Page 19 - Module 4 - Trading_Ways_and_Means

Module 4 - Lesson 4 Forex dependence on financial and socio-political factors

Financial factors are vital to fundamental analysis. Changes in a government's monetary or fiscal
policies are bound to generate changes in the economy, and these will be reflected in the exchange
rates. Financial factors should be triggered 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.

1. The role of interest rates
Using the interest rates independently from the real economic environment translated into a very
expensive strategy. Because foreign exchange, by definition, consists of simultaneous transactions
in two currencies, then it follows that the market must focus on two respective interest rates as well.

This is the interest rate differential, a basic factor in the markets. Traders react when the interest
rate differential changes, not simply when the interest rates themselves change. For example, if all
the G-5 countries decided to simultaneously lower their interest rates by 0.5 percent, the move
would be neutral for foreign exchange, because the interest rate differentials would also be neutral.
Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in
both the interest differential and the exchange rate.

Traders approach the interest rates like any other factor, trading on expectations and facts. For
example, if rumour says that a discount rate will be cut, the respective currency will be sold before
the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or the other
way around. 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 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.

This happened in both September 1992 and the summer of1993, when the European central banks
lost unprecedented amounts of money trying to prop up their currencies, despite having high
interest rates. The market perceived those interest rates as artificially high and, therefore,
aggressively sold the respective currencies. Finally, traders deal on the perceived importance of a
change in the interest rate differential.

2. Political crises influence
A political crisis is commonly dangerous for the Forex because it may trigger a sharp decrease in
trade volumes. Prices under critical conditions dry out quickly, and sometimes the spreads between
bid and offer jump from 5 pips to 100 pips. Unlike predictable political events (parliament elections,
interstate agreements conclusion etc.), which generally take place in an exact time and give market
the opportunity to adopt, political crises come and strike suddenly.

Currency traders have a knack for responding to crises. The traders should react as fast as possible
to avoid big losses. They have not much time to take decisions, often they have only seconds. Return
on the market after a crisis is often problematic.

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