Tuesday, April 21, 2015

The Role of Financial 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 in the early
1990s. The realities of the marketplace revealed the underlying artificiality of
this approach. 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 rumor 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. "Buy on the rumor, sell on the fact...".
Other factors affecting the trading decision are the time lag between
the rumor 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, what is 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 of 1993, 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.

Political Events and Crises
Political events generally take place over a period of time, but political
crises strike suddenly. They are almost always, by definition, unexpected.
Currency traders have a knack for responding to crises. Speed is essential;
shooting from the hip is the only fighting option. The traders' reflexes take
over. Without fast action, traders can be left out in the cold. There is no time
for analysis, and only a split second, at best, to act. As volume drops
dramatically, trading is hindered by a crisis. Prices dry out quickly, and
sometimes the spreads between bid and offer jump from 5 pips to 100 pips.
Getting back to the market is difficult.

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