How to Spot a Bottom Coming in the Currency Markets

Happy Weekend Currency Traders!

Financial analysts like to say there are no fundamentals or support levels during a bear market. But what they really mean is no one really cares about a company's nuts and bolts when markets start to head south.

It's the same in the currency markets. When markets head south, no one tends to care about a country's (or its currency's) fundamentals.
What Matters Most When Markets Fall Apart

In addition to fundamentals, Forex traders also track a currency's technical performance to gauge how a particular currency will perform.

During normal markets, there are key areas where a currency pair will stop on the charts. Sometimes it's a "round number" like 1.36 or 1.40 but other times it's just a place on the chart where the pair has resisted falling many times. These are called "support levels."

Unfortunately, technical analysis isn't the best gauge of a currency during a bear market either. Most of the usual technical analysis becomes obsolete during a bear market because investors simply aren't paying attention to it. At those times the market is almost purely driven by sentiment (i.e. how the majority of traders feel about the market). In a bear market, investors tend to let fear rule their trades.

So what puts a bottom in the currency market? A change in sentiment.

Here's the problem: Only drastic measures force a sentiment change. So this is what you sit back and watch for.

I watch stocks a lot as a clue as to when certain key carry trades will turn around. (Remember: Carry trades happen when investors borrow low-yielding assets to buy higher-yielding assets and then pocket the difference.) You'll see from the chart below that the Dow Jones Industrial Average and the EUR/JPY (euro vs. the Japanese yen) look almost identical. They feed off of one another.

When the Dow Turns, Inevitably the EUR/JPY Pair Also Turns!

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Why else do I watch stocks to see where currencies may go? Because I know that the Fed practically worships the stock market.
VIX - Let the "Fear Gauge" Be Your Guide

The Fed officials don't sleep well at night when stocks are falling. So many Americans either work for or invest in publicly traded companies, so if these companies are failing, it's also going to hurt the rest of the economy.

Hence, the Fed-Heads think they have to do something so they can get these stock prices headed in the right direction.

So during these times, I switch gears and mainly look at market indicators that judge sentiment such as the VIX (found at stockcharts.com using symbol $VIX), mutual fund redemptions, and unusual government activity.

Let me explain in a bit more detail. If you've been reading my articles, you know that I'm a big proponent of judging the "risk" appetite out there in the market. When markets are calm, the VIX has a low reading. However, when times get shaky, the VIX has a very high reading as investors become what Forex traders call "risk averse."

You see, the VIX judges fear in the market. When the VIX heads to historic highs, fears are also at historic highs too. When fear reaches its peak, it generally predicts that a sentiment shift is coming. And a sentiment shift means a bottom is coming in the markets.

Mutual Fund Redemptions Are Your Next Clue For Finding a Bottom

Mutual fund redemptions are yet another. You can just listen to CNBC or Bloomberg TV during bear markets and they'll tell you about mutual fund redemptions. Just this last week, mutual fund redemptions hit an all-time high! This tells me that the retail investors have been shaken to the core and are running for cover.

Investors are so scared that they can't take it anymore. So they cash out their 401ks and IRAs and taxable accounts. Inevitably, this is when the markets are near their bottom and the change comes.

You see, the Fed sees investors scampering all around and they know they have to step in and do something.

So when the Fed and/or the Treasury make unusual moves, I know a bottom is here or near. Either way, I know its time to start tip-toeing back into the waters by buying the euro vs. Japanese yen pair (EUR/JPY).

Here's why: When I see a bottom coming in the stock markets, I know that EUR/JPY is about to bottom as well. For starters, the EUR/JPY largely follows the stock market. So when the stock bottoms, so will the EUR/JPY.

Also, the EUR/JPY is a riskier trade because it gives a higher yield. If the stock market is bottoming, risk-taking will become popular in the markets again. Stock investors will plow back into stocks, while currency investors plow back into the riskier trades.
That means the EUR/JPY will rise.
"Unusual Government Actions" Signal It's Time to Leap Back In

Well, so what have we had recently? We've had the Fed and Treasury dumping tons of dollars into the financial markets lately in an attempt to fix the credit crisis.

Not only has that been an unusual move but the U.S. Fed coordinated a "group interest rate cut." The Fed, European Central Bank (ECB), Bank of England (BOE) and three other central banks all cut interest rates at the same time on the very same day.

Then the government started buying positions in banks to support the financial system. Some are even nationalizing some of their banks to rescue them.

Not only is the U.S. committing money to their financial system but Germany, France and the U.K. all do the same. Collectively they pumped TRILLIONS of dollars into the market.

When you see drastic measures like this, you know the central banks of the world are trying to "re-inflate" their economies from the deflationary spiral they've gotten into.

And they will be successful, at least for now. As they work their magic, stocks will eventually heal. When they do, high-yielding carry trades like the EUR/JPY will also profit.

Governments are opening up the floodgates and they won't stop until they feel the markets have reversed and a sentiment change has taken place.

So in times like these (where the market is looking for the turning point), make sure to focus on sentiment type indicators like the VIX and mutual fund redemptions. Most importantly, keep an eye out for any government interventions.
Have a great weekend,
Sean