North Korean tension & the return of risk-on/risk-off

Currency trading in the coming months will require more attention to fundamental and sentiment analysis than usual. Rising tensions relating to North Korea’s nuclear capability are generating special challenges to currency traders. Currency price direction that commonly reflects economic expectations relating to monetary policy and interest rate differentials is being punctuated by sudden unexpected comments by President Trump and responses from North Korean leader Kim Jong-un. This war of words can distort price patterns. For example, bullish sentiment in the U.S. dollar grew on Aug. 4 due to a better than expected jobs report. However, bullish persistence was thwarted by increased geopolitical tension due to the North Korean situation, and in particular, following Trump’s “fire and fury” remarks of Aug. 8. The bearish reaction in the U.S. dollar/Japanese yen (USD/JPY) currency pair and related pairs are leading indicators of what the future may hold for currency traders.

Currency strategies based on reliable technical patterns and long-term fundamentals are being trumped by a return to risk-on/risk off trading and safe-haven flows: the VIX increases, the yen and CHF get stronger and gold surges. They follow principles of crowd behavior. The initial reaction to an aggressive Trump tweet or a North Korean missile test or threat is to take capital out of harm’s way.

The challenge ahead is how to monitor and trade through these turbulent forex waves. A first step is to establish safe-haven patterns. A good idea is to have the Japanese yen (USD/JPY), gold (XAU/USD) and Swiss Franc (USD/CHF) on your screen. If geopolitical news comes out, the five-minute pattern provides an early signal of the strength and seriousness of the reaction. This concept reflects the principle that a currency pair will remain in a pattern until news breaks it out of its pattern. A key metric for measuring the strength of the move is whether the pair involved is able to engender a sequence of new high or new low closes. The forex sector often is the first to read and react to geopolitical news.

A second clue to provide insight into how the currency market is responding to North Korean tensions is realized by monitoring the CHF cross pairs. The Swiss franc gains strength during geopolitical tension. Knowing this, the CHF pairs should be generally bearish, and one of the best crosspairs to be watched is the euro/Swiss franc (EUR/CHF) pair. Because the euro has been relatively strong due to economic conditions, how the euro reacts in the context of a North Korean crisis will be particularly revealing. Money will tend to flow out of the euro into the CHF. A strong euro will be no match for the strengthening CHF in the case of a risk-on/risk-off market. This crosspair will provide a quick confirmation of whether the tensions are cascading throughout the currency markets. It will also provide confirmation of stress relaxation as tensions recede and the EUR/CHF returns to a bullish pattern.

A third approach to trading the next North Korea provocation would be to find a currency pair that magnifies the move. The British pound/Japanese yen is such a pair. The pound has been bearish, independent of a rise in geopolitical tensions. This is mainly due to Brexit uncertainties coupled with a decline in consumer confidence and negative real wage growth. The pound will be particularly vulnerable to a safe-haven move into the yen and GBP/JPY will likely lose more than other yen crosspairs.

Trading through tensions in North Korea and other geopolitical hotspots requires good timing skills and diligence. Nervous markets produce sharper spikes. Stops and resting orders can be dangerous as can holding positions overnight. Monitoring a set of underlying instruments (USD/JPY, XAU/USD, EUR/CHF, GBP/JPY) will provide real-time clues to how global markets are reacting. An actual outbreak of hostilities will completely change the trading environment and present huge obstacles to trading. Margin requirements will certainty increase. Stops will be taken out with a great deal of slippage. The USD/JPY may strengthen by 1,000 pips. Central banks may coordinate intervention to stabilize the currencies. The best approach to trading in such a scenario would be to stand aside and let price action confirm a relaxation of tensions.