Forming hunches in Forex

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How to Form Hunches

To trade currencies, it helps to know what assumptions most traders have made, even if you don't share them. Compared with last August, for instance, the market has scaled back expectations of rises in UK interest rates. If the previously strong housing market was the spur to raise rates, its current softness could pave the way for a cut. Sterling's recent strength will also have had a strong anti-inflationary effect as it reduces the relative cost of imports. And the start of any new downwards trend in UK rates should lead to a weaker pound.

The most interesting near-term influence on sterling will be the UK general election. Even though the Bank of England is independent of the government as far as interest-rate decisions are concerned, it may be that a spring interest-rate cut is rather easier to sanction than a rise, although there is unlikely to be any change until after the election.

The added uncertainty of this event is likely to mean that, although the pound may display local volatility, it is difficult to see it breaking beyond the $1.80-$1.90 zone in the first half of this year. The most important UK economic numbers continue to be retail sales and house price surveys, as well as Bank of England minutes on interest rates.

Euro Zone

The consensus on eurozone interest rates is that the European Central Bank (ECB), wary of the German economy, will not raise rates anytime soon. Indeed, after 20 months at 2 per cent, the next move could even be down. That possibility has helped temper last year's sharp rise in the euro, catching out many bulls of the euro who were betting on it rising to $1.40.

The most important European indicators are the jobless rate of 8.9 per cent which capped growth at less than half the pace of the US, as well as the money supply growth rate. This is the ECB's yardstick of future inflation and it rose to an 11-month high of 6.4 per cent in December. ECB President Jean-Claude Trichet said on 3 February that he expects inflation to slow to less than the ECB's 2 per cent ceiling this year, underlining the 'no change' stance that is likely to dominate 2005.

US

When George Bush won re-election in November 2005 it seemed to mark the end of the US's 'strong-dollar' policy, in the hope that a weaker US currency would help reduce the budget deficit. For six weeks, the forex markets became a one-way bet towards $1.40 against the euro and £2.00 against the pound.

But a reaffirmation of the strong dollar policy by US Treasury Secretary John Show, as well as hints by the Federal Reserve that it would take a more aggressive stance on raising interest rates than previously thought, have pushed the dollar back to where it was in the beginning of November. In addition, Mr Snow's recent assertion that higher taxes are not the way to cut the deficit and his commitment to permanent tax cuts appeared to have undermined confidence in the administration's determination to cut the fiscal deficit.

The key US numbers to look out for at the moment are the non-farm payroll data (which is considered to be the most direct measure of the strength of the recovery of the economy), the Michigan University Consumer Sentiment survey and, of course, the trade deficit itself. Trading ahead of these numbers is something that most traders simply do not do.

Trading Signal

By all means, adopt a view on where currency crosses are going on a three or six-month basis. Just don't expect cable to follow your logic on a minute-by-minute basis. The currency day trader, while aware of the underlying fundamentals, may only be looking to buy cable at $1.8560 at 8am and exit at $1.8590 come 8.30am. Such a trader is exploiting the natural volatility of the cross and, in the absence of any news, the trade will largely be a technical one. Ideally, the reasoning behind a trade will be a mesh of the trader's fundamental view and what the technicals of his chart tell him.

As well as the daily, hourly and five-minute chart in front of them, traders will also monitor a news feed and use their favourite charting software. Information overload can be a problem, so stick to one website that you can customise. Regular reading of these news sources will familiarise you with the consensus view on the major crosses as well as giving you an indication of how fellow traders are reacting.

But be warned. There will be times when an excellent technical trade goes awry after an unexpected comment from the governor of the Bank of England. And there will be times when an interest-rate cut will actually strengthen a currency because it has already been factored into the price.

The Decision-Making Process

Stick to factors that can be anticipated instead of taking a punt on the latest piece of economic data. When a major number comes out, the market frequently spikes in both directions, or initially moves to counter the logical direction of the new fundamentals.

A typical trading decision will involve weighing up several factors and then turning this into an entry point, a stop-loss, and a target - in that order. For instance, after a near 10 cent decline from 2004 highs, GBPUSD made an intra-day low of $1.8526 in January and, so far, $1.8511 in February. This does rather invite a buy below $1.8600 in order to place a stop-loss below $1.8511. But a word of warning against such simple stop-loss-driven trades. You do not usually make money in forex for doing the obvious. It may be better to sell the pound into strength, rather than try to pick the bottom of a two-month 10 cent sell-off.

GBPUSD: Technical Analysis $1.8685 Near-Term Falling Wedge

Charting has become a key component of forex trading. It is rare that the technicals of a cross are totally absent from a buy or sell decision. Most of the big banks have proprietary technical models and projections on which to base trades. But charting rules form the basis of such analysis and, over the past few years as software has improved, its importance has grown.

Although the charting term 'falling wedge' may sound negative, this is actually a bullish formation for the pound, especially if it is able to break the December resistance line currently running through $1.88 (see the green lines in the GBPUSD chart, below). As things stand, though, I see a bear trap rebound from just below January's intra-day low of $1.8526. February's low, so far, has been $1.8511 and it is typical of this cross to deliver such trading googlies.

The next step for the cross is likely to be an attempt to break the December resistance line but, if this is not achieved by the end of the month, you would have to anticipate a final leg down to the floor of the overall rising September price channel at $1.83.

So the near-term $1.83 to $1.88 range seems to be mapped out quite well and the advice would be to avoid this cross as it is in the middle of the range.

Given the apparent overall ascending six-month pattern, the most comfortable trade would be to buy the pound as near as possible to the September support line. Only an end-of-day close below $1.82 would prevent a return to the highs of last year in the mid $1.90s.

GBPEUR: Technical Analysis $1.4507

When the dollar really began to drop last summer, traders had to choose between backing sterling or the euro. They chose euros. This may have been because they were anticipating the end of the UK interest-rate hiking cycle. Anyone buying GBPEUR on the basis that UK interest rates are twice eurozone levels will have had a sinking feeling. This was on the basis of pressure from the falling 200-day moving average near E1.4650 and the descending 2004 price channel.

The channel's mid line (green) runs through E1.46 and this month has seen a retreat from this line and an overbought 14-day relative strength indicator just below 70. The best-case scenario is for a bounce for the cross at the 50-day moving average just under E1.44, otherwise a two-day close below this charting feature suggests a re-test of the lows of July 2003 at E1.40.

Only sustained price action (a weekly close) above the 200-day moving average and E1.46 would even begin to change the trend back in favour of the UK currency.