Methods For Predicting Large Currency Changes
In the past twelve months the AUD/USD has risen from a low of 0.87711 to a high of 1.10805
, a difference of 2309.4 pips. Over the same time the EUR/USD has fluctuated in a 2352.2 pip range between 1.25879 and 1.49399. Meanwhile the USD/CHF plummeted from a high of 1.05347 to a low of 0.7035, a 3299.7 pip plunge.
So what is behind these dramatic fluctuations?
Internationally, currencies are traded in order to exchange products and services between different economies. However, currency values are not determined by the amount of goods being traded, but by the
forex market, which is a free market subject to the differing opinions and motives of traders and investors, meaning that fundamentals and economic data can be overwhelmed by sentiment.
Compared with the total of world trade done in 2006 USD12 trillion the USD4 trillion daily volume of forex trades is enormous, meaning that, in the forex market, economic data is dwarfed by speculation. Consequently, theories other than economics are probably more useful for predicting currency changes.
Method 1 Bias in one currency compared to a basket of others
Looking at a forex pair only tells a trader about the relationship between the two currencies. However, comparing a currency to a group of currencies can tell a trader more about the performance of that currency, and can also help explain its movements within forex pairs.
The US dollar index is an index that measures the value of the greenback against a number of currencies, and it can provide a context for the trading within USD related pairs. Although individual pairs may deviate from the trend, often pairs with the USD as the first named currency will rise and fall with the dollar index.
Method 2 Primary economic input
Some currencies are impacted by one factor more than others, and this can significantly sway forex movements. Commodity currencies are a good example of this, such as the Canadian and Australian dollars.
The CAD has a strong correlation with the price of oil and the level of oil exports. Canadian oil exports grew from 7% of Canadas exports in 1999 to 20% of the countrys total exports in 2007, rising at the expense of other exports, and giving the single commodity a greater influence on the value of the currency.
However, commodities are not the only factors that can significantly impact forex pairs. In the case of the Japanese yen, low interest rates have made it a popular carry trade candidate. As the carry trade involves buying a high yielding-currency against a low-yielding currency (such as the AUD against the JPY), it can push the value of the JPY down, and can cause the value of the JPY to rise when traders start selling off their carry trade pairs.
Method 3 Government policy
While forex rates are largely speculative, a primary driver of future movements is the markets reaction to government policies such as monetary policy, balance of payments and foreign assets and liabilities.
Monetary policy and interest rates impact exchange rates, frequently after the initial announcement has been made. Interest rate announcements will have varying effects on currency pairs depending on the currencies concerned, as well as whether or not the announcement delivered and expected result. Increasing interest rates may appreciate a currency as investors looking for higher-yielding assets need to convert their money into the local currency to purchase these investments, and an increasing interest rate differential between two currencies is likely to increase the volatility of the forex pair. If interest rates move too quickly or inflation accelerates, the reverse occurs.
Current account imbalances can also impact currencies, as large deficits may make foreign countries wary of buying the currency. This will result in lower demand for the currency and a potential speculator sell-off. Central banks may also engage in speculation by taking on excess reserves and finding high-yield investments.
A countrys balance sheet and the currencies in which they hold most of their assets and liabilities are also an important factor in the forex market. For example, an economys falling currency may be viewed positively because it increases export demand, but it may harm the country if most of their liabilities are priced in an appreciating currency as their debt obligations will become harder to pay when converted into the domestic currency.
Conclusion
Dramatic currency movements often defy logic, swinging from one extreme to another. However, if traders keep in mind that a currency may be displaying similar patterns against a basket of currencies, the primary factor that affects the value of a particular currency, and that government policy can often influence both short-term price movements and longer-term currency trends, they will be in a better position to predict movements in this volatile market.
by: Lara Short
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