The perpetual learning curve

In the markets every day is a learning curve or so says the old adage. We have been reminded of that fact in the first trading week of the New Year got off to what we might charitably call a rocky start.

In fact it was one of the worst starts to a trading year in living memory.

Regular readers will be aware of our negative stance on China and in particular the reliability of its official economic data. We noted these concerns once again, in the article "We need to talk about data". Which was published in our newsletter of 14/12/15 and again in the most recent edition of FX Trader Magazine (see Pages 21 to 24.) In fact in this piece we used the sharp revision to Japanese Q3 GDP as an example of this type of questionable data.

The sharp falls in Chinese equities and the weakening of the Yuan versus the US dollar, over the last week, suggest that that our bearish take on China and the fallout from there, was the correct one. But before we give ourselves a big pat on the back we need to recall that we weren't right about how the Yen was likely to behave over the last few weeks of 2015 and the start of 2016.

Our stance had been that Bank of Japan (BOJ) Quantitative Easing and the Three Arrows policies of Shinzo Abe's government have been ineffective in ending the decades of economic stagnation that Japan has endured, since the bubble economy of the 1980s & early 1990s collapsed.

After all a weak Yen has been a key policy tool in both the Japanese monetary and fiscal camps. Indeed the Yen traded up to 125.83 versus the dollar in early June 2015, before it plunged to 116.12 in Mid-August. From where it very quickly rebounded and then resumed its path lower by Mid-October.

Given the above we felt vindicated in assuming that the Yen would continue to weaken in 2016. Particularly as we had anticipated continuing easing in the Chinese Yuan. Some of which we saw and highlighted before the Christmas holidays. The assumption being that a weaker Yuan makes Chinese exporters cheaper, therefore regional competitors such as Japan would follow suit to keep their exports competitive.

What we have seen instead is consistent Yen strength so what went wrong with our thinking?

I believe we can break it down as follows:

Assumption: They say that when you assume you run the risk of making an Ass out of U and Me. To some extent we were guilty of this in our thinking about the Yen, by assuming that it would continue to weaken. Despite a reduction in the number Yen short positions in the IMM currency futures. As noted in recent Commitment of Traders reports. Which we were aware of, but considered to be nothing more than year-end book squaring, as the BOJ chose to not to take any further action at its last meeting in 2015.

Confirmation Bias: The psychology of trading is one of the most important things to be aware of. One of the mistakes that traders often make is believing their own publicity and compounding that by seeking out the opinions of those that hold a similar view. Thereby reinforcing that opinion.

Instead of which you should seek out contrary views and having heard or read them, you should retest your own thinking and consider where you could be going wrong. There is no guarantee that having done this you will change your mind but it should always be a part of your process.

Forgetting: Correlations and relationships between asset classes and individual instruments are constantly evolving and very few have any real longevity, though there are exceptions to the rule.

An obvious example of which is the relationship between US dollar strength and commodity prices or the Canadian dollars inverse relationship with the price of Oil. There are others, some of which have slipped into distant memory.

One of these relationships returned from the fog of the past this week however. Namely the Japanese Yens status as a safe haven currency, when markets adopt a risk off mode. This relationship has been the subject of several academic papers over recent years including two from the IMF in 2013. But given the extraordinary fall in the Yen since the summer of 2013 (when it traded at 94 to the dollar) and the perilous state of Japans economy and public finances they have been overlooked by many.

The drivers of the Yens safe haven status are complex and may not even be fully defined. However the IMF reports flag a useful barometer which we can use to determine when a market is in a risk off phase and therefore when we might expect to see Yen strength.

That barometer is the positioning of the VIX index relative to its 60 day Simple Moving Average or SMA. If the VIX is trading 10% or more above its 60 SMA then we can consider the market in risk off mode according to the IMF research. As we can see from the chart below (sourced from Yahoo) this has been the case for some time.

CBOE VIX index versus its 60 D SMA

Saving Graces: The good news is, there several of these.

Firstly though we were prone to confirmation bias in our thinking we were not slavishly so we had noted the positional change in IMM Yen currency futures and had drawn a line in the sand (a stop-loss) beyond which we would concede we were wrong or needed to modify our strategy in the Yen. That level was support at and around Yen 119.20.

Secondly we recognised and registered the fact that we had got the Yen wrong. Most importantly admitting that to both ourselves and our peers. Thirdly we took the time to investigate why and pledged to learn from the experience and modify our strategy going forward.

To sum up

In summary then even the most experienced participants in the market can get it wrong and they are not immune from falling into common psychological trading traps.

However strong your view you must have a stop-loss in place. Because as John Maynard Keynes famously pointed out even if you are right "the market can remain irrational much longer than you can remain solvent".

Remember it's ok to be wrong as long as you discover why (be honest with yourself here) and learn from the experience. Then use this knowledge to modify your behaviour next time out. If you do that then you will be in good company.

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