Commodities Corner: Commodity FX January Overshoot

Commodities Corner: Commodity FX January Overshoot

Commodity FX: With dramatic declines in Commodities and the correlated moves in the main commodity FX pairs, I wanted to analyze evidence of FX markets overshooting in January as consensus thematic trades become overcrowded. There is in fact evidence of this, but only for AUD, CAD, and in particular NZD. This probably reflects a combination of relative lack of liquidity and strong pro cyclicality for all three. For AUD, NZD, and CAD, the start of 2016 has been a carbon copy of the start of 2015, with losses of 6–7% compared to losses of 5–7% in January 2015. In this context, it is worth assessing the issue of January overshooting. Might a rush into year-ahead thematic trades in January cause overcrowding set markets up for a subsequent reversal? Using a simple systematic trading strategy, there is some evidence that it does.

A simple systematic trading strategy premised on January 31 each year, if currency x has risen in the month, sell it and stay short for the remainder of Q1 and vice versa. AUD, NZD, and CAD all produce significantly positive returns and all have hit ratios better than 50%, particularly so in recent years and especially for NZD (almost 50% return and hit ratio of over 80%). The evidence that these currencies overshoot at the beginning of the year is quite compelling. AUD, NZD, and CAD show real evidence of overshooting in January.
Of course, 16 years is a relatively small sample and the results could be spurious, but there are several intuitive reasons to think these currencies might be vulnerable to overcrowding. Relative illiquidity is likely to be one factor. Turnover in AUD, the most liquid of the three, is typically less than half of that in GBP and less than one-fifth of that in EUR. And AUD is five times more liquid than NZD. The perceived high beta that all three have to the global and local economic cycles may be another factor—any one would be a candidate to express a view on a cyclical turning point for the year ahead.
Main message here is simply that we should not get carried away with the moves in the commodity currencies in January. Market still fundamentally negative on all three, but the risk of a pullback is significant based on historical data. Traders that have core shorts in AUD, NZD, and CAD should look to reduce exposure as we move toward month-end. Traders looking to add short commodity currency exposure should probably wait for better levels to do so.

Technical & Trading Takeaways

Lets take a look at the NZDUSD specifically and see where trade locations may develop in synchronicity with the statistical set up into month end. The current structure remains bearish although there are preliminary indications of a momentum decline in the downside, which at a minimum could portend a correction in the Kiwi.
2016-01-26 14_53_55-
The trend line tracking from the 2014 highs is mature and the last test began to erode the resitance it has offered. A fourth test would like see the trend line breach and set up a deeper corrective phase. The technical indicators are stabilizing with OBV and Psych supportive of a move higher from current levels. I am inclined to venture long through the highs of the current consolidation at .6570 with a protective stop at .6330 initial target will be structural resistance at .7200 with an extension target at .7600
Trading Update: NZDUSD Long .6570 Stops To Entry
For updates on trade of the day set ups and the other trades I am currently monitoring be sure to follow me on Twitter @LFXPatrick
Posted in Commodities Corner, Forex Analysis, tagged with on