What Moves the Currency Market?
There are two primary ways to analyze financial markets: fundamental analysis and technical analysis. Fundamental analysis is rooted in understanding underlying economic conditions, while technical analysis uses historical prices to predict future movements. For as long as technical analysis has been around, there has been an ongoing debate as to which methodology is more successful. Short-term traders prefer to use technical analysis, focusing their strategies primarily on price action, while medium-term traders tend to use fundamental analysis to determine a currency’s current and future valuation.
■ Fundamental Analysis
Fundamental analysis focuses on the economic, social, and political forces that drive supply and demand. Those using fundamental analysis as a trading tool look at various macroeconomic indicators such as growth rates, interest rates, inflation, and unemployment. Fundamental analysts will combine all of this information to assess current and future performance. This requires a lot of work and thorough analysis, as there is no single set of beliefs that guides fundamental analysis. Traders employing fundamental analysis need to continually keep abreast of news and announcements, as they can indicate potential changes to the economic, social, and political environment. All traders should be aware of the broad economic conditions before placing trades.
- Capital and Trade Flows – Capital flows and trade flows constitute a country’s balance of payments, which quantifies the amount of demand for a currency over a given period of time. Theoretically, a balance of payments equal to zero is required for a currency to maintain its current valuation. A negative balance of payments number, on the other hand, indicates that capital is leaving the economy at a more rapid rate than it is entering, and hence, it should fall in value. This is particularly important in current conditions (at the time of this book’s publication), where the United States is running a consistently large trade deficit without sufficient foreign inflow to fund that deficit.
- Capital Flows – Capital flows measure the net amount of a currency that is being purchased or sold due to capital investments. A positive capital flow balance implies that foreign inflows of physical or portfolio investments into a country exceed outflows. A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors. There are generally two types of capital flows—physical flows and portfolio flows (which are further segmented into equity markets and fixed-income markets)
- Physical Flows – Physical flows encompass actual foreign direct investments by corporations such as investments in real estate, manufacturing, and local acquisitions. All of these require that a foreign corporation sell its local currency and buy the foreign currency, which leads to movements in the FX market. This is particularly important for global mergers and corporate acquisitions that involve more cash than stock. Physical flows are important to watch, as they represent the underlying changes in actual physical investment activity. These flows shift in response to changes in each country’s financial health and growth opportunities. Changes in local laws that encourage foreign investment also serve to promote physical flows.
- Portfolio Flows in Equity Markets – As technology has enabled greater ease with respect to transportation of capital, investing in global equity markets has become far more feasible. Accordingly, a rallying stock market in any part of the world serves as an ideal opportunity for all, regardless of geographic location. The result of this has become a strong correlation between a country’s equity markets and its currency: If the equity market is rising, investment dollars generally come in to seize the opportunity. Alternatively, falling equity markets could prompt domestic investors to sell their shares of local publicly traded firms to take advantage of investment opportunities abroad.
- Portfolio Flows in Fixed-Income Markets – Just as the equity market is correlated to exchange rate movement, so too is the fixed-income market. In times of global uncertainty, fixed-income investments can become particularly appealing, due to the inherent safety they possess. As a result, economies boasting the most valuable fixed-income opportunities will be capable of attracting foreign investment—which will naturally first require the purchasing of the country’s respective currency.
Prior to the mid-1980s, fundamental traders dominated the FX market. However, with the rising popularity of technical analysis and the advent of new technologies, the influence of technical trading on the FX market has increased significantly. The availability of high leverage also led to an increased number of high frequency and momentum. They have become active participants in the FX market, with the acute ability to influence currency prices.
Unlike fundamental analysis, technical analysis focuses on the study of price movements. Technical analysts use historical currency data to forecast the direction of future prices. The underlying belief behind technical analysis is that all current market information is already reflected in the price of that currency; therefore, studying price action is all that is required to make informed trading decisions. In a nutshell, technical analysis assumes that history will repeat itself.
Is Technical Analysis or Fundamental Analysis Better?
No one will ever win the age-long battle between technical and fundamental analysis. However, most individual traders will start trading with technical analysis because it is easier to understand and does not require hours of study. Technical analysts can also follow many currencies and markets at one time, whereas fundamental analysts tend to focus on a few pairs due to the overwhelming amount of data in the market. Nonetheless, technical analysis works well because the currency market tends to develop strong trends. Once technical analysis is mastered, it can be applied with equal ease to any time frame or currency traded.
However, it is important to take both strategies into consideration, as fundamental analysis can trigger technical movements such as breakouts or reversal in trends. Technical analysis, on the other hand, can also explain moves that fundamentals cannot, especially in quiet markets, causing resistance in trends or unexplainable movements.