Eight Forex Trading Ideas for 2010

01/05/2010 12:01 am EST

Focus: FOREX

In this article, you will find eight different trading ideas for 2010, each representing the personal opinion of a DailyFX analyst. In fact, exchange rate forecasts are often wrong because no one can really predict the future (at least we can’t!), however, by looking at the same investment theme from different angles, you may improve your chances of making profitable trades in 2010.

In 2008, a substantial deterioration of the global economy led to a considerable appreciation of the US dollar against other major currencies. In general, periods of economic uncertainty prompt an increase in investor demand for less-risky assets, and the US dollar was supported by its safe-haven status and strong demand for US Treasuries. However, in 2009, a sudden change in investor sentiment towards more risk taking led to a massive rally in stocks, but also to considerable losses in the dollar exchange rate. After all, the US Federal Reserve said it would keep rates exceptionally low for quite some time, and investors looked elsewhere for higher yielding assets.

That said, I think 2010 will not be an extension of 2009. First, the Federal Reserve is no longer implementing quantitative easing. Second, the resumption of economic growth in the United States is likely to have a positive impact on the overnight Fed funds rate. Third, exchange rate volatility is way below its long-term average, and I expect it to revert back to mean in 2010. In fact, just a few weeks ago, a possible credit default by the city-state of Dubai reminds us that financial markets remain fragile. Usually, when volatility increases, the dollar receives a boost as investors seek refuge in US Treasuries. So I recommend going long USD/JPY and short EUR/USD. Please make an intelligent use of leverage and always use stops to protect your account from severe losses.

Since the end of the Bretton Woods era, the EUR/USD (DEM rates were used before 1998) exchange rate has exhibited a long-term rhythm of close to a decade up and four years down. If the rhythm holds, then the EUR/USD has been in a bear market since topping in July of 2008. So, it is important to keep in mind how important a USD turn may have occurred at 1.6000. This is bearish in that it indicates distribution followed by consolidation. Moreover, looking at a EUR/USD monthly chart, one way to estimate the right shoulder of a possible head-and-shoulders top is to extend a line parallel to the neckline from the top of the left shoulder. Of course, it is not known that a head and shoulders has unfolded until the neckline breaks. However, utilizing this “trick” of extending a parallel line from the top of the left shoulder often gives an early warning that the pattern in question is indeed a head and shoulders. Such is the case here.  In 2010, the neckline crosses 1.2635-1.2866. A break of the neckline would expose 10760, 10215, and 9600.

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Heading into the end of the year, the dollar has marked a meaningful reversal against key counterparts (the euro, Australian dollar, and Canadian dollar). However, until the primary fundamental driver for the dollar—that depressed the currency to the 16-month lows that it was scrapping through the end of November—definitively reverses course, I will continue to treat long positions on the reserve currency as a countertrend trade. That means I will continue to book profits after each significant rally.

So, what is the key driver? Market-wide risk appetite. This may seem a vague and intangible driver, but in reality, it is pretty straightforward to qualify, and the payoff is that there will be an abundance of trading opportunities when it can be confirmed. When underlying sentiment truly does reverse, we will see its effects far and wide. Not only will the dollar recover ground, but high-yield currencies will tumble, low yield currencies will turn into safe havens, equities will plunge, commodities will contract, and fixed income will rally as capital seeks out a stable return. I believe this will happen in the first quarter of 2010, and the correction will be aggressive. When this tactical shift does occur, I will be looking particularly at building a long position in USD/JPY, which is turning off 14-year lows and will soon see a tectonic shift in funding currency roles. As for the other majors and yen crosses, there will be other opportunities, but they will not last nearly as long. Considering the correction that is forthcoming would be on a trend that took a considerable time to build up and has not retested pre-crisis highs, it will be limited. Eventually, we will come to a period of stability where more realistic expectations of risk and reward will meet conditions where stimulus is withdrawn and regulation limits leverage. When this occurs, I will turn to short- to medium-term swings as long-term positions will take a considerable time to generate anything on the level of returns that I have grown used to in 2009.

For the latter half of 2009, I argued that financial risky asset classes would likely correct and send the US dollar significantly higher. I was obviously early in my forecasts to say the least, but in December, we’re already seeing what, in my opinion, looks like the US dollar turnaround. My top trade in 2010 will be to continue buying US dollars against the euro, especially; but also against the seemingly unstoppable Australian dollar, New Zealand dollar, and Canadian dollar.

This bet leaves me very exposed if financial markets continue higher, but I think current economic optimism is well overdone. The recent wave of positive economic data will almost certainly end, and the lofty highs across key financial market risk barometers will prove unsustainable. A large correction would likewise lead to lower commodity market prices, leading the Australian dollar, New Zealand dollar, and Canadian dollar all lower against their US namesake.

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Having had trouble with this view in 2009, I nonetheless continue to believe that the US dollar is headed for a major push higher against the spectrum of major currencies (with the possible exception being the Japanese yen). Initially, the catalyst is likely to be a correction downward in global stock markets as investors come to terms with the fact that most economic growth in 2009 has owed to inherently finite fiscal stimulus, with the road to self-sustaining recovery rooted in the private sector being a much more distant prospect. This looks likely to boost the dollar as risk aversion once again lifts the safety-correlated currency.

Further ahead into the year, the USD up move will be sustained by a re-examination of the Federal Reserve’s monetary policy favoring a more hawkish US central bank than had been expected through much of 2009. This should strip the greenback of the dubious honor of being the most attractive carry trade funding currency and break down the inverse correlation between USD and stock markets and allow the dollar to gain even as equity markets begin to tread higher once again. On balance, the best way to express this idea seems to be going short EUR/USD.

It is easy to go into 2010 bearish the yen considering the recent actions and rhetoric from the Bank of Japan. The central bank announced a ten-trillion-yen lending program and signaled that fighting deflation is their primary concern with the statement that the BoJ “Does not tolerate a year-on-year rate of change in the CPI equal to or below zero percent.” Therefore, the policy makers aren’t expected to raise rates until inflation becomes a concern, which they predict will be subdued until March 2012. The greatest case can be made for taking a long dollar position against the Asian currency as the greenback is starting to gain favor with the outlook for US interest rates rising. The dollar has been the primary funding currency in 2009, and as traders start to repay their borrowings, demand for the reserve currency will drive its appreciation higher. Theoretically, we should see investors then look to finance their future investments by borrowing yen, thus increasing its supply and lowering its value.

The obvious nature of the trade generates reservation and calls for a counter argument. However, considering that current levels have only been seen twice in the last 30 years, it is difficult to make a case that downside risks are greater. Yet, any signs that a double-dip global recession is underway could send the pair to test the 1995 low of 79.70. However, we may need to see the US credit status deteriorate for it to be surpassed as the safe-haven currency of choice. Chinese growth put the entire Asian economy on its back, and the resulting demand for Japanese goods could raise its own growth and inflation outlooks. In a best-case scenario, that would be toward the end of 2010, which leaves plenty of time to make profits on a bullish USD/JPY position. I would wait for a break above trend line resistance (8/15/08, 8/7/09 high), which would trigger a bullish trade with the initial target at 101.43-4/6 high, followed by 110.65-8/15/08 high.

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There have been significant moves in the EUR/USD this year as governments all over the world took unprecedented steps to prevent the collapse of the global financial system, and we are likely to see some of these trends turn around or come to an end into 2010 as policymakers look to unwind the emergency measures. Over the first half of the following year, we are likely to see the US dollar lose its popularity as a funding currency as the Federal Reserve aims to normalize monetary policy, which could lead the EUR/USD to fall back towards the June 2009 range that lies around 1.3800-1.4000. However, if Fed chairman Ben Bernanke fails to raise the benchmark interest rate during mid-2010, we may see renewed weakness in the greenback, with the exchange rate climbing back towards the 2009’s high around the 1.5100 level.

At the same time, the Australian and New Zealand currencies have certainly carved out a near-term top during the second half of 2009, and interest rate expectations are likely to have a significant impact on price action throughout the following year. The Reserve Bank of Australia and the Reserve Bank of New Zealand have held a slightly hawkish tone in December, but the marked rise in global asset prices paired with fears of a protracted recovery may drag on carry interest, along with investor’s willingness to move into higher-yielding currencies. Moreover, as investors expect global interest rates to rise over the coming months and look to unwind their high risk/reward trades, the AUD/USD and the NZD/USD is likely to fall back towards the 38.2% Fibonacci retracement levels of this year’s rally, and may hold a broad range going into the second half of 2010 as investors weigh the outlook for future policy.

Bet on the USD in 2010. While my trading methodology does not permit me to take such long-term trades, I do hold a techno-fundamental core USD bullish outlook for the buck in 2010, with a majority of the USD strength seen in the initial half of the year. Technically, a closer look at all major currencies against the USD shows the greenback near cyclical lows and in the process of carving out a major base. Fundamentally, it is all about yield differentials and interest rate expectations. The onset of a global recovery is starting to put the Fed in a position to at least consider the possibility of an exit strategy and reversal of their super-accommodative monetary policy measures. While I do concede that this will also result in a continued reversal in other central bank monetary policies, which we have already seen through the likes of Australia and Norway (among others), the rate at which the Fed will be required to tighten going forward will be that much more extreme and aggressive given where US interest currently stands. This will therefore force a significant narrowing in yield differentials back in favor of the USD, which should result in some major position adjusting and shift back into the USD.

Another theme that I see supporting the USD comes more peripherally through the equity markets. US equity valuations are arguably very attractive at current levels, and the lure of potential investment back into the most efficient stock market in the world should produce some major inflows back into the United States and thereby prop the greenback.  This should also result in a more proper positive correlation of strong US equities and strong dollar, which has been inversely correlated over the past several months.

By the staff at DailyFX.com

DailyFX provides forex news on the economic reports and political events that influence the currency market.

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