European Economic Community

European Economic Community

 

Talks on the formation of a populist coalition government in Italy have dominated headlines for the past week. Following a closely watched and ultimately as yet inconclusive election in Italy that took place over two months ago, a potential coalition between the ‘Five Star’ and ‘League’ populist parties appears to be on the cusp of fruition. Thought to be the worst possible outcome of an already difficult situation, the coalition is already wreaking havoc on Italian equities, bonds and the Euro in general.

 

The Five Star Movement, which claimed over 32% of the vote in March, represents a highly anti-establishment and disruptive party. Italy’s ‘Lega’ party in turn took the third highest percentage of the vote, 17.69%, increasing its share of the vote by an immense 13.59% versus its previous performance. The League is a far-right party, and within the coalition threatens to drag the Italian nation further away from its previously controversial but unmistakably centrist and orthodox modern history.

 

A draft version that was leaked to the Italian press highlighted the potential coalition’s desire to force Italy out of the Euro – in fact, potentially, the European Union in general. The European project is widely recognised to have been around since 1951 with the creation of the European Coal and Steel Agreement. More recognisably, the signing of the Treaty of Rome in 1957 consolidated European solidarity and cooperation. However, the European Union only came about in 1992 with the Treaty of Maastricht; the agreement that also provided for the creation of the Euro.

 

The subsequently denounced draft coalition agreement spoke of the two parties’ mutual desire to deliver Italy back to a “pre-Maastricht setting” with a rediscovered “monetary sovereignty”. The desire is largely due to (the not entirely unfounded) blaming of the monetary union for the creation and perpetuation of a sovereign debt crisis and economic downturn that crippled Italy, providing unabating unemployment and meagre growth.

 

However, alongside the Maastricht treaty came the concept of European citizenship and the consequent free movement of people, a common foreign and security policy, not to mention judicial cooperation across borders. Responsible fiscal governance was also introduced alongside a banking and monetary stability mechanism. To return to a pre-Maastricht setting implies the denouncement of all of these mechanisms and values.

 

Of course, the United Kingdom is leaving the European Union, so what’s the problem? Well, as a principal premise, it would be nice to assume that the draft treaty of a potentially governing coalition of a developed European economic power would choose its words carefully, so one must assume that pre-Maastricht means pre-Maastricht. Therefore, it is not a hyperbolic extrapolation of the leaked document to assume that the potential coalition wishes to withdraw from all of the above.

 

Within such a case, Italy’s populist turn undeniably takes secession further than the United Kingdom’s exit. Even within the UK’s premature negotiations to date, concessions upon security and defence, the rule of European law and potential mutual recognition have already been made; all of which would be precluded by a pre-Maastricht setting.

 

The consequences for the Euro are immense. Already in the past few days since the announcement, the Euro has lost almost 1.5% against Sterling and closer to 2% against the US Dollar. The devaluation of the single currency is at least in considerable part due to the political and economic risk within the Euro. The immediate reaction within Italian treasury was a rise in bond yield on the ten year note in the order of ten basis points. Whilst risk is already heavily re-priced back into the Euro, there would remain considerable risk to the Euro from any contagion threats from an openly secessionist, populist, Italian government.

 

The threat to the Pound may also be significant. As has been visible from meetings of the European Council, and reportedly behind the closed doors of the supranational European Commission, a punitive persuasion is apparent. If it can be proved that member states are better off inside the Union than outside by using the United Kingdom as an example then member states and their populations will consider membership in their benefit, including a increasingly Eurosceptic Italian state. The increase in populist, secessionist, sentiment within the Union could exacerbate these tendencies, making the expected outcome from Brexit marginally worse. Understandably, therefore, there is also an increased risk to the Pound too from the potential Italian coalition. Overwhelmingly, the risk of contagion and break up within the Union and Euro is driving the currency lower.

 

 

Discussion and Analysis by Charles Porter

 

 

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An Unreliable Boyfriend:

Sadly, Dr. Mark Carney looks like he’s in for another round of being labelled the unreliable boyfriend. Accusing markets of significantly under pricing the probability of a rate hike and claiming that the Bank views the UK economy through far more sanguine eyes than the market at large, the central bank Governor looks highly likely to perform a U-turn on later today.

 

 

Through gradual coercion, the Bank of England principal and his peers led market participants to believe, and price in, the progression of this adolescent phase of monetary policy tightening. Signalling that the UK economy was gaining strength and proving resilient following a lost decade of growth, the Pound rallied strongly. The change of environment was pivotal in the bid to stem a bullish run towards GBPEUR parity: a paradigm where one Pound Sterling would be worth one Euro. Tangibly, the expectations led global investors to believe that the reward for saving and investment in the UK political economy would rise, manipulating asset allocation as the cost-benefit matrix of reward vs. safety began to tilt in the developed economy’s favour.

 

As a result of Carney’s teasing, markets came to price in a 25 basis point interest rate hike at the Bank’s next monetary policy announcement on Thursday, so much so that it became the dominant and semi-infallible expectation. However, data looks to have forced the Bank into an impossible position, where a hike would be seen as irresponsible and harmful to the public that the monetary policy instrument is ultimately there to serve.

 

A slurry of data over the last two weeks has diminished the probability of a hike this afternoon. As discussed in last week’s publication, consumer price inflation data, purchasing managers’ indices, and gross domestic product readings have all cast a shadow over the short-run economy. Now, adding to the inhibition to higher rates, it seems there’s just not enough money to facilitate a hike!

 

Whilst I certainly don’t possess the market manipulating power of leviathans such as the (in)famous Robert Peston, I should caution that a run on the banks is not necessary at this point; the Bank of England is one of a finite handful of institutions that has a genuinely infinite amount of money. Instead, it is the UK public that can’t put its money where Carney’s mouth is.

 

Statistics measuring all sorts of permutations of ‘money’ were published earlier in May, and the results weren’t pretty. The numbers were remarkably weak, showing a stagnant growth of ‘M1’, or to you and me, smaller numbers in bank accounts and less notes and coins loitering on the counter, our pockets and under the sofa. In fact, after taking (admittedly rampant) inflation out of the equation, the real growth of this tangible form of fiat money has fallen to zero. However, following the decline of monetarist central banking after the a posteriori falsification of Milton Friedman’s monetarist economics that dominated the 80s, monetary policy is now relatively ignorant of readings of the money supply. So what problems does this create?

 

Well, even if we skip (as I shall) the socialist suggestions of an inevitable conclusion to the capitalist market structure as infinite desires fail to be satisfied in a zero-monetary growth paradigm, the implications remain significant. So long as M1 – normal money – remains subdued, the Bank will face considerable criticism not to raise rates.

 

The reason is simple: markets facilitate the pulling forward of future wealth and income for immediate consumption – a mortgage, car finance and a fiver from a non-philanthropic friend all perform the same fundamental function – disposable income now at the (tacit or explicit) promise of future repayment when circumstances permit or expectations make profitable. At times of low money growth, people still want, desire and need ‘stuff’ – all of which costs money. People therefore need to drawdown money from their future for present consumption in order to sustain and maintain their present level of utility.

 

The satisfaction of the public is highly significant to any government that retains the fundamental desire (supposedly and hopefully) to stay in power. An unhappy public leads to political change as dissatisfaction manifests as resentment towards the incumbent government that failed to satisfy and maintain their desires and expectations.

 

Whilst independent from the government, the Bank of England is a public institution with a mandate from the government and a weak and shrouded, but unmistakable, interest in politics. Therefore, despite having an almost exclusive mandate for price stability, it should care about people and the income and financial conditions they face. From a holistic monetary economics point of view, the Bank could even justify maintaining the status quo as a defence from political upheaval and the spill over effects within the domestic economy.

 

Following this final blow to domestic monetary policy expectations, the Bank is now largely expected to keep interest rates on hold. Unless Carney, the previously unreliable boyfriend, delivers an immense and purely symbolic gesture to flaunt the strength and resilience of the economy, he and the monetary policy committee will once again face jesting taunts. Moreover, any positive latent expectations behind a hike will be priced out, resulting in a potential devaluation of the pound. The reaction to the stubborn hike, much like the partner’s reaction to the boyfriend’s pointless and ostentatious gesture, is likely to be highly mixed at best.

 

The reward for investment and vote of confidence would generate a bid behind the economy, however, the irresponsibility behind the decision might flatten the future curve and mute the expectations for subsequent hikes as the public reel from the hike. Perhaps more important than the decision itself (particularly in the face of a no-hike decision), will be the forward guidance of the monetary policy committee concerning the future path of tightening.

 

P.S. oh yeah, Brexit.

 

 

 

Discussion and Analysis by Charles Porter

 

 

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Morning Snapshot

With Super Thursday upon us, considerable volatility lies ahead for Sterling, and for that matter global, currency markets. At midday today, the minutes from the meeting of the Bank of England’s monetary policy committee will be released. Only thirty minutes later, Dr Mark Carney, the Bank’s governor, will hold a press conference. Expectations for a 25 basis point interest rate hike peaked a couple of weeks ago, with markets pricing a 90% probability for a rate hike today. However, at the time of writing, the implied probability stands at little more than 15%. Still, considerable downside and upside remains within the Pound and will be released dependent upon the decision itself, and the committee’s approach to future monetary policy. The threat of consolidation of a populist coalition in Italy in weighing on the Euro moderately as it trades down by 0.03% on a trade weighted basis at the time of writing. The strong appreciation of the Dollar over the past two weeks, in addition to Trump’s decision on Iran’s nuclear arrangement, has weighed heavily on the Rand and emerging markets in general. The Rand has regained some strength this morning as the Dollar has sold off considerably.

 

 

Discussion and Analysis by Charles Porter

 

 

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Friendship Highway

If it ain’t broke… Fix it.

That’s certainly been the message and driver of the European Union (or its predecessors, the previously unbroken European Economic Community, or functioning European Coal and Steel Community). This observation, be it a criticism or a compliment, can’t be levied at the EU exclusively: everything human, perhaps even living, with infrequent exception has a desire to expand its capacities and improve. In the case of the European continent’s most ambitious project, this pervasion and growth, whether positive or negative, has been strongly felt.

Created for the purpose of making war on the continent (already observed twice in the space of a half century at the time of its conception), not only materially impossible but unthinkable, the EU has developed into a mesmeric (again good or bad) volume of common rules, an organised economic force and, with exceptions, its own monetary union. Growing from a collection of just six nations, with only two conflicting hegemons at its centre, the Union now stands at 28 (minus 1). At present, the desire or at least impetus for change and evolution comes from two opposing directions, the south east and France.

Mr. Macron’s proposed set of reforms have been bandied across screens and newspapers even outside of the single currency area. Met with a reaction little shy of sheer ambivalence in Berlin and across much of the Eurozone, the French President’s programme shows little sign of gathering momentum, at least for now. Arguably, the lack of momentum presents a long run risk for the longevity of the Eurozone, however, more of this for another time.

The second, developing and arguably highly salient emerging force for evolution comes from the Balkan states, in particular, the rapidly thawing nation of Macedonia.

Macedonia and its capital Skopje has long since had a clash with the EU, mostly due to its disaffection towards Greece, itself a relatively new member of the Union. Amidst a strong narrative for the accession of Balkan states into the Union, despite their largely and explicitly communist market structures following the dissolution of the former Yugoslav Republic, the international perception of the bloc is imperative. As a consequence, we await to see how a relatively minor set of concessions and gestures towards the Union, and in particular towards Greece, are to be interpreted.

The renaming of an airport and main road into the City might do little to sway the perceptions of the state from the incumbent EU member, Greece, that currently vetos their accession bid to the (less and less) exclusive club. It’s true, dropping the name of notorious warrior and invader, Alexander the Great, from the airport banner might not lead to an immediate flurry of thanks from Athens. Similarly, the somewhat cringeworthy name of Friendship Highway painted over Alexander’s own might trigger a somewhat different and involuntary bodily function than the intellectual reaction of forgiveness and concession building. But, hey, baby steps!

Following a European Sovereign Debt crisis accentuated by the economic differential between peripheral and core member states, the momentum behind accession is not immense. However, the force does remain perceptible, acute and largely internally driven within the Commission, as opposed to emanating from the constituent heads of state in the Council. Successful accession to the group does create significant risks to the single currency, the Euro. Whilst idiosyncratic arrangements could always be bargained for under multilateral and consensus bargaining, the Lisbon treaty explicitly states that all acceding member states must work towards, and accept, eventual membership of the Euro.

In conjunction with Macron’s desire to strengthen and deepen any incumbent economic and political structures within the monetary union, the prospect of widening the union to include additional member states is particularly concerning.

For example, President Macron’s vision of the Eurozone includes a highly distributive component: a monetary and fiscal fund in order to prevent the exacerbation and even initial momentum behind another Union-wide downswing. The (largely unjustified yet pervasive) concern of an unrelenting bias towards peripheral states, those with the most severe business cycles and economic fluctuations, would almost certainly be exacerbated. Worse still, if the drain on developed markets during adverse economic conditions were a valid concern, the eventual destruction of the bloc and domestic political instabilities within the Eurozone would be right around the corner.

With two forces for fixing the unbroken operating in such conflictual directions, and in a sequencing that may well ultimately favour expansion over deepening, the long run outlook for the Euro remains cloudy. These unintentionally destructive forces will play a highly significant role in the general direction of the Euro.

Today, and for each day over the past week, the Euro has remained highly stable. In fact, only public comments from ECB President Mario Draghi were able to move the single currency more than 0.2% on an intraday basis. Against a strongly appreciating Dollar, EURUSD dropped through 1.20 last Wednesday. The Euro is almost certainly on a cyclical downswing, however, remains at a confident level. Against the Pound, the Euro has traded at around 1.1425 this morning. Today, a considerable risk to the Euro will emanate from Italy as Berlusconi suggested he will not stand in the way of a populist Five Star – the League coalition that could be publicised within the next 24 hours.

 

 

Discussion and Analysis by Charles Porter

 

 

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Nuclear Overload

As things look to have cooled off within the Korean Peninsula, the nuclear problem looms its head in another area; this time Iran. The run up to the decision had numerous impacts upon markets, with the brunt of the volatility being felt in oil markets.

 

Following the lifting of sanctions in line with the Iranian-US-and-ally nuclear pact, the nation has come to be responsible for a daily oil production in excess of 4m barrels. The increase in production has seen Iran reliably produce an already globally systemic proportion of oil. Naturally, the tapering back of the deal and the reimposition of tariffs would cause the supply of oil from the nation to fall, projected to be in the order of several hundreds of thousands of barrels per day.

 

The impact for FX is confusing:

 

Firstly, it is important to remember that we exist in a new paradigm of oil: the United States of America is a net exporter of oil. Production in the world’s largest economy is therefore most likely to be internally reorientated, in and of itself generating a dampening effect to the medium run implication of a reduction in oil supply and the concomitant increase in its market clearing price. Nonetheless, even in the run up to the decision on Tuesday evening, oil prices rallied to reach as high at $70pbl. Following Trump’s threat to impose the ‘toughest sanctions’, Oil continued to rally through to approximately $77pbl.

 

There could well be a mild boost to domestic economic activity due to the idiosyncratic sectoral boost, however, the overall impression within the aggregate economy would be negative, generating a headwind that pervades across all sectors. Because the market for oil is truly global, the dampening effect is likely to be limited. However, if the rise in the costs of production and energy hampers President Trump’s prised headline economic indicator and success barometer of Gross Domestic Product, protectionist rules ensuring the provision of low cost oil to US companies are, for once, not at all out of the question.

 

The US, however, could be left in a tricky position from Trump’s decision to drop the deal: falling growth due to an economic headwind and rising inflation as the cost of factors of economic production rise could lead to a cursed situation know as stagflation, where an economic turn down is usually so pronounced that the fall in aggregate national utility and disposable income leads to severe political, and eventually civil, unrest.

 

Naturally, hostile domestic economic conditions and falling growth should indicate a weaker Dollar, as monetary loosening coincides with falling productivity and output. However, rising inflation would demand just the opposite unless the Federal reserve and government alike do the unthinkable and unwise, and abandon a target of price stability close to 2%.

 

A round of monetary tightening to constrain a rising price level could in turn lead to a stronger dollar should underlying economic growth and the domestic money supply, M1, remain resilient. Under this scenario, the Dollar should appreciate. However, sheer uncertainty and the threat of a stagnant economy with high price inflation should ensure a weaker dollar prevails.

 

The immediate move on Tuesday evening was a sell off in the dollar as concerns of upsetting the Fed’s current accelerating round of monetary tightening and economic growth developed. However, the countervailing forces were plain to see as, by European market open, the Dollar had once again gained strength and rallied by approximately 0.2%. Should more sympathetic conditions arise as natural stabilisers and economic resilience push through, the medium run trend of the US Dollar should be revised up.

 

 

Discussion and Analysis by Charles Porter

 

 

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To Me – To You

The signals of last night’s monetary policy decision by the US Federal reserve appear to have been misread. In fact, the initial reaction across equity, treasury and FX markets appeared to imply that markets expected the FED to raise rates during this meeting, despite their persistent and vocal admonitions that a rate hike is not expected until the US central bank’s next monetary policy meeting.

 

This meeting of the Federal Reserve Bank of America was not followed by a press conference from the Committee’s top officials and Chairman, Jay Powell. Therefore, little else can be mined from the decision apart from the headline “no hike” decision, and the publication that accompanied and contextualised it.

 

The monetary policy decision provided one of the most hawkish signals plausibly possible, short of an actual interest rate hike. Short-term interest rates were held by the US central bank within a band of 1.5-1.75 per cent – the level reached following a rate hike at their last monetary policy decision in March. Following this decision, and a turn to a tone biased towards tighter monetary policy, the US Dollar has appreciated dramatically.

 

Despite not being expected to unveil a rise in underlying interest rates, the run up to the event was characterised by great anticipation, discourse and attention. The reason for the heightened attention to the decision was the significant tick up in inflation during the last reading of the general price level in March. Moreover, the yield on US 10-year treasury broke through the highly significant and psychological 3% threshold eight days ago.

 

During previous monetary policy decisions, the post-meeting statements and public speeches by US policy makers, the FED has been swift to announce that the Committee was “closely monitoring inflation”, largely in an attempt to ensure that this round of monetary policy tightening was not detrimentally affecting the very variable that the mechanism is designed to control; inflation!

 

Following the convergence of the observed annual change in the actual price level and the FED’s economic target and mandate, the central bank was willing and able to adapt this phraseology and, instead, include a sanguine message about inflation expectations. This precipitated the expectation that the FED on the whole does, as expected, feel liberated to raise interest rates as it sees fit and prudent over the medium-long run. Despite all these hawkish signals and visions of a strong underlying economy, the differential between the 2 year and three-year bond does at present suggest that the FED’s current round of monetary policy tightening will fade into an easing of monetary conditions (and looser policy) by 2020.

 

As discussed above, the relationship between interest rates (both those determined by policy and implied by treasury) does have a significant and causal impact upon the value of the domestic currency. As such, this decision might have been expected to see the Dollar rally significantly.

 

At 7p.m. London time yesterday, however, the US trading session saw the Dollar shed value, in a counter intuitive decision that suggested, somehow, markets had expected even more – perhaps even a hike! The Dollar dropped down by as much as 0.35% within a minute of the decision. However, within the hour markets appeared to re-evaluate and internalise the decision to restore the greenback with an additional 0.5% of value to allow the dollar to rally towards an intraday high on a trade-weighted basis. Following this decision, with traders mimicking the classic chuckle brokers catch phrase, the Dollar encroached upon the Euro and the Pound to trade at a value of 1.1939 and 1.3562 respectively. Moreover, bond yields that had fallen in the first minutes following the decision rallied back towards 3% on the 10-year note.

 

As trade tensions appear to ease following optimistic and somewhat restrained comments by President Trump and Secretary of the Treasury, Steve Mnuchin, the Dollar has received a sizeable bid. Whilst the scope does look clear for further dollar strength as the coupling of interest rates and exchange rates continues to re-establish itself as a credible macroeconomic relationship, the Dollar’s run could still prove to be short lived. The Dollar will face serious technical resistances both against the Pound and the Euro, likely to at least partially stunt its appreciation against its two international dominant reserve counterparts.

 

 

 

Discussion and Analysis by Charles Porter

 

 

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Market Snapshot

 

As Sterling has hit a year-to-date low this week, the US Dollar has rallied and, in turn, trades at its highest value of 2018 so far. The market snapshot this morning shows a flat Pound Sterling along with a dampened Euro. Despite weak inflation data in the Eurozone being announced this morning, the single currency has proved resilient. Losing moderate value this morning following an uneventful yet positive interest rate announcement yesterday evening, the US Dollar trades down almost 0.3% on a trade weighted basis. The Rand has been particularly volatile over the past few days while technical pressures spilling over from the Dollar’s two-week-long bull run create emerging market turbulence. Following a chronic weakness yesterday, on average, the Rand now trades 0.35% higher versus its counterparts. Despite a data-heavy end to the week, the salience of many statistics announcements will be limited. In the United States, a Labour market survey scheduled to be released tomorrow afternoon London-time could prove to be risky for the Dollar.

 

Discussion and Analysis by Charles Porter

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A Pounding for Sterling

Since a Consumer Price Inflation report on 18th April, the Pound Sterling spot index has lost over 5%. The GBP index provides a holistic picture of the Pound’s performance conditioned upon the economy’s relative exposure to respective currency pairs. By purely reflecting the strength of the Pound sterling without the influence of idiosyncratic contra currencies, it’s clear that the Pound has endured a shocking couple of weeks.

 

As Brexit news has remained muted, the sell-off in the Pound has been almost exclusively economic and technical driven. In fact, on the political scene, only the fleeting tumult caused by the surprise resignation of Home Secretary and “Remainer”, Amber Rudd, caused a sell-off in the Pound. Whilst the market reaction to this political uncertainty was far from negligible, the news seemed mild, having followed months of Brexit blows, impeachment threats and foreign secretary slip-ups.

 

The economic calendar has thrown up five distinct surprises: Consumer Price Index (CPI), Mark Carney, Retail Performance, Purchasing Managers’ Index (PMI), Gross Domestic Product (GDP). On 18th April, Consumer Price Inflation came in 0.2% lower than expected. Whilst still raging far above target at 2.5%, the outlook for tighter monetary policy remains credible, however, severely dented. The relationships between inflation rates, interest rates and exchange rates are highly significant, with the causality running in that order.

 

As the rate of price inflation and the general price level decreases, so too does the need for tighter monetary policy to constrain economic activity through the manipulation of the cost of borrowing and the reward for saving. Consequently, as the inflation data undermines the perception of strength behind the domestic economy, the incentive for investors and traders to endow the domestic currency with strength and value disappears. Similarly, the expectations for a higher rate of return from investments in the domestic economy and currency also erode. In sum, the dominant momentum is low price level, weaker currency.

 

Following the statistics release from the Office of National Statistics, the Pound Sterling lost in excess of 1%, a move exacerbated by weak retail data published the following morning. What moved Sterling markets considerably more, however, were the words of Bank of England Governor, Dr. Mark Carney, when he cautioned the public and investors against the inevitability of an interest rate hike on 10th May 2018.

 

Earning himself the title of the unreliable boyfriend for at least the third time, the Governor forced a concerning sell off in the Pound. Admittedly, his comments were mildly compensated for by the words of his Monetary Policy Committee colleague, Michael Saunders. Directly unsettling the second causal step, interest rates, the whole event so far saw the Pound trade below 1.41 against the Dollar for the first time in weeks. Against the Euro, the Pound fell through 1.14, setting a new month-to-date low.

 

The woes of the Pound continued to mount the following week when, on last Friday 27th April 2018, economic growth came in 0.2% below expectation. This data release substantiated the impressions generated a week earlier and supported a conclusion that the inflation statistic was not a rogue observation and, instead, might purport to show a natural cooling down of the economy. Leaping directly to the third causal step and the underlying economy, GBPEUR closed the day trading 1.2% below is open; leaving Sterling-Dollar only a modicum above 1.3750.

 

With the amalgamation of weak soft data and UK Purchasing Manager’s Indices, the Pound reached its low of 2018 yesterday, falling through 1.35 against an appreciating Dollar. Given that this week’s bearish Pound was largely generated by a shifting of expectations surrounding the Bank of England interest rate decision scheduled for 10th May, there does remain an opportunity for the central bank to restore expectations and even ultimately deliver another 25 basis point hike. Moreover, there is likely to be some short run consolidation for a Pound that is trading well below its short and medium run moving averages.

 

 

Discussion and Analysis by Charles Porter

 

 

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