1. Forex Traders Provide Insights for US Stock Investors
Around $3 Trillion in foreign currency (forex) is traded every day, almost 10x the volume of US stocks. A lot of smart people trade forex. Every government, large financial institution, and business that buys or sells overseas trades forex to hedge their investments and production costs, as do hundreds of thousands of private professional speculators worldwide. Thus it's well worth heeding their opinion about the current rally.
A. Background: Different Currencies Have Different Risk/Reward Profiles
As a general rule, when US stock indices rise, the world currency markets feel more optimistic about the world economy, and show higher risk appetite. This in turn increases demand (at least in the short term) for currencies that carry higher risk of depreciating in bad times yet pay higher interest rates on deposits. When US stock indices are dropping, currency traders are often more pessimistic, and flee higher risk currencies into lower risk currencies.
Here's a brief quiz. Look at the table below showing central bank rates of the world's major currencies. Which do you think are considered the most risky? Which are considered the safest?
Approximate Central Bank Rates (fx360.com)
Answer: the Australian dollar is considered the riskiest. The Yen is considered the least risky, with the U.S. dollar considered the next safest. You may agree or disagree, but this IS the prevailing belief in the world currency markets.
B. Background: Currencies Trade in Pairs
Almost everything is priced in terms of a currency. So are currencies themselves. They are always traded in pairs. For example, what's the Euro worth? It depends on what currency you value it in. Here are a few examples.
Sample Euro Currency Pairs (Courtesy AVA FX)
In other words, the Euro as of this writing sells for 1.7677 Australian dollars, 1.5725 Canadian dollars, 1.5131 Swiss Francs, etc.
2. A Rising USD Suggests Forex Traders Doubt the US Stock Rally
If forex traders believe in a US stock rally, they feel more optimistic about the world economy. The Yen and USD tend to lose value in the short term against other major currencies as traders seek riskier currencies with higher yields. If they don't, the Yen and USD rise as traders seek safety over yield.
For reference, here's a daily chart of the S&P 500. Note how the recent rally began in early March (as positive news about US banks started to come out).
The S&P 500 (courtesy AVA FX)
C. AUD/USD Traders Doubt the US Stock Rally
Below is a daily AUD/USD (read: USD per AUD) chart.
Note that the currency pair AUD/USD is read as "USD per AUD," and NOT like a mathematical ratio of AUD per USD.
What do forex traders think about the US stock rally, based on this AUD/USD chart (i.e. USD per AUD)?
AUD/USD DAILY CHART (courtesy AVA FX)
Note that as the US stock rally proceeded, the AUD rose against the USD. Forex traders felt optimistic about the budding US stock rally as it rose off of oversold levels. Thus they were willing to accept the risk of holding the AUD for the sake of the higher yield.
Over the past few days, however, the rise has stalled along with the US stock rally.
The implication: the AUD/USD forex traders doubt the rally will continue. If they believed in it, they'd continue to flock to higher yielding currencies.
D. USD/JPY (Read Yen per Dollar) Traders Also Don't Believe in the US Stock Rally
The Yen is the only currency considered safer than the USD, and as shown above sports an even lower yield. If the rise in the USD was due to something other than risk aversion, we'd expect the USD to rise against the Yen. However, it has been falling for weeks against the only currency consider safer.
THE USD/JPY DAILY CHART (courtesy AVA FX)
Note how weeks before the current US stock rally stalled, the USD/JPY forex traders were betting against the rally and sought the perceived safety of the Yen, driving its value up against the USD.
Implication: USD/JPY traders are also feeling more risk averse because they don't believe the US stock rally will last.
Admittedly, forex is notoriously complex, and a variety of factors could influence the above charts. However the above charts reflect the overall recent strengthening of the USD against various other currencies. There are also those who believe that the dollar simply moves short term inversely with the US stock markets.
They key point – the forex markets are not showing belief in the US stock rally. Should we?
If not, get ready to take positions that benefit from a declining market. These include:
Using short term hedges like Proshares Ultrashorts ETFs like SDS (rises 2x the decline rate of the S&P) or SKF (same but for financials)
Selling covered calls on stocks you own for extra income. See 3 Must-Know Options Strategies for Dividend Investors -- Seeking Alpha for more info.
Want more ideas on how income and dividend investors can best survive and prosper on the next leg down? Stay tuned for the next article on this very topic.
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Disclosure: The author may own interests in the above traded instruments.