an agreed-upon direction. Prices jump all over the place. And to understand how all this works, you need to understand …

The Four Types of Market Players

As I’ve stressed many times before, an understanding of investor sentiment is crucial in successful trading. Here are four different types of market players, as I’ve categorized them, whose attitudes impact trends.

The Devout — This group focuses on a few key issues that, when validated over time, create a strengthening adherence to their initial view. These players become very much married to a position. And when it comes to the dollar, for instance, they’ve married into a bearish position and become quite happy. It will take nothing short of a tragedy, in their eyes, before they take that ring off their finger. For the dollar can only go one direction — down.

The Eclectics — This group represents intermediate-term trend followers who enjoy making well-informed decisions. Their use of fundamental and technical analysis proves they’re not opposed to commitment, but they also won’t allow themselves to become married to a position. Again, in the case of the U.S. dollar, they see the longer-term trend as being down. And they’re more confident and comfortable when they see dollar-bearish trade set-ups. Unlike the Devout, the Eclectic don’t want that ring on their finger.

The Swingers — This merry band of traders prefers regular, alternating interaction. Technical analysis and key news helps the Swinger capture intraday price swings. They have little allegiance to either bulls or bears. And even when it comes to the dollar they are weary of binding themselves to one course.

The Sideliners — A skittish bunch by nature, they abhor volatility. Uncertainty scares them. In the case of the dollar, they’ve certainly grown skeptical that significant downside remains. So they wait for a fresh, clearly-defined trend to emerge before pledging allegiance.

By nature, certain players may dabble in the camps of other players, e.g. the Eclectics may join the Swingers when they see a trading setup they’re confident in. Even the Swingers may settle down at times and do some position-trading.

Ultimately we try to gauge the movement among these various players. While there is no single side-switching indicator we can rely upon, remember …

Sentiment Turns FIRST, Followed By Price Action

My bet is that the Commitment of Traders report — which offers a breakdown of the long and short positions in currency futures on the Chicago Mercantile Exchange — will show that some of the Devout and Eclectics have joined the Sideliners on the confusing price action and fundamentals flowing from the market this week. In addition, I suspect many Swingers are seeing a near-term move higher in the dollar, and have likely switched sides and turned bullish.

This means the numbers will likely look a lot less dollar bearish than they did at the start of the week. Better numbers may be a catalyst for some Sideliners to take a position in favor of the dollar.

Does this mean we’ve seen a bottom in the dollar after it hit a 40-year low this week? It’s still too soon to say. But real people moving real money is the way major trends change. And we may be seeing just that when it comes to the dollar right now.

Stay tuned!

Best wishes,

Jack

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