What Moves the Currency Markets?

When trading, we often fall into the trap of thinking that fundamentals or technicals are moving the market. It is as if the support or resistance line was something real. We often forget that the thing that is really moving the market is expectations and the applications of vast amounts of money to support those expectations. Market movements are really only indirectly connected to fundamentals or technicals.

When trading, we often fall into the trap of thinking that fundamentals or technicals are moving the market. It is as if the support or resistance line was something real. We often forget that the thing that is really moving the market is expectations and the applications of vast amounts of money to support those expectations. Market movements are really only indirectly connected to fundamentals or technicals.

“Never confuse the finger pointing at the moon with the moon itself” – Chinese Proverb

At the core of the currency market, central banks set targets around acceptable price levels and use then apply macro-economic policy levers, jaw boning and perhaps even the odd intervention by the mythical plunge protection teams to keep the price within the acceptable price region.

Baring a few exceptions, most central banks play an international tit-for-tat game of seeing “who can devalue their currency the most”. A devalued currency helps prop up the domestic export economy and keeps unemployment under control. Whereas an over valued currency usually creates inflation and is accompanied by interest rate rises to combat the inflation. Given that low unemployment is usually politically more acceptable than the consequences of inflation and high interest rates, the international race to the bottom continues. At the moment the Fed is the king of the heap as it has successfully managed to push the US Dollar the lowest.

Its the expectations by cashed up market participants around future policy changes and the movement of money based on those expectations which in turn drive the market. These expectations are an extremely strong force in the Forex market and the Forex market can be subject to speculative exaggeration as forex traders are inclined to bet fairly quickly on certain trends not yet factored into other markets, such as the 3 month bond markets.

To trade the Forex Market successfully a good trader needs to really master sentiment analysis and concentrate on how expectations are driving the market. Since other traders are in the same situation, only a few factors genuinely end up affecting exchange rates. This process can easily gain momentum of its own, with no one daring to buck the trend. Re-appraisal only occurs when an exchange rate is quite clearly outside the acceptable band for the central bank.

As the USD is the currency that is used for the majority of international trade and is held in reserves by most central banks, expectations around the USD is the most important place to start your analysis from. While many moves in the market can be explained by trade differentials, interest rate differentials, commodity prices, geo-politics, etc, the majority of moves are based on expectations around US interest rate policy, future economic growth and US participation in global politics. To demonstrate this point, attempts to explain the large cyclical swings in the commodity currencies, such as the Aussie dollar on the basis of interest rate differentials or commodity prices is largely a waste of time. Evidence suggests the Aussie dollar movements are largely a by product of sentiment toward the USD. The USD cannot explain many of the short term moves, but it does explain 85% of long term moves.

As always the currency market evolves. Pre-World War II, the pound was the dominant currency for international trade. After the war finished Winston Churchill made a stupid mistake around setting the exchange rate policies, and the whole world moved over to the US Dollar as the preferred currency for international trade. The same thing is happening to the US dollar now. The dollar is chronically devalued at the moment and a number of central banks are moving a portion of their reserves into Euros and the demand for the Euro as the preferred currency for international trade is increasing. As a result the dollar is quite volatile. However, this does not mean that it is all down hill for the “mighty” dollar. The English pound is still a highly valued currency after all these years (certainly much higher than what the UK economy might imply it is worth). Rome wasn’t built in a day, and the fall of the Roman empire took centuries of mismanagement before the Barbarians came knocking at the gate. Just like the decline of Rome, it will take a very long time before the US dollar will be displaced by the Euro and even then it will hold its value for a long time to come.

Trading the currency markets can be extremely difficult at times. It is event driven and full of exceptions to the rule that make predictions more than a month out difficult to do reliably. Trying to trade the FX market using rigid rule based systems and the blind application of technical analysis, is a sure fire way of loosing money. To trade successfully you really need to factor shifting market expectations into every trade.

Macrotactics is a blog devoted to recording a part time trader’s journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has

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