Forex Analysis Cause, Effect and Cycle of Speculation
Some traders have the wrong
perception that supply and demand are completely independent of one another. Let’s
think about it for a moment.
If this was true, price
trends could not exist at all, because forex markets would immediately work to remove
any supply or demand imbalances. The fact that this doesn’t happen and that
price trends do occur suggests that there are intervals, sometimes substantial intervals,
before such imbalances can be reduced.
Besides, supply and
demand are not completely objective concepts. They reflect the views stated by market
traders, who make up that supply and demand. In other words, supply and demand
are both cause and effect.
What does this mean in
practice?
Currency traders know well that particular flows will have more effect than others and thus will materially affect the supply/demand dynamics.
Say a large multinational
corporation transacts an end-of-quarter hedge in the Euro–Dollar exchange rates.
Granted, this is the most liquid currency pair in the world, but if the flow is
large enough it may affect both current market pricing and future market
thinking.
Of course the term “future”
means different things to different people. To the multinational, it means months
at least if not years. To the interbank dealer transacting the flow in the
market place it means minutes or hours at most.
Forex markets are
essentially flow-driven over short time frames, and therefore it is vital to
understand the relationship between supply and demand dynamics.
Just as supply and demand
are not independent of one another and are both cause and effect, so the
relationship between “speculation” and economic fundamentals is also not just one-way.
Economic theory needs
that markets remove “speculative excess”, thus returning balance. However, we have already established that “balance”
is actually a moving target. If the “speculative excess” is the extent to which
markets diverge from balance, then that “speculative excess” is also a moving
target.
Finally, the belief of
economists is that economic fundamentals drive market pricing and thus to an
extent speculative excess. Even if we accept this, it has also to be
acknowledged that speculative excess can
in turn affect economic fundamentals.
The speculative cycle
of exchange rates” can be expressed in 4 steps:
Fundamental market
participants deem a currency good (poor) value and start buying (selling) it on
a sustained basis, thus creating a currency trend.
The longer the trend continues,
the more speculative it becomes in nature, as more and more speculative market
participants (i.e. no underlying asset in the transaction) buy (sell) the currency
trend.
However, as the trend of
currency appreciation (depreciation) continues it creates increasing economic
deterioration (improvement), encouraging an increasing number of fundamental
market participants to sell (buy) their positions.
For a time, speculative
inflows (outflows) more than offset those fundamentals outflows (inflows), but
eventually in the face of increasing economic deterioration (improvement)
they capitulate and the
currency collapses (rallies).
Economists may note that this
model is not that dissimilar in essence from the belief that speculative excess
will be corrected by fundamentals, back towards an equilibrium level. The crucial
difference however is that the relationship between speculation and
fundamentals is
not one-way but two-way.
What the two ideas have
in common however is that they believe in a cycle. The cycle of foreign
exchange activity may or may not be the same as the economic cycle, depending
on a number of factors such as positional risk and investor asset allocation.
In addition, there is no
telling how long it will last. It could take weeks, months or even years. However,
it is a discernible pattern, reflecting the key dynamics of the currency market
and focusing specifically on speculative flows.
In addition, it can be
used as a framework for the analysis and prediction of exchange rates over the
short to medium term.
