When developing a perspective on the future direction of any investment, having a clear and data-driven process is critical. While relying on intuition is helpful for most day-to-day tasks, intuition alone is a very poor tool for assessing financial markets. This is because human beings are prone to psychological biases, and we often 'see' things that don't actually exist. Our minds have the powerful ability to re-shape reality into a picture that we want to see (known in psychology as 'confirmation bias'). While this is a difficult concept to truly appreciate, it is important to understand that intuition alone can lead one down the wrong path. Thus incorporating data into any investment process is critical. By having a process based on numbers, you can force your mind to accept that reality may not match your pre-conceived notions.
At MarketsNow, we analyze forex using three distinct perspectives. Specifically, we look at current and future policies, sentiment, and economic data. Each are described in greater detail below.
When assessing economic policy, we look at how governments dictate both fiscal policies and monetary policies. This is the least quantitative aspect of our process, but fairly critical given that currencies can be strongly influenced by government actions.
When looking at fiscal policy, we assess areas such as current and future tax rates, government spending plans and developments in international relations (particularly relating to trade and diplomacy). Currencies tend to appreciate when governments enact positive fiscal plans that are likely to boost near-term growth. Examples include tax cuts, increased government spending or signing new foreign trade deals. Currencies tend to depreciate when governments enact fiscal plans that are likely to hurt near-term growth. To see an example of how government actions can influence a currency, see our take on the US House of Representatives vote on the budget resolution. The House ended up passing the budget resolution, which sent the US dollar soaring shortly afterwards on expectations of future tax cuts.
When looking at monetary policy, we assess the likelihood of a central bank becoming more hawkish (i.e. prone to increasing the cost of borrowing money) or more dovish (i.e. prone to decreasing the cost of borrowing money). Central banks typically influence the cost of borrowing money by lowering or raising interest rates, although some have resorted to extraordinary measures in recent times including negative interest rates or quantitative easing (buying securities such as government bonds using central bank-created funds).
The most important aspect of assessing monetary policy is to gauge the divergence between central banks from different countries. For example: if the US is on a path of raising interest rates while Australia is comfortable with current interest rates, all things being equal, the US dollar will appreciate relative to the Australian dollar. To see an example of how central bank policy moves currencies, see our preview of the ECB's meeting in October 2017. In line with our thoughts, the ECB failed to meet the market's expectations, leading the euro to sharply sell off after the event.
As markets tend to move in cycles, we look for signs that suggest sentiment is at an extreme and due for a change in direction. Using trading terminology, we expect a currency to depreciate when it looks overbought and we expect a currency to appreciate when it looks oversold.
One of the best sources of data for assessing sentiment comes from the US Commodity Futures Trading Commission's (CFTC) Commitments of Traders (COT) report. The report provides a weekly breakdown of how futures traders are positioned in various markets (including currencies). The report is especially powerful as it categorizes traders into many different categories (e.g. speculators, asset managers, dealers, commercials, etc.).
While there are many perspectives on how to assess the COT report, we focus on how speculators are positioned in each currency. Our analysis is focused on signs that positioning is at a bullish or bearish extreme. Specifically, we look at positions in terms of the number of standard deviations from the trailing 1-year and 3-year average position. When aggregate positions are more than two standard deviations higher or lower than the 1-year or 3-year average in any currency, we flag the large position as a risk.
While this sounds fairly complex, the easiest way to understand the paragraph above is to read a recent analysis on the COT report. Any extreme positions are bolded, and thus at risk. Extreme positioning typically foreshadows a change of direction in the future, although it does not indicate an imminent reversal. Instead, it's an early warning sign that a change of direction may be on the horizon.
Beyond COT data, we also look at a variety of technical analysis indicators, which are particularly helpful when analyzing shorter time frames. Specifically, we like oscillators such as the Relative Strength Index, candlestick patterns that define the direction of the trend such as Heikin Ashi, and looking at historical tops and bottoms.
Similar to how prices move in cycles, economic data also tends to move in cycles. The most important figures are those directly relating to GDP growth and inflation. This is because the trajectory of growth and inflation drives central bank actions (described above), in turn causing prices in financial markets to rise or fall.
In order to gain a clearer perspective on economic data, we look at all figures in annual rate-of-change terms (that is, year-over-year). Unfortunately, data announcements in the media are often described in quarterly terms (e.g. "growth this quarter is up 4% relative to last quarter!"), but this not particularly helpful when trying to understand the longer term cycle. In the short-term, data can be very volatile and trends tend to be short-lived. When looking at year-over-year figures, the underlying trends are much easier to discern. To see how this works in action, see our recent thought piece on why Canadian growth is likely to slow in the latter half of 2017.
Once the trajectory of both growth and inflation are clearer, predicting the direction of a currency is much easier. Central banks tend to hike interest rates the most aggressively when both growth and inflation are rising in tandem (causing a currency to appreciate). This is because central banks can justify their actions using data. Conversely, central banks tend to get stuck when only one of the two numbers are moving in the right direction. When both growth and inflation are falling, central banks lend support to the economy by lowering interest rates (which results in a depreciating currency).
Our process of assessing currencies at MarketsNow is multi-dimensional, and based on hard data where possible. Given the competitive nature of financial markets, our view is that it is no longer sufficient to specialize in a single field alone. Once the implications from studying the three areas above are taken into account, the future direction of a currency is much clearer. This is why all the content we produce is geared towards understanding a currency based on current and future developments in government policy, speculator sentiment and economic data.