FX Analysis

Two types of analysis are used for forecasting market movement:

Fundamental Analysis

Fundamental Analysis focuses on the theoretical models of exchange rate determination, and the major economic factors and their likelihood of affecting the foreign exchange rates.

Technical Analysis

The chart study of past behavior of currencies' prices in order to predict future price trends.

Theories of Exchange Rate Determination

Purchasing Power Parity

Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate - the law of one price. There are two versions of the purchasing power parity theory:

The Absolute Version

Under the absolute version, the exchange rate simply equals the ratio of the two countries' general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries which produce or consume the same goods. Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and well - sometimes obvious and sometimes hidden, and they influence costs and the distribution of goods.

The Relative Version

This version disregards the importance of brand names. For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive"). Under the relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level. The relative version is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult, and in the long term, countries' internal price ratios may change, causing the exchange rate to move away from the relative purchasing power parity.

In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial, and not by commodity market conditions.

Theory of Elasticity

The theory of elasticity holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the exchange rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies. A decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods and, therefore, less demand for its own currency.

The elasticity approach is not problem-free because in the short term, the exchange rate is more non-elastic than it is in the long term, and additional, exchange rate variables arise continuously, changing the rules of the game.

Modern Monetary Theories on Short-Term Exchange Rate Volatility

The modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets' role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability.

One of the modern monetary theories states that exchange rate volatility is triggered by a one-time domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth.

The purchasing power parity theory is extended to include the capital markets. If, in both countries currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money.

Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the financial markets. This version is known as the dynamic monetary approach.

Synthesis of Traditional and Modern Monetary Views

In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of the traditional and modern monetary theories.

A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance of payments equilibrium. Speculative forces, commodity market disturbances, and the existences of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand.

Due to the fact that financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes, and in the long term by commodities changes.

Fundamental vs. Technical Analysis: The Debate Continues

One of the dominant debates in financial market analysis is the relative validity of the two major tiers of analysis: Fundamental and Technical. In Forex, several studies concluded that fundamental analysis was more effective in predicting trends for the long-term (longer than one year), while technical analysis was more appropriate for shorter time horizons (0-90 days). Combining both approaches was suggested to be best suited for periods between 3 months and one year. Nonetheless, further empirical evidence reveals that technical analysis of long-term trends helps identify longer-term technical “waves,” and that fundamental factors do trigger short-term developments.

Let’s take the declining USD/JPY exchange rate in 1999, as an example. The pair lost 16% in the second half of the year, reaching a year low of 101.90. Both fundamentals and technicals alike could explain the downward move. Fundamentals attributed it to the continuous capital inflows into Japanese assets, which reflect investors’ increased optimism with the Japanese recovery. Technical analysts were likely to explain the move with the simple argument: the language of the market voiced a clearly downward tone that became more resounding after the breach of key technical landmarks (115 yen and 110 yen). Thus, both technicals and fundamentals reached the same conclusion.

The devil is in the details. Fundamental analysts with a technical blind spot risk missing key market turnarounds after the breach of an important support/resistance level. Conversely, a technically inclined analyst with a disregard for fundamentals and news releases would miss rebounds in currencies triggered by data releases.

Here is another example:

In July 1999, the release of stronger than expected German business sentiment survey (IFO) triggered a rebound in EUR/USD. Up to that point, the Euro had lost 15% reaching an all-time low of $1.010. Most market observers - fundamentalists and technicians – were predicting the Euro to break below $1.00. Technical analysts stated psychology, momentum, and moving averages as arguments for further downfall. But fundamentally inclined analysts who paid attention to the strong survey would have been able to promptly exit their long dollar positions in favor of the Euro. On that day, the Euro jumped 200 points against the dollar with an additional 260 points on the following day, and an extra 150 points in the third day. In just two weeks, EUR/USD soared by more than 800 points. Obviously, the IFO survey release was not the single reason behind the Euro’s 7% rebound. Other factors over the subsequent weeks also helped prop the currency. These included a broadening improvement in economic fundamentals throughout the Eurozone and an increasingly hawkish stance (favoring higher interest rates) from the European Central Bank. Nevertheless, the release of the IFO survey was the turning point in shifting expectations of the Euro.

It has been often stated that combining fundamentals with technicals was counterproductive. Owing to their contrasting types, technical and fundamental analysis are often said to be mutually exclusive. Yet, a large number of traders combine the two approaches, even instinctively. Thus, technically inclined traders do pay attention to central bank meetings, give consideration to employment reports and heed the latest inflation numbers. Similarly, fundamental traders are often trying to figure out the major and minor levels of support, and determine the percentage of retracement formations. There is no specific formula for figuring out the optimum approach of combining fundamental and technical analysis in the Forex market. Some computer software packages claim to be able to make such decisions, weighing one approach against another depending on economic, technical, and quantitative parameters. Yet, these are based on models from past patterns of inter-market dynamics and previous technical and fundamental behavior. The FX market is too dynamic for such pre-formed frameworks. Expectations and sentiment, and fundamental and technical factors, are undeniably essential in determining foreign exchange dynamics.

There are two additional factors that are paramount to understanding short-term movements in the market. These are expectations and sentiment. They may sound similar, but remain distinct. Expectations are formed ahead of the release of economic statistics and financial data. Solely paying attention to the figures released does not suffice in grasping the future course of a currency. If, for example, the US GDP came out at 7.0% from 5% in the previous quarter, then the dollar may not necessarily move as you would expect it to. If market forecasts had expected an 8% growth, then the 7.0% reading might come as a disappointment, thus causing a very different market reaction from the one you were expecting had you not been aware of the forecast. Nonetheless, expectations could be superceded by market sentiment. This is the prevailing market attitude vis-à-vis an exchange rate; which could be a result of the overall economic assessment towards the country in question, general market emphasis, or other exogenous factors. Using the above example on US GDP, even if the resulting figure of 7.0% undershot forecasts by a full percentage point, markets may show no reaction. A possible reason is that sentiment could be dollar-positive regardless of the actual and forecasted figures. This might be due to solid US asset markets, or poor fundamentals in the counter currency (Euro, Yen or Pound). A term that is commonly interchanged with “sentiment” is “psychology.” During the first two months of 2000, the Euro underwent fierce selling pressure against the Dollar despite persistently improving fundamentals in the Eurozone. That is because market psychology had decidedly favored US dollar assets due to continuous signs of non-inflationary growth, and sentiment that further increases in US interest rates will work in the advantage of US yield differentials, without derailing the economic expansion.

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