Geo-Political Factors
There are two necessary methods in forecasting the currency market – fundamental analysis and technical analysis.
As the technical analysis focuses on the study of price movements, fundamental analysis focuses on the economic, social and political forces that drive supply and demand. Fundamental analysts look at various macroeconomic indicators such as economic growth rates, interest rates, inflation and unemployment. However, there is not single set of beliefs that will guide fundamental analysis. There are several theories as to how currencies should be valued.
Financial Factors
Financial factors are extremely vital to fundamental analysis. Any changes in a government's monetary or fiscal policies are bound to generate changes in the economy, and in turn these will be reflected in the exchange rates. Financial factors should be triggered however only by economic factors. When governments focus on different aspects of the economy, or have additional international responsibilities, financial factors may have priority over economic factors. This was painfully true in the case of the European Monetary System (EMS) in the early 1990s. The realities of the marketplace revealed the underlying artificiality of this approach.
Political Crises Influence
A political crisis is known to be dangerous for Forex because it can trigger a sharp decrease in trade volumes. Prices under critical conditions dry out quickly, and at times the spreads between bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliamentary elections, the conclusion of interstate agreements, etc.), which generally take place in an exact time and give the market the opportunity to adapt, political crises come and strike suddenly. Currency traders have a knack for responding to crises. The traders should react as quickly as possible with risk management to avoid big losses. They do not have a lot of time to make decisions – often mere seconds. Return on the market after a crisis is usually problematic.
The Role of Interest Rates
Using the interest rates independently from the real economic environment translates into a very expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions in two currencies; it follows that the market must focus on the two respective interest rates as well.
This is known as the interest rate differential, which is a basic factor in the markets. Forex traders react when the interest rate differential changes, not simply when the interest rates change. For example, if the G-5 countries decided to lower their interest rates by 0.5 percent simultaneously, the move would be neutral for foreign exchange only, because the interest rate differential would also then be neutral. Most of the time the discount rates are cut unilaterally, a move that can generate changes in both the interest rate differential and the exchange rate. Forex traders approach the interest rates like any other factor, trading on expectations and facts. If rumor says that a discount rate will be cut, the respective currency will be sold before the fact. Once this cut occurs, it is highly likely that the currency will be bought back or vice versa. An unexpected change in interest rates is likely to trigger a sharp currency move. Other factors affecting the trading decision are the time lag between the rumour and the fact, the reasons behind the interest rate change and the perceived importance of the change. The market generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is therefore neutral to the market. If the discount rate was changed for political rather than economic reasons (a common practice in the European Monetary System), the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones.
Monetary Operations by Central Banks
All central banks, including the US Federal Reserve System (FRS), affect the foreign exchange markets’ changing discount rates and perform the monetary operations like currency and interventions.
For foreign exchange operations, most significant are repurchase agreements in order to sell the same security back at the same price at a pre-determined future date and at a specific interest rate. This arrangement amounts to a temporary injection of reserves into the banking system. The impact on the foreign exchange market is that the national currency should weaken. The repurchase agreements are usually customer system or customer repos.
Matched sale-purchase agreements are just the opposite of repurchase agreements. When executing a matched sale-purchase agreement, a bank or the FRS sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a pre-determined time. This arrangement amounts to a temporary drain of reserves. The impact on the foreign exchange market will cause the currency to strengthen.
Monetary operations include payments among central banks or to international agencies. In addition, the FRS has entered into a series of currency swap arrangements with other central banks since 1962. Also, payments to the World Bank or the United Nations are executed through central banks.
Intervention in the United States foreign exchange markets by the US Treasury and the FRS is geared toward restoring orderly conditions in the market or influencing the exchange rates. It is not geared toward affecting the reserves. There are two major types of foreign exchange interventions – naked intervention and sterilized intervention.Naked intervention refers to the sole foreign exchange activity. Only thing taking place is the intervention itself, in which the Federal Reserve will either buy or sell US dollars against a foreign currency. If the money supply is impacted, then consequent adjustments must be made in interest rates and in prices. Therefore, a naked foreign exchange intervention has long-term effects.
Sterilized intervention neutralizes its impact on the money supply. There are rather few central banks that want the impact of their intervention in the foreign exchange markets which would affect all corners of their economy, sterilized interventions have commonly been the tool of choice. This holds true for the FRS as well. The sterilized intervention involves an additional step to the original currency transaction. This step is the financing of a sale of government securities that offsets the reserve addition that occurs due to the intervention. It's easier to visualize if you think of it as the central bank financing the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a particular currency, its impact will therefore tend to have a short- to medium-term effect.
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