Detecting the end of trends

Detecting the end of trends

Cofnas, Abe

The trading axiom “the trend is your friend” has held many traders in good stead, but the caveat “except when it is at an end” has also held true. One of the most important challenges for the forex trader is to detect the end of trends. When trends are at an end a confluence of economic, psychological and technical events occur that generate an optimal trading environment. The first step in detecting the end of trends is to recognize that the trend itself is a multi-dimensional concept and that there are several types of trends that need to be diagnosed.

While trends are measured by price and are essentially technical in nature, there is the economic trend, which is the fundamental basis imbedded in price action and the psychological trend, which is the expectation of future direction. The economic trend is measured by a country’s gross domestic product (GDP) growth rates and inflation rates. The psychological trend measures whether market sentiment is bullish or bearish on the dollar. The U.S. Trade Weighted Index, crude oil and gold are strong indicators of dollar sentiment. The technical trend shows whether the currency pair is experiencing higher highs and higher lows (uptrend) or lower highs and lower lows. All three shape future strategy and trades.

What is the current trend? In economic terms we are in a global slowdown. Here is what the world bank says:

“The slowdown in the United States and in much of Europe has intensified since the end of 2007, and GDP for the high-income members of the Organization for Economic Cooperation and Development (OECD) is projected to slow a full percentage point in 2008. In Europe and Japan, the secand half of the year is expected to be weaker than the first, as leading indicators point to weakness in activity over the period three to six months ahead.”

In the United States, Great Britain and Europe, GDP is declining, if not stalling. In Asia, even the surging Australian economy is evidencing a slowdown in growth, and neighboring New Zealand has cut rates from the 8.25% to 8.0%, fearing a recession. But growth cannot be considered without looking at inflation, which has cascaded into a global uptrend with energy and agricultural prices contributing to growing fears. Most central banks target 2% as the top acceptable level of inflation. “Global economic parameters” shows that this threshold has been broken across the world.

The current situation shows a policy conundrum. Slow economic growth usually is remedied by interest rate cuts, but rate cuts would, in general, risk inflation. The central banks are becoming stuck in a stagflationary scenario where there is little room for action, leading to greater uncertainty. Currency price movements are prone to react more than ever to any news on economics. This leads to the next dimension of trend analysis, detecting dollar sentiment.

Because the global economic picture has a precarious balance of slow growth and inflation, the trader trying to gauge dollar sentiment is facing a very difficult challenge. On purely economic criteria, the dollar bear’s case is strong. But traders of sentiment need to go beyond the reality of an economy’s performance. What counts is the reality of expectations. Dollar rallies will occur not because of positive dollar news but as a result of a change in expectations. The demand for dollars will increase because those who have sold dollars have to buy them back when any good news surprises the market. If the market perceives that any bad news is not as bad as expected, the dollar rallies. From a psychological trend point of view, the dollar can reverse at any time. The lesson for the forex trader is to watch the “hawks” on the central banks. Central bank minutes provide very good leading indicators of sentiment changes regarding whether inflation fears are shaping interest rate policies. Currently the Federal Reserve Board has shown a renewed concern regarding inflation at recent meetings.

So two legs of trend analysis show a possibility of a reversal, which should make every forex trader pay closer attention to their charts to look for technical confirmation.

Abe Cofnas is president of FXdimensions.com. He can be reached at abe@secretsoftraders.com.

Copyright Futures Magazine Group Sep 2008

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