What is the purpose of the foreign exchange market, or any trading market for that matter? It seems like a simple question with a simple answer. The purpose is to facilitate exchange, to permit participants to sell and buy commodities, equities or futures and to trade one currency for another. But that simple definition disguises a world of complexity.
If two parties wish to conduct an exchange, of one currency for another or of an equity or bond for a sum of cash the first question is at what price should the transaction take place? In the consumer world, in a supermarket or department store, the price is predetermined by the seller and is rarely changed. The purchaser measures their need for the item against the price asked and makes the decision to buy or not. There is little discussion and no bargaining over the price. The consumer does not say the price will be lower in a few minutes; I will wait until then to make my purchase. Likewise the seller does not normally remove the item from sale expecting the price to rise in a few days. This basic function of price determination or price discovery is essentially different in a trading market. A market transaction differs from a consumer purchase because both the seller and the buyer continually adjust their price expectations to information flowing out from the market to participants and into the market from outside sources.
Market participants, in theory, incorporate all available information into the prices at which they buy and sell. This is called the perfect information assumption of efficient markets theory. Each participant in the market acts as an independent decision maker. Each decision influences the overall market and price level. The market or to be more precise, the price level of a market traded item, is, at any time, the amalgamation of all the price decisions made by all market participants.
On this one topic-- what should the market price be-- the market reflects the decisions of its participants. In foreign exchange markets the decision makers are the traders, all of them, from the smallest retail trader to the largest hedge fund. But how do 1,000 or 10,000 individual decisions, made in ignorance of each other become a market price? How do we know that the price of this mass decision accurately reflects the wishes of 10,000 people?
If three market participants want to buy a commodity at a certain price level and 50 want to sell, the market price for that commodity will fall. But what actually happens? The three bids in the market will be filled but that leaves 47 sellers. If no other bids enter the market the sellers will begin to react to the lack of bids by adjusting their offering prices down, displaying lower and lower prices until buyers enter bids and a trade is made at the new lower level. The sellers and the buyers incorporated the information flowing out of the market, the temporary lack of bids, into their price expectations producing a new price.
A commentator would perhaps say ‘the market fell today ‘. But a market is not an entity. It is only a method for coordinating the decisions of its participants. What occurred is that each participant in the market reacted to the information coming to them from within the market and their combined reaction is the movement in price. It appears to an observer that the ‘market’ traded lower because the thousands of individual decisions that comprise the movement are not given separate life. Only the mass decision, ‘the price’, is represented.
This sense of the decision making power of markets and the ‘market’ as almost a living entity is reflected in the terms we use to describe the price action. We often say’ ‘the market reacted badly to the news’ or ‘the market took profit today’. We personify the market and its behavior. Of course we all know that there is no “market” somewhere below the pavement on Wall Street making the decisions for the stock exchange. But the common use of this ‘market’ shorthand tends to obscure what is the most important psychological point in understanding market behavior. Namely, that the ‘market’ is a picture of the thoughts of its participants, the market is a snapshot; it is a mass mind.
We can remove some of the sense of mystery from the term, “the market” when we remember just who or what ‘the market’ is? The answer is plain enough, to paraphrase the comic strip character Pogo, “we have met the market and he is us’. The logic, analysis and fear that motivate market behavior have their source within the mind and psychology of market participants, that is, within each of its traders.
When analyzing market behavior it is instructive to keep this very simple fact in mind. The market is a mass mind focused on one topic, price. It represents the momentary culmination all of the external and internal inputs that bear on the price of the traded commodity as ranked by the traders in that market. But even if the method by which the market arrives at a decision is obscure, its ingredients are not—they exist in the analysis, outlook aspirations and psychology of each individual trader.
Since the market is a reflection of the minds of its participants and a traders job is to make profits it follows that a trader’s primary task it to match his decision to that of the mass, to anticipate and mimic the decision of the market. There should be no mystery in ‘the market’ even when it thrashes our positions, for the chances are that the operating logic was known to most of traders. Known and rejected by the losing minority of traders but embraced by the majority.
When our trades lose money, whatever the logic of the position, we can be sure we were not alone. But we can equally be sure that we were in the minority. Had we been in the majority the market would have performed as we had anticipated. The market decision process is that simple. It is a matter of putting our assumptions in line with the majority as often as we can. The most effective tool to achieve that is our own empirically tested market psychology. We are the market, if only we can let the mass mind of the market and not our individuality rule our decisions.
The market does not reward iconoclasts.
Joseph Trevisani
Tuesday, July 28, 2009
Thursday, July 23, 2009
Wednesday, July 22, 2009
Market Direction
Since late May the dollar has traded in a limited four figure range against the euro - limited and a bit odd. Good American economic news pushes the dollar down; bad news returns it to favor.
May Non Farm Payrolls, unexpectedly positive, gave the dollar a fainting spell. The June numbers, worse than predicted, revived the greenback. Retail sales figures and consumer confidence have gradually returned from oblivion and the value of the dollar ebbed as they rose.
Risk aversion is the standard explanation. Risk capital, or perhaps it is better to name it capital that is averse to risk, is sequestered in Treasury bills and other dollar denominated safe investments when the economic environment looks, well, risky. The demand for these dollar assets pushes the US currency higher as foreign denominated capital enters the currency markets and is converted to dollars. When economic risk is judged to diminish these funds suddenly pour back out of US Treasuries seeking higher returns. Since those returns are often overseas the dollars are changed for foreign assets and the dollar sinks.
This mechanistic and simplified logic may suffice to explain the weak pro and anti-dollar moves that have played back and forth in the currency since late May. But a larger question looms. Why hasn’t the dollar benefited from the improvement in the US economy? Currency markets, like equities and futures, are discounting machines. They trade now for where their participants think that currencies, stocks or commodities will be at some point in the near future.
The US economic situation compares favorably with that of any of its major currency trading partners. The financial panic has long since dissipated. The banking system is not going to collapse. Present inflation is benign, whatever the real or imagined fears for 2011 and beyond. The Federal Reserve has restrained its essay into overt monetization. At the last FOMC meeting the Reserve Board declined to add to the $300 billion already allotted for Treasury purchases. Perhaps most informative on Fed thinking, the M2 money supply, long neglected, has leveled and even declined a little in May. Last fall and spring as the crisis escalated M2 had jumped at historically unprecedented rates as the Fed pumped liquidity into the economy. But now it seems the Fed has drawn back from the money glut and that can only help to contain future inflation.
One year ago the US unemployment rate was 5.5 %, it is now 9.5%. While such numbers are a serious hardship for workers and businesses they are also a sign of the flexibility of the US labor market. Because American firms operate under relatively few restrictions they are free to use labor as they see fit. US firms can restructure and redeploy resources to meet actual demand. When growth returns US firms are often in a better financial condition to rehire. US unemployment rises faster in a recession but it also falls faster and to a lower level under economic growth. Compare the US employment situation to that of the European Monetary Union (EMU).
EMU unemployment has risen from 7.4% a year ago to 9.5% in June, half the amount of the US increase. In Europe it is far harder for firms to eliminate workers and doing so is far more costly. Thus when the recovery begins there are fewer empty places to fill. Companies remain wedded to resource deployment designed for the last expansion with no guarantee that the new cycle will ask for the same product mix. In comparison US firms are able to meet the new economic situation with a far more flexible outlook.
Many secondary US economic indicators have improved substantially in the past months. Housing is stable, purchasing managers indices have recovered and consumer confidence and retail sales are on the mend. This is not to say that the recession is ended or even ending. But that as a comparative lesson the US is arguably in better shape for recovery than its European competitors. When this improved economic situation is joined to the historical ability of the US economy to work its way out of trouble faster and with more emphasis than any other industrialized economy we have to ask again: Why has the dollar declined?
The answer may lie in Washington and the political and economic agenda of the Obama administration. Currency markets are making their own discount judgments on the potential economic effect of the two major initiatives of the administration: the climate change bill and the creation of a government health service.
Irrespective of the political and policy aims of the two pieces of legislation, and aside from any opinion on the social and environmental desirability of their stated goals, there is no doubt that both will impose huge economic costs on the US economy. For the climate bill the intention is to apply a proper cost to carbon output. The legislation is designed to impose huge new taxes on any users of carbon. Since almost every consumer or industrial product uses carbon somewhere in the production cycle the economic costs will stretch across the entire economy.
The health service bill cannot be funded without raising taxes and will likely incur large additional deficit spending as well. Few economists advise raising taxes in a recession. A further increase in the already vast Federal deficit could well squeeze out much of credit needed for the private economy and raise the cost of credit for all. Both bills, if passed in present form, seem destined to restrict US economic growth and retard recovery from the recession.
American equities have had a strong recent surge as the passage of these bills has become more problematic. The currency markets will soon notice. If the climate bill fails and the universal health care provision is watered down or put off until next year then restraints on the dollar will fall away and it will follow equities higher.
Joseph Trevisani
May Non Farm Payrolls, unexpectedly positive, gave the dollar a fainting spell. The June numbers, worse than predicted, revived the greenback. Retail sales figures and consumer confidence have gradually returned from oblivion and the value of the dollar ebbed as they rose.
Risk aversion is the standard explanation. Risk capital, or perhaps it is better to name it capital that is averse to risk, is sequestered in Treasury bills and other dollar denominated safe investments when the economic environment looks, well, risky. The demand for these dollar assets pushes the US currency higher as foreign denominated capital enters the currency markets and is converted to dollars. When economic risk is judged to diminish these funds suddenly pour back out of US Treasuries seeking higher returns. Since those returns are often overseas the dollars are changed for foreign assets and the dollar sinks.
This mechanistic and simplified logic may suffice to explain the weak pro and anti-dollar moves that have played back and forth in the currency since late May. But a larger question looms. Why hasn’t the dollar benefited from the improvement in the US economy? Currency markets, like equities and futures, are discounting machines. They trade now for where their participants think that currencies, stocks or commodities will be at some point in the near future.
The US economic situation compares favorably with that of any of its major currency trading partners. The financial panic has long since dissipated. The banking system is not going to collapse. Present inflation is benign, whatever the real or imagined fears for 2011 and beyond. The Federal Reserve has restrained its essay into overt monetization. At the last FOMC meeting the Reserve Board declined to add to the $300 billion already allotted for Treasury purchases. Perhaps most informative on Fed thinking, the M2 money supply, long neglected, has leveled and even declined a little in May. Last fall and spring as the crisis escalated M2 had jumped at historically unprecedented rates as the Fed pumped liquidity into the economy. But now it seems the Fed has drawn back from the money glut and that can only help to contain future inflation.
One year ago the US unemployment rate was 5.5 %, it is now 9.5%. While such numbers are a serious hardship for workers and businesses they are also a sign of the flexibility of the US labor market. Because American firms operate under relatively few restrictions they are free to use labor as they see fit. US firms can restructure and redeploy resources to meet actual demand. When growth returns US firms are often in a better financial condition to rehire. US unemployment rises faster in a recession but it also falls faster and to a lower level under economic growth. Compare the US employment situation to that of the European Monetary Union (EMU).
EMU unemployment has risen from 7.4% a year ago to 9.5% in June, half the amount of the US increase. In Europe it is far harder for firms to eliminate workers and doing so is far more costly. Thus when the recovery begins there are fewer empty places to fill. Companies remain wedded to resource deployment designed for the last expansion with no guarantee that the new cycle will ask for the same product mix. In comparison US firms are able to meet the new economic situation with a far more flexible outlook.
Many secondary US economic indicators have improved substantially in the past months. Housing is stable, purchasing managers indices have recovered and consumer confidence and retail sales are on the mend. This is not to say that the recession is ended or even ending. But that as a comparative lesson the US is arguably in better shape for recovery than its European competitors. When this improved economic situation is joined to the historical ability of the US economy to work its way out of trouble faster and with more emphasis than any other industrialized economy we have to ask again: Why has the dollar declined?
The answer may lie in Washington and the political and economic agenda of the Obama administration. Currency markets are making their own discount judgments on the potential economic effect of the two major initiatives of the administration: the climate change bill and the creation of a government health service.
Irrespective of the political and policy aims of the two pieces of legislation, and aside from any opinion on the social and environmental desirability of their stated goals, there is no doubt that both will impose huge economic costs on the US economy. For the climate bill the intention is to apply a proper cost to carbon output. The legislation is designed to impose huge new taxes on any users of carbon. Since almost every consumer or industrial product uses carbon somewhere in the production cycle the economic costs will stretch across the entire economy.
The health service bill cannot be funded without raising taxes and will likely incur large additional deficit spending as well. Few economists advise raising taxes in a recession. A further increase in the already vast Federal deficit could well squeeze out much of credit needed for the private economy and raise the cost of credit for all. Both bills, if passed in present form, seem destined to restrict US economic growth and retard recovery from the recession.
American equities have had a strong recent surge as the passage of these bills has become more problematic. The currency markets will soon notice. If the climate bill fails and the universal health care provision is watered down or put off until next year then restraints on the dollar will fall away and it will follow equities higher.
Joseph Trevisani
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