Tuesday, March 1, 2011

Fundamental Factors and Currency Exchange Rates

People often try to explain changes in the short-term currency rates because of fundamental factors, i.e. the dollar is dead, everyone wants a new reserve currency. Most explanations have little to do with reality. It's not that fundamental factors don't play a role in currency exchange rates. They most certainly do. But this is over the longer term and has almost nothing to do with most currency traders who are in and out of the market on any given trade in less than a week in most cases and less than a day or so in many. And let's not even discuss intraday scalpers who work off five-minute or less charts.

Yesterday, I ran across a post where someone was attempting to explain the failure of the USD to rally in light of the recent unrest in the middle east countries. Their explanation was that first, "It is over for the US Dollar," and second, the possibility of future military action by the US in the mid east would stretch the US to the breaking point and cause the printing of more dollars which weakens the dollar and therefore it's over for the US dollar. Which was "argument" one. Talk about circular reasoning. The evidence for the first argument was primarily from Rupert Murdoch's rag, the Wall Street Journal. They cited an article talking about how something known as purchasing power parity (PPP) indicated that China was surpassing the US.

I did respond. I'm posting my response here for a couple of reasons.

First, one can get distracted by discussions that sound reasonable and use economic jargon such as purchasing power parity. But one has to ask, what does this do for one's trading? Does it improve it?

In addition, as much as the field of economics is subject to ridicule, it is a field with an identifiable body of study and to understand it takes much study. There are contrary opinions from educated people who have studied and earned advanced degrees in the subject. So what do you make of that? What it says is that it's not a hard science and that the best one can do is offer hypothesis in many cases. But hypothesis is not truth and often has subtleties not apparent to the average person. While the writer of the post may have understood the nuances of what he wrote, it's not likely many of his readers did.

Finally, as regular readers know, this blog is about trading. Psychology plays a big part in trading. I've written on this before. You read the dollar is dead and the next thing you know you're shorting the dollar even though the chart may tell you otherwise.

Now I'm not saying that US policy will do anything that will be good for the dollar in the short term. Or maybe even in the long term. I am not sure the US administration cares about the dollar. That's not a slap at Obama. I like Obama. I don't like that he used the same goons from the Bush administration to determine our economic policies.
What I am saying is that getting caught up in the fundamental factors is irrelevant since trading should be done on a technical basis. Personally, I do look at fundamental factors but only in the broadest sense. Those things that impact a currency, i.e. interest rates, need to be kept in mind. But as a direct relationship in the short-term even that can break down.

Most currency traders I run across are struggling with how to make money trading. Stay focused on the charts. Turn off the noise. In the short-term it's all noise.

Here's my response that I posted:

As a recovering fundamental trader, I usually stay away from discussions based on fundamental factors for what's happening in the short term. (I agree that fundamental factors dominate in the long term but that's not usually how FX is traded and in any case technical analysis still should govern entries and exits). But because PPP raises its head here and because I wrote a long paper in university once upon a time on this topic, I'll comment.

First, PPP is not one thing. It can have to do with the law of one price, the absolute parity, or relative parity. Both of the first two seem to have problems depending on what studies one reviews; the latter can be useful for long term exchange rate trends. However, PPP doesn't hold up well in short-term studies as to impact on exchange rates. This, though, is true of most fundamental factors--they're not useful for the short term and the statements in the WSJ article you cite appear geared to the short term.

Second, PPP is controversial. It can be difficult to find baskets of goods that are comparable to compare across economies. The quality of those goods is also problematic. This is why people like the Big Mac Index. But even this can be skewed depending on market to which it's being compared and the demographics of the purchasers. Besides which, the index is an absolute PPP. All that said, again, over the longer term, it can play a role in fundamental analysis.

Fundamentally, I do agree that it's probably some long-term interaction of a monetary approach with relative PPP that has to do with exchange rates. But not in the short-term and this failure of the USD to move up, while interesting, can still be classified as a short-term aberation. Or maybe it's just the stars as the financial astrologers will tell you, LOL.

The fear of further military involvement is interesting but I'm not going to take it on because first, it's already discounted in, and second, this is what happens with fundamental arguments--one gets consumed by them and meanwhile, luscious trade opportunities are floating by based on technical analysis.

Dianne Fecteau, CMT
Read my Forex blog at http://www.forexreflections.blogspot.com

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