Tuesday November 22, 2005 - 10:00:55 GMT
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Black Swan Capital - www.blackswantrading.com
Currency life cycle
“When I first look at a trade, I don’t ask, ‘What is the potential profit I can realize?’ but rather, ‘What is the potential loss I could suffer?’”
Yesterday, ECB President Trichet said, "It would not be a good working assumption...to consider that we are at the start of a series of interest-rate increases." Since then, traders have been buying the dollar, proving that yield is on the minds of most traders.
No doubt, yield is the key driver in this dollar move. It has proven a solid and reliable rationale for currencies, over time, on the way up and on the way down. The chart below shows the ebb and flow correlation between the US $ Index and 5-yr Treasury Yield Index:
In the time frames we trade in its tough to key off yield. But we know it’s always lingering and doing its work off in the background.
We tend to get nervous when we see most all the players focused on the same thing—and now yield is that thing. But as they say, the consensus is wrong at the ends but right in the middle—maybe we are in that middle.
Here’s a look at the Currency Life Cycle we first published on January 14th 2005. At the time we first presented this Cycle, we wanted to make the point that extreme pessimism—as was rampant toward the dollar then—was actually the beginning of the $ cycle. The paradox of markets thing—when things look most bearish, they are actually most bullish.
It’s hard to pinpoint where we are, as this same cycle plays out in fractal time frames. There are still big banks and gurus holding on to the old rationales for dollar weakness (the structural stuff). So, if we had to guess, we would say we are still in stage 3—Perception of the trend.
Currency Life Cycle
Ok, that’s the technical picture. But earlier I mentioned “conversion flow.” Here is a roadmap of a typical currency cycle. It should help put the term “conversion flow” into perspective for you.
1. Extreme bearishness—this is the stage where “shoe shine boys” are shorting the currency and can articulate the rationale to anyone and everyone who will listen. This is when things seem the most bearish, but are in reality most bullish (as later can be seen with the elusive gift of hindsight).
2. Conversion flow—this is the stage when bears start to question their “so obvious” rationale for being short. It is the stage where the flaw in perception of the crowd begins to be recognized by members of the crowd. Conversion flow has an early stage and a more advanced stage. It is why we see increased volatility when the trend changes. The players begin to realize something has changed. But they realize it at different times.
3. Perception of the trend—this is the stage where the crowd recognizes that a new trend may be underway. They have discarded the old rationale and are beginning to accept the new one.
4. Capitulation to the trend—now the trend is fully underway. The crotchety old diehard bears can’t hold out hope any longer—they capitulate and buy into the new trend. Often this is a sign that the new trend is actually becoming a bit stale, for now even the diehards are along for the ride.
5. Extreme bullishness—now the “shoe shine boys” are buying the currency and are articulating the rationale to anyone and everyone who will listen. This is when things seem the most bullish, but are in reality most bearish.
(Footnote: I credit John Percival, editor of the Currency Bulletin, for much of the Life Cycle stages presented above.)
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