Doubt surrounds US Tax legislation

Daily Analysis - 19/12/2017

This is how to trade the uncertainty about changes to the US tax codes.

uncertainty


Uncertainty over the details contained in the current bill working its way through the US Congress have weakened the US dollar against the Japanese Yen and the Euro. Gold too shows signs of renewed buying which is driving the price up 1.96% over the last five days.

Capital market sensitivity


Capital markets do not tolerate uncertainty well. And for good reason: When the future is less clear, risk rises. Risk is defined as the probability of the unexpected occurring. When expectations are blurred, as is the current case with the tax reform legislations winding its way through the corridors of political power in the US, the probability that an unexpected outcome will occur rises, hence the risk. The likelihood that the bill will falter altogether or that it will arrive with less than clear benefits for business and industry is causing the US Dollar to become weaker relative to the Euro and the Japanese Yen.

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Currencies are like stocks but for trading zones rather than corporations


When currencies weaken or strengthen against each other it means that the markets, i.e. traders like you and me, value the strengthening currency over the weakening currency. For reasons like those that drive a stock price up: Good leadership in its zone of operation, strong growth in its economy, healthy profits being generated for its constituents and so forth. And of course the opposite is true too: When leadership is weak, as is the case with the current US administration, it will cause traders to desire the “stock” of the trading zone, the US Dollar, less than its alternatives and drive them to sell the US Dollar or buy it’s alternatives with the US dollar causing the US Dollar to weaken relative to the currency being purchased with that US Dollar.

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Alternatives to Currencies, versus alternatives to stocks


Currencies, as proxies for the “stock” of a trading zone, have alternatives sort of like stocks do. In the sense that a particular apparel manufacturer may be having a bad season while some or most of its competitors are booming, so too are currencies alternatives for one another. Sort of. In the case of the apparel manufacturers, while they may not make exactly the same types of clothing, different manufacturers will compete directly in the same niches. Think sports gear, or daily wear, or even haute couture. Nike can substitute for Adidas, but not for Ralph Lauren. Still, there is overlap and therefore practical substitutes are available. This is less true in the currencies because entire trading zones are less alike one from the other. So what is being traded when currencies are exchanged is not the direct applicability between them, like the difference between Nike and Adidas, but rather the marginal differences between them. In other words, the differences that result from the market’s perceptions of their peripheral performances, not the differences in their absolute performances. The Euro does not weaken because the quality of European steel is seen as inferior to American steel. Rather, the market feels that aspects on the edge, the periphery, of the economy are diverging and therefore a profit opportunity exists to exploit that transient difference or divergence.

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Mixed Signals


The signals that result from and feed into currency trading are mixed. An engineer would say that there is noise in the signals. This means that there are random movements and irrelevant developments that occur and must be filtered out. Today we present some examples of this mix. The US Dollar is weakening against the Japanese Yen and the Euro as well as against Gold. Yet, the US stock market continues its steady grind upwards setting new all-time highs on a very regular basis. (See the attached charts). The mix of different signals emanating from competing economic zones is understandable. After all they are not direct competitors like the example of the apparel companies. They differ in as many ways as they are similar. Yet it is the marginal perceptions, those sensibilities traders express about those ideas and values mentioned above that sway the relative values of currencies. As they are straight forward and easily understood from reading newspapers, they are therefore terrific opportunities to trade profitably. Understanding the market’s mentality and psychology will usually provide predictable outcomes. We will delve into this psychology in further briefings.

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