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February 22nd, 2008
A fairly new set of trading and diagnostic tools in the form of Exchange Traded Funds (ETFs) are now available to the forex trader. ETFs are becoming an important asset category and provide investors and traders wirh new opportunities to participate in targeted markets. For the forex trader, ETFs can be used to derive supportive information about the direction of currencies. Many ETFs also offer options providing even more potential for shaping trades. ETFs that are related to currency trading include dollar sentiment ETFs, ETFs on economic sectors (housing, real estate, etc.), ETFs tracking currency pairs and ETFs on commodities. All of these categories can help the forex trader in deciding direction, especially ETFs that track dollar sentiment.
As for the dollar, the impact was mixed. The unwinding of carry trades saw a rally in the U.S. dollar against the Aussie, kiwi, euro, sterling, Canadian dollar and gold, as traders unwound positions, which drove the preceding dollar sell-off earlier in the year. Once risk trades were re-established, equities surged to new highs and the yen slumped to multiyear and record lows. Complacency returned to the market, along with renewed pressure on the greenback in most of the second quarter and into the third.
So what happens when we spread these two different funds (see “Bottom dollar”)? We see the status of the spread at the close of the year was 3.88. The spread between the bull and the bear ETFs was in its 83.56 percentile. This means that an eventual narrowing of the spread is likely and could become a leading indicator for a shift in sentiment from the current bearish downtrend to neutral territory.
But an additional pattern began to form in July, which was not solely driven by carry trades chasing high yielding plays, but also driven by a broad loss of confidence in the U.S. dollar. Rising concerns about the U.S. economy were intensified by downgrades of subprime-backed debt by S&P and Moody’s, prompting worries that the subprime fallout had extended toward consumers (falling home prices and anticipated mortgage resets); companies (depending on construction and home improvement); and banks/hedge funds (holding downgraded paper).
At its highest, the spread was 5.25, at the lowest it was -0.19. Being at 3.88 means that it is in its outer part of the statistical bell curve. Another point of alert occurs when the spread hits the center of the curve at the mean (1.9756). This would show a relative balance between the bulls and bears and could indicate a breakout in either direction. This occurred in July prior to a minor correction, in August prior to a larger dollar correction and in September, just prior to the dollar breaking through a double bottom support area. Of course, when this will occur is not known, but the signs will become discernable if the forex trader knows where to look. The ETFs may very well prove to be a leading resource for shaping forex trades into 2008.
Before outlining these factors, it is important to shed light on the drivers behind the market developments of late February through early March, which triggered a 5% decline in the yen, a 6% decline in the S&P 500 and a sharp slide in high-yielding currencies in less than two weeks. More significant, gold dropped more than 9% during the same period amid a sharp reduction in risk appetite following a one-day 9% drop in China’s main equity index.
The forex trader can use the Powershares DB U.S. Dollar Index Bullish Fund (UUP) to detect a shift in the dollar sentiment. UUP employs a bullish dollar strategy. The ETF is long the dollar against several currencies including the euro, yen, British pound, Canadian dollar, Swedish krona and Swiss franc. Obviously this has not been a profitable fund recently, but this ETF can indicate the mood of the market. Changes in its price will alert the forex trader when there is a shift in dollar sentiment. In contrast the Powershares U.S. Dollar Index Bearish Fund (UDN) is an ETF with a bearish strategy.