What Moves Forex
Currency market participants, economists and central bankers have been trying to answer the question about what factors drive exchange rates since national currencies come into being. Predicting exchange rates is more art than science; even analysts often have splitting views on the direction of currency prices.
There are basically two primary approaches of analyzing currency markets: fundamental analysis and technical analysis. Fundamental analysis is based on the underlying economic conditions, whereas technical analysis is about using historical price information to forecast future price actions. In recent years, more and more traders are switching to technical analysis, and they are mostly short-term traders. Medium to long-term traders tend to use more of fundamental analysis to predict future currency valuation.
It is not uncommon for the strongest technical signals to be thwarted by reactions to fundamental events. The reverse is also true in that prices may move according to technical patterns even when there are no major news released. Being a pure technical or fundamental trader would mean missing out half of the information, and being kept in the dark.
Fundamental analysis involves the assessment of macroeconomic indicators, economic growth (capital and trade flows) and geopolitical risks when evaluating the value of a currency relative to another. These forces drive the supply and demand of money.
Major macroeconomic indicators include the Gross Domestic Product (GDP), interest rates, inflation, unemployment, money supply and foreign exchange reserves. Economic growth comprises capital flow and trade flow. Geopolitical issues have an impact on people’s perceptions of a country’s level of stability and of the ability of a country’s government to deal with the political issues at hand. In addition, central banks in various countries may occasionally intervene in the forex market to adjust the value of their currencies, either by increasing domestic currency supply in an attempt to lower the price or by buying their domestic currency in order to raise the price. Sometimes, instead of making physical adjustments, their interventions may come in the form of hints or threats so that the market can pay heed and obey accordingly.
The most dramatic price movements, however, occur when unexpected fundamental events happen. Such events could range from a central bank raising domestic interest rates to the outcome of a political election or even an act of war. Since the market is made up of players, and it is the players’ emotions that determine price actions, the key driver of the currency market is their expectations and perceptions surrounding the event, rather than the event itself.
The application of technical analysis to foreign exchange markets is a recent hot development in trading due to the advent of new technologies.
Technical analysis is based on the assumption that all information is already included in the prices. After all, the price at any given time is the sum of the knowledge, fears, hopes and expectations of the people already in the market and those contemplating getting into it. How might those bystanders affect the price? Let’s say if they hold back from buying EUR/USD, they are keeping the price lower than it otherwise would be.
One feature of the market is its discounting mechanism, and it is one of the main reasons for using technical analysis. The market does not actually predict anything, but it reveals what the major market players like hedge funds or trading pros think.
When the forex market anticipates robust economic growth, players become willing to pay more for the country’s currency, and this drives the currency higher. Conversely, when market players expect a slowing economy, they become less willing to bid for the country’s currency if they think that there would be less demand for it as a result. Hence, market participants have already factored in today’s news into the prices, and begun to anticipate tomorrow’s breaking news. In addition, technical analysis works under the assumption that history tends to repeat itself.
Technical traders use charts, support and resistance levels, and numerous patterns and mathematical analyses to identify trading opportunities, based on historical currency data. Technical analysis works well in the forex market because short-term exchange rate fluctuations are primarily determined by human emotions or market perceptions. Perception as reality is very true, and this concept manifests itself strongly in the markets. If you think that a currency is worth x amount against another currency, then it will be what it is worth.