Analysis of the Forex Markets
With the size of Forex trading, and the many different international markets involved, it’s true that some of your technical analysis tools aren’t appropriate — particularly the ones that use volume. It’s also a good idea to have knowledge of the fundamentals that affect the currency markets. While technical analysis is appropriate for short term holdings and reflects the fundamentals by definition, it doesn’t hurt to know where the moves are coming from.
Any market is driven by supply and demand, and in the case of foreign exchange the supply and demand comes from the need for global trade in goods, services and capital. However, there are some obvious drivers of the markets.
Fundamentals
Interest Rates
All currencies have an associated interest rate, usually set by the country’s central bank. Any changes in interest rates can have an immediate impact on the value of a currency. When the interest rate goes up it usually has a positive impact on the currency. Foreign investors seek to buy the currency and benefit from the high rates, which increases the currency value. This increasing value can also, in turn, attract more investors who want to ride the trend.
This is the usual case and reflects when interest rates are increased because of domestic pressures, such as the economy overheating. However if the interest rates go up because of international pressures, then the currency may well fall.
Trade Deficits
Typically having a large trade deficit is detrimental for a currency. The problem is that a large deficit means that more of the country’s currency is flowing out and less of other currencies is coming in. This devalues the home currency — effectively you’re selling more currency to other countries who don’t necessarily want it so the supply is up and the demand is down, lowering the value.
Economic Growth
If the economy is strong, it attracts more investment which drives up the value of the currency. If the economy is weak it attracts less investment, or even loses investment which is withdrawn to go to other countries. A strong economy also means more available money, and the government will typically take money out of the system by raising interest rates, which as mentioned above is good for the currency.
Inflation
Of course when investors are looking at interest rates they must also consider inflation. The rate of inflation is a material factor when central banks decide what to do with interest rates. Typically, banks will cut interest rates when inflation is down to encourage economic activities. When inflation is up, banks will raise the rates to discourage spending.
Political Situation
Surprisingly, in the long-term it’s the economic forces, and not political ones, that tend to drive a currency. That said, from day to day politics can have an impact on the exchange rates. It’s only if a country suffers chronic political instability that you can expect the government to have a long-term effect on the currency rates.
Market Psychology
Psychology is a big factor in trading, and no more so than in foreign exchange. Sometimes just the expectation or rumor can drive exchange rates. For example, the Federal government cut US interest rates from September 2007, but even now they have stopped cutting and held rates steady, there remains a strong negative feeling towards the US dollar.
Technicals
Despite the fact that Forex is not the customary type of market, and is spread out around the world in many locations, there are many technical analysis techniques that can be used to help with your trading. You will find that the shorter-term you are trading on, the less relevant the fundamentals are. You need to depend on technical analysis when you are trading at the shortest time periods.
Trend Analysis
If the currency pair is trending, then it is a simple matter to apply trend analysis to the chart and come up with a plan for your trading. This works particularly well with the exotics, where the trends are usually more reliable.
Support and Resistance
Much of the time, currencies aren’t necessarily trending. Unlike equities, which can have bullish or bearish trends depending how the company is run, currencies in stable economies will tend to stay related. But this can mean that horizontal support and resistance lines come into their own. The currencies can form a strong relationship, with the price repeatedly hitting the support and resistance levels, giving a good basis for frequent trading.
Fibonacci Retracements
You’ll also find that Forex markets are respectful of the Fibonacci ratios, and frequently you will see 50% or 61.8% retracements in a trend. As with all these techniques, it pays to look at several different time scales to locate significant turning points, and in this case to find a recent peak and a recent trough between which to draw or stretch out the Fibonacci ratios.
Elliott Waves
As the Forex markets are large and well behaved, another successful technical analysis technique is to apply wave analysis to the charts. Unlike stocks, where sometimes you can find manipulation or irrational effects due to a large intervention, the Forex market will often follow the classic theory and exhibit the wave formations that we covered in an earlier module.
Indicator Divergences
The classic technical analysis tool, you should watch for divergences between the price movement and indicator movements. Usually when the indicator moves in the opposite direction to the price, the current trend cannot be sustained, and you need to keep a close watch on the charts.
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