The Greek austerity vote offers more proof that currency analysis has changed.

Understanding that change will be the key to bigger profits in the months ahead…

To get into what I mean, take a look at these headlines from The Financial Times about today’s Greek austerity vote.

Before the vote: Greece Faces Suicide Vote on Austerity

And now? Stocks and Euro Rise as Greece Passes Austerity Package

To me this indicates that the currency markets have undergone a significant change. Traditionally, currencies increased in value when they reflected more growth and greater interest rates than another currency. The major force was interest rate differentials.

Today, however, things have changed. Since the financial collapse in September ’08, the challenge has been more daunting. As countries pushed their interest rates near zero, differentials became largely irrelevant. Traditional economic-based fundamentals collapsed and were trumped by psycho dynamics of market fear.

While the era of zero interest rates is essentially over, the magnitude of fears as a force remains predominant. Traders have to detect and filter those fears in order to shape a trading strategy.

Let me show you what I mean…

Today there are three predominant fundamental fears influencing weekly price action:

• Greek debt problems – Fear mongers have been making doomsday scenarios if Greece defaults. Economist Martin Feldstein has written that Greek default is inevitable. Esteemed investor George Soros has speculated that the eurozone may break up. And that’s led to headlines like the Greek suicide voting.

• Fears over US debt – Investors are on guard for a downgrade of US bond ratings, if not actual default. The fruitless finger-pointing and fear mongering between President Obama and Congress aren’t doing investors any favors. Any nervousness about a negotiated approach to the US debt financing has resulted in market gyrations.

• Fear of China – There are actually two things investors are afraid of. First, China could dump its US dollars, driving down the greenback’s value. Second, the country’s bubbling economy could slow down. Any time a rumor occurs about China’s economy, it cascades around the globe and causes market moves.

So how do we as traders approach these fears?

I say with a contrarian point of view and a little bit of political science. Whenever fears are at such extremes that only one point of view pervades, the best approach is to go the opposite way.

Think of it this way – Greece defaulting and the eurozone collapsing would be extraordinary events. Everyone is working hard to make sure it doesn’t happen. Yet the crowd thinks these are both strong possibilities, making betting against it far more rewarding.

Similarly, fears over the US debt offer opportunities in the dollar and stock market. Yes, if the United States defaults on its debt, there will be chaos leading to a new financial collapse. But the politicians know this, and no political leadership wants to see it happen. It would stain the reputation of the political party responsible for the lack of an agreement.

The bet is that it won’t happen. It will certainly be tense with a lot of last minute panic. But that will be the extent of it. The trading strategy should be to buy US dollars when the worst is feared or bet on an oversold market.

Looking ahead, you can take these lessons and apply them to China.

First, let’s apply a little political science to the fear that China is getting ready to dump the dollar. China’s greatest value is stability. A precipitous decline in the US dollar destroys that stability. China holds over a trillion dollars of US debt, and more than that in its cash reserves. It reminds me of the old adage that when someone owes the bank a lot of money, the bank is in trouble.

China won’t abandon the US dollar, but rumors of that will persist.

Fear of a China slowdown is the only fear that is valid from an economic point of view. China cannot sustain nearly double-digit growth without inflation, and it cannot suppress pressures of wage inflation as its middle class increases. China will slow down; it’s just a matter of timing.

But for now, both fears about China seem overblown, creating contrarian opportunities for us. My currency of choice is the Australian dollar (AUSUSD), which acts as a surrogate for Chinese growth expectations. It will be severely impacted on any change in China growth… and has the most to gain if investor fears are too early.

So keep a close eye on the AUDUSD for contrarian DOOM plays to cash in on investor fears!

[The Sleuth’s Note: As you may know, Abe’s favorite way to play currency movements is by using binaries.  If you missed his tutorial on binaries, just click here. We suggest you give binaries a shot. They’re exciting. Fast paced. And potentially very profitable. For a great tutorial, check out the Nadex binary exchange. You can find its step-by-step, interactive guide right here.]

Sincerely,

Abe Cofnas
Currency Analyst for the Penny Sleuth

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• October 11, 2011 -- Currency In Focus: Analyzing and Trading Fear
• September 19, 2011 -- Currency in Focus: The Biggest Movers in the Currency World

Abe Cofnas

Abe Cofnas has been a full-time analyst of global currency trading for over twenty years and ranks among the top Foreign Exchange (Forex) traders working today. He has written three books on the subject. The most recent, Sentiment Indicators was published in 2010. Cofnas is the managing editor of the Fear & Greed Trader, Agora’s primary source for currencies information. He has also been Futures Magazine’s Forex Trader columnist since 2001, having written over 100 pieces.

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