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Momentum and Moving Averages for Currencies

Posted in Currency Trading, Momentum Investing, Technical Trading

A reader asked: “Does a combination of rotation by relative strength (momentum) and moving averages, similar to that described in Mebane Faber’s Ivy Portfolio, work for the main currencies?”

The most relevant papers discovered via searches of the Social Science Research Network on the key word combinations “currency momentum”, “currencies momentum”, “currency moving average”, “currencies moving average” and “currencies technical analysis” are (underlining added):

From March 2001, “Do Momentum Based Strategies Still Work in Foreign Currency Markets?”: “This paper examines the performance of momentum trading strategies in foreign exchange markets. We find the well-documented profitability of momentum strategies with equities to hold for currencies as well and to have continued throughout the 1980s and the 1990s. Our results indicate that the long/short strategy of buying the most attractive currency and shorting the least attractive currency obtains average excess returns that are significantly positive. Of particular note, the profitability to momentum strategies in foreign exchange markets has been particularly strong during the latter half of the 1990s. By examining 354 long/short moving average rules across eight currencies, we show the results are insensitive to the specification of the trading rule and the base currency for analysis. We also show that the correlations of the long/short momentum strategies using differing base currencies are very high – typically around 0.90. This would indicate that strong/weak momentum currencies relative to a base currency at a particular time are typically also strong/weak currencies relative to most other base currencies as well. Finally, using a bootstrap methodology we show that the performance is not due to a time-varying risk premium but depends on the underlying autocorrelation structure of the currency returns. In sum, the results lend further support to prior momentum studies on equities. The profitability to momentum-based strategies holds for currencies as well.”

From October 2002, “Macromomentum: Returns Predictability in Currencies and International Equity Indices”: “This study examines momentum and reversals in currencies and international equity market indices. We find momentum in country equity market indices during the first year after the portfolio formation date and reversals during the subsequent two years. We also find momentum in currencies up to three years after the portfolio formation date but no reversals. Positive currency momentum predicts low stock index returns in the future weakening momentum and strengthening reversals in U.S. dollar-denominated stock index returns. Additional tests show that countries with positive (negative) equity momentum experience declining (increasing) nominal federal fund rates in the first year after portfolio formation date and increasing (decreasing) interest rates in the subsequent two years. We discuss the implications of our findings for rational and behavioral theories.”

From March 2009, “Value and Momentum Everywhere”: “Value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities. We study jointly the global returns to value and momentum and explore their common factor structure. We find that value (momentum) in one asset class is positively correlated with value (momentum) in other asset classes, and value and momentum are negatively correlated within and across asset classes. Liquidity risk is positively related to value and negatively to momentum, and its importance increases over time, particularly following the liquidity crisis of 1998. These patterns emerge from the power of examining value and momentum everywhere simultaneously and are not easily detectable when examining each asset class in isolation.” [See “Combining Value and Momentum Across Asset Classes” for a deeper summary.]

Abstracts of findings suggest that momentum, whether based on past returns or moving averages, exists to some degree for currencies. The studies appear not to address combining past returns and moving averages to predict currency market returns.

Exchange-traded funds for currencies have generally not been around long enough to support testing at intervals normally used for momentum.

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