are still missing an important component, namely the weights to attach to each player and his favoured factor, and the vectors by which the factor invades another player’s consciousness. In the set of matrices shown below, we start out with an allocation of the importance of various factors to professional bank traders. We chose bank traders as the leading edge of FX price determination – these are the players who cause directional breakouts based on their interpretation of factors. Don’t forget that the professional bank traders are informed by the trading decisions of hedge funds and others who have a global worldview and make value judgments; the bank trader is not going to fight the tape if he sees sentiment shifting in a particular direction.
Let’s say that over the summer of 2010, professional traders attributed a weight of 50% to interest rates and expected interest rates (Period 1 in the tables below). We can quibble over the weights, but let’s take 50% for the minute.
Period 1 – June 2010 to end-August 2010
Then Ben Bernanke pre-announced QE2 at the Kansas City Fed summit in Jackson Hole, Wyoming in August 2010. The focus immediately shifted to interest rate expectations, which now get a much higher weight in Period 2. The other players, seeing the dollar fall on the pros building a wider differential against the dollar, increased their weight to that factor, too. The weight attributed by the pro bank traders bled into the other players’ evaluations of factors.
Period 2 – Quantitative Easing 2: end-August 2010 to end-December 2010
In Period 3, Eurostat released data showing that inflation was over the ECB cap of 2%, raising the spectre of the ECB tightening rates faster than the US. The interest rate expectation factor thus got stronger, the dollar fell more, and because the FX market is reactive, all the other players imputed a higher weight to this factor, too.
Period 3 – euro zone inflation rises: January 2011
At end-January 2011, Tunisia experienced rioting and the government fell (Period 4). Civil unrest broke out in Egypt, and in a single day, geopolitical factors became the dominant factor. Oil rose, returning the commodity correlation story to the fore.
Period 4 – revolution in Egypt, 28 January 2011
If these matrices were on a set of cards and you could fan them in order, you would get a moving picture that would show first the interest rate expectation gaining dominance, then bleeding to the other players, and then the geopolitical factor taking over. In other words, you’d get a moving picture showing how the weight of factors increases and then bleeds into other factors.
Flickering off to the side would be the technical factors. Technical factors never really go away but can always be trumped by institutional factors. This is a useful way to think about how and why exchange rates move – better than two dimensional charts labelled with world events – but obviously it is too cumbersome and impractical for anyone but a programmer to attempt.
That brings us to the thorny problem of factors that are temporarily not at the top of the list but which are still present; a form of known unknowns. On the day in January 2011 when the Egyptian riots took over the imagination of traders in all markets, nobody was talking about fiscal sustainability in Greece, Ireland, Britain, Japan or the US. In fact, S&P had downgraded Japan’s sovereign rating just the day before, but the yen didn’t move an inch on the downgrade. Still, a new geopolitical issue coming along does not kill a factor, it just supersedes it for a while.
Perversity of the FX market
While the various matrices are a handy metaphor for market behaviour, not everything can be explained in a rational way. On any day, a sane interpretation of events may suggest the dollar should move up when in fact it goes on to move down. In the middle of the worsening euro zone peripheral debt crisis, the euro rose for almost a full year (June 2010 to May 2011).
What’s going on here? Why does the FX market behave in this perverse fashion?
Understanding this perversity
In a way, perverse FX responses to events are a form of irrational rationality, like the prisoner’s dilemma. Both parties (bulls and bears) would benefit if they both stay silent, but often the first prisoner will confess because he doesn’t know whether the second prisoner appreciates that his self-interest lies in staying silent. Translated to FX, it pays to jump to conclusions on the assumption that others will jump to those conclusions, even if they are nonsensical conclusions. One such perversity, after the 2008 global financial crisis, is the dollar reliably, consistently and persistently falling on good economic news – it occurs because good US data implies the environment is safe for risk-taking in non-US dollar currencies and assets.
To get oriented in trying to answer the perversity question, you have to accept two ideas mentioned in the Introduction: the first is that the price of a currency is set at any one moment in time by traders whose only goal is to make a profit. FX traders usually do not know, nor do they care about, fair value. They want to buy low and sell high, or buy high and sell higher. The second idea is that a key tool in this quest for profit is technical analysis.
Technical analysis in the FX market
Like the addition of hitherto exogenous variables to the basic FX matrix, the spread of technical analysis is relatively new. While technical analysis has been used since right after the dollar was first floated in 1974 – as a remedy to mass confusion over the determinants of FX prices – it was the advent of the personal computer in the 1990s that made it widespread. Technical analysis is more efficient than fundamentals – you use three or four indicators on a single chart against a complicated, interactive matrix of fundamental and institutional factors.
Moreover, technical factors can drive and override fundamentals, at least sometimes, even if in the end the fundamentals always have the last word. Unlike in other securities fields, in FX there is no clear-cut dividing line between the fundamental and the technical. Fundamental and technical effects are as interactive with one another as fundamental and institutional factors. For example, once the euro bottomed in June 2010 and started rising, it had upward momentum and upward-pointing patterns that set a new stage for evaluating the later worsening of sovereign debt and the banking crisis.
This is called Bayesian analysis, wherein what you think you knew is changed by subsequent knowledge. You literally go back and remember your original thinking differently from what it really was at the time. In a nutshell, everything is relative. The first appearance of a crisis is more shocking (and causes a bigger price move) than a later worsening of the same crisis, when the effects of the first shock have worn off and the first shock has become part of the background environment. In the case of the euro, the second shock was buffered significantly by its healthy image, which was both cause and effect of the first rebound.
Pinpointing how multiple factors – fundamental and technical – interact is tricky because in FX there are no absolutes. We might postulate that at the beginning of a price move, fundamentals drive the technicals, but once the fundamental event is known, the technicals can lead. For instance, a key level will be resisted solely because the probability of
