Analyzing the Forex Market
There are three ways to interpret the Forex markets: Fundamental Analysis, Technical Analysis, and Sentiment Analysis. But the markets move for just one reason: Supply and demand.
Supply and demand changes slowly or fast, depending on the current economic events, but that change is due to the Sentiment or beliefs of the major operators about what they think are imbalances of the market. That happens when institutional traders believe the current price is not a fair price, and it is due to change in the near or far future. The best strategies combine the tree methods to make the trading decisions, but a trader must always keep in mind the fundamental forces that move the Forex markets.
Fundamental Analysis deals with the economic and political events and situations that change supply and demand. Among the most important indicators are economic Growth Rates, Inflation, Interest Rates, Government Debt and Spending, Gross Domestic Product, and Unemployment. Fundamental Analysis combines all this information to determine the possible sentiment of the market participants and ultimately forecast the future performance of an asset.
Supply and Demand
Currencies’ prices change primarily driven by supply and demand. If the supply is larger than the demand, the price drops, and if the opposite happens, it goes up. We, as traders, cannot determine if the imbalance of the supply-demand forces is due to hedging, speculation, or monetary conversion. For example, the US dollar moved with strength from 1998 to 2001 when the Internet as the NASDAQ boom drove international investors to participate in the US financial markets in search of high returns. Investors had to buy dollars and sell their local currency, so the Dollar gained strength. At the end of 2001, the political climate changed after the 9/11 event, the stock market fell hard, and the FED started to cut interest rates. Therefore, stock investors moved their capital elsewhere, so they sold the Dollar, and its price dropped.
Capital Flows and Trade Flows
The flows of capital and trade are two major factors in the balance of payments. These two factors quantify the amount of demand for a currency. Common sense tells us that a balance of zero is needed for a currency to hold its value.
A negative number in the balance of payments will indicate that capital is leaving the domestic economy more rapidly than it is entering. Under these circumstances, the currency should move down. The opposite should happen if the balance of payments is positive.
An example of this is the Japanese Yen. Despite the fact of negative interest rates, the Japanese yen has managed to trade mostly moved by its high trade surplus; thus, this currency tends to increase in value. The Japanese government uses a negative interest rate policy and increases the money supply (by printing new money), counteract the inflows of currency coming from the export business to hold the currency’s value to a level not endangering its export business.
The capital flows show a measure of the net amount of currency bought and sold due to capital investments. A positive figure implies that the inflows originated from international investors entering the country exceded those bought by domestic investors abroad.
Physical flows are originated by foreign investments, directly purchasing real estate, manufacturing facilities, and acquisitions of local firms. These operations require that foreign investors buy dollars and sell their local currency.
Physical flows data are essential, as they show the underlying changes in the physical investment activity. A change in the local laws encouraging foreign investments would boost Physical inflows. That happened in China when it relaxed the laws for foreign investment due to its entry into the World Trade organization in 2001.
Portfolio inflows measure the capital inflows in the equity and fixed-income markets.
The Internet and computer technology enabled a greater easy to move fast and easily capitals from one market to another one in the search for profit maximization. A rally in the stock market can be an opportunity for any investor no matter where he lives. If the equity market rises, the money will flow in and drive the local currency up. If it moves down, investors would quit and move their money away.
Fig 1 – US Yields versus Stock Market Cycles
The attraction of the equity markets compared to fixed-income markets ( bonds and monetary investments) is growing since the early 90ies. For example, the foreign transactions of US government bods dropped from 10-1 to 2-1.
That can also be verified when we see that the Dow Jones has over 80 percent correlation with the US Dollar Index.
Fixed Income Markets
Fixed income markets start being appealing in times of global uncertainty due to the perceived safe-haven nature of this type of investment. As a result, countries offering the best returns in fixed income products are more appealing and attract foreign money, which would need to be converted to the country’s money, boosting the demand for this particular currency.
A useful metric to analyze fixed-income flows is the short and long-term yields of the different government bonds. For example, comparing the 10-year US Treasury note yield against the yields on foreign bonds. The reason is that investors tend to move their money to countries offering the highest-yields. Thus, for instance, a rise in yields would signify a boost in the inflow of fixed-income capital, which would push the currency up.
Aside from the US Treasury notes, the Euribor futures or the futures on the Interbank Rate is a good gauge for the expected interest rate in the Eurozone.
Fig 3 – 10-year note yield curves on Industrialized Countries
Trade flows are needed for import and export transactions. The Trade flows figure is a measure of the country’s trade balance. Countries that are net exporters will show a net surplus. Also, they will experience a rise in the value of their currencies as the result of the exchange transactions, when exporting companies trade the foreign currency for local money, as the local currency is bought more than sold.
Net importer countries will show a negative figure in its trad flow metric, and, since its currency is more often sold than bought will experience a push to the downside.
It seems logical that changes in any of the discussed flows would affect the involved currency pair. Traders, though, should focus on economic surprises. That is, data releases that are considerably different from the consensus forecasts. An unexpected figure would shatter the market and likely produce a long-term trend change. The trader should not trade the event itself, but use it to forecast future price trends and plan his short-term trading strategies with the long-term figure in mind.
Reference: Day Trading and Swing Trading the Currency Market, Kathy Lien