Foreign exchange forecasting in practice

Most of the approaches to foreign exchange rate determination tell only part of the story—like the several blindfolded men touching different parts of the elephant’s body—and other, more comprehensive explanations cannot, in practice, be used for precise forecasting. We do not yet have a way of bringing together all of the factors that help determine the exchange rate in a single comprehensive approach that will provide reliable short- to medium-term predictions.

The exchange rate is a pervasive and complex mechanism, influencing and being influenced by many different forces, with the effects and the relative importance of the different influences continuously changing as conditions change. To the extent that trade flows are a force in the market, competitiveness is obviously important to the exchange rate, and the many factors affecting competitiveness must be considered.To the extent that the money market is a factor, the focus should be on short-term interest rates, and on monetary policy and other factors influencing those shortterm interest rates. To the extent that portfolio capital flows matter, the focus should be broadened to include bond market conditions and long-term interest rates. Particularly at times of great international tension, all other factors affecting the dollar exchange rate may be overwhelmed by considerations of “safe haven.”

Indeed, countless forces influence the exchange rate, and they are subject to continuous and unpredictable changes over time, by a market that is broad and heterogenous in terms of the participants, their interests, and their time frames.

With conditions always changing, the impact of particular events and the response to particular policy actions can vary greatly with the circumstances at the time. Higher interest rates might strengthen a currency or weaken it, by a small amount or by a lot—much depends on why the interest rates went up, whether a move was anticipated, what subsequent moves are expected, and the implications for other financial markets, decisions, or government policy moves. Similarly, the results of exchange rate changes are not always predictable: Importers might expect to pay more if their domestic currency depreciates, but not if foreign producers are “pricing to market” in order to establish a beachhead or maintain a market share, or if the importers or exporters had anticipated the rate move and had acted in advance to protect themselves from it.

Nonetheless, those participating in the market must make their forecasts, implicitly and explicitly, day after day, all of the time. Every piece of information that becomes available can be the basis for an adjustment of each participant’s viewpoint, or expectations—in other words, a forecast, informal or otherwise. When the screen flashes with an unexpected announcement that, say, Germany has reduced interest rates by a quarter of one percent, that is not just news, it is the basis for countless assessments of the significance of that event, and countless forecasts of its impact in number of basis points.

Those who forecast foreign exchange rates often are divided into those who use “technical”  analysis, and those who rely on analysis of “fundamentals,” such as GDP, investment, saving, productivity, inflation, balance of payments position, and the like.

Technical analysis assumes certain short-term and longer-term patterns in exchange rate movements. It differs from the “random walk” philosophy—the belief that all presently available information has been absorbed into the present exchange rate and that, the next piece of information as well as the direction of the next rate move is random, with a 50 percent chance the rate will rise, and 50 percent chance it will decline.

Nearly all traders acknowledge their use of technical analysis and charts. According to surveys, a majority say they employ technical analysis to a greater extent than “fundamental” analysis, and that they regard it as more useful than fundamental analysis—a contrast to twenty years ago when most said they relied many more heavily on fundamental analysis.

Perhaps traders use technical analysis in part because, at least superficially, it seems simpler, or because the data are more current and timely. Perhaps they use it because traders often have a very short-term time frame and are interested in very short-term moves. They might agree that “fundamentals” determine the course of prices in the long run, but they may not regard that as relevant to their immediate task, particularly since many “fundamental” data become available only with long lags and are often subject to major revisions. Perhaps traders think technical analysis will be effective in part because they know many other market participants are relying on it.  Still, spotting trends is of real importance to traders—“a trend is a friend” is a comment often heard—and technical analysis can add some discipline and sophistication to the process of discovering and following a trend.

Technical analysis may add more objectivity to making the difficult decision on when to give up on a position—enabling one to see that a trend has changed or run its course, and it is now time for reconsideration.

Most forex market participants probably use a combination of both fundamental and technical analysis, with the emphasis on each shifting as conditions change—that is, they form a general view about whether a particular currency is overvalued or undervalued in a structural or longer-term sense, and within that longer-term framework, assess the order flow and all current economic forecasts, news events, political developments, statistical releases, rumors, and changes in sentiment, while also carefully studying the charts and technical analysis.

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