Shares Magazine
March 2007

The 1970s produced a hypothesis that a US nuclear reactor core meltdown could burn through to China. Today’s equivalent of that syndrome is financial rather than radioactive and, as recent events have shown, likely to move in the other direction. Marilyn McDonald watches equity pebbles cause forex ripples in minds as much as markets.

It’s been said that when the US sneezes, the world gets a cold. While this is still widely quoted, I think it’s pretty fair to say that in today’s market when China sneezes the world gets a cold – or at the very least a bad allergy. This was highlighted quite dramatically in late February and early March when the Chinese stock market dropped a 9%-loss pebble into the world market pond. This held ramifications that rippled across equity and forex markets worldwide.

The Chinese markets had been skyrocketing over the previous year, building what some saw as a bubble primed to burst. Many have pointed to the offending needle but the truth is a combination of a lack of real liquidity and fears of additional Chinese legislation and taxes. The frenzy started in the Asian markets and continued around the globe as markets opened. As New York and London came online the markets were in utter confusion.

The US markets were further jolted by a drop in the Q4 GDP, the dreaded R word uttered by Alan Greenspan and problems in the Us subprime mortgage market, not to mention a couple of computer glitches. All of that combined to send those markets into a tailspin. In one day, the Down Industrial average dropped 3.3% and the S&P 500 dropped nearly 3.5%.

For FX traders, the risk was seen in the overextended carry trade, which spurred considerable bids for the Japanese yen and the Swiss franc. The yen posted huge gains against most of its currency counterparts, particularly against the New Zealand dollar. It also confirmed a downward trend against the US dollar.

There’s no debate that all this combined to fuel major changes in the FX markets and furthered the dollar’s decline against the yen. Japan’s Nikkei index then fell 3.3% to solidify the worldwide retreat in the equities market.

These dramatic moves echoed across the other currency pairs in equally dramatic fashion. On the 29th of February, the euro/dollar also took a turn and headed south.

What does this all mean? Well, hindsight is 20/20. The dollar/yen sank to a new three-month low. But as the equity markets start to regain some of their earlier strength, traders will see corrections mirrored in the FX charts.

So much of the news reported throughout this time was overhyped and poorly analyzed. In fact, my local news channel, which never has market analysis, led with big news items speculating about market crashes and the general populace losing retirement accounts. It was an over-dramatized snapshop of what was going on. In reality, the Chinese market has seen growth of 10% annually over the past two years. So a 9% retracement on stocks that were up 13% over the previous month shouldn’t have been the portfolio-threatening event it was portrayed to be.

Ripples in equity markets can quickly translate to earthquakes in the forex markets. Whether 28 February 2007 will be seen as a great buying opportunity or the emergence of a new trading range remains to be seen. However, it wasn’t the catastrophe that many foretold in the early hours of the moves. And considering US Treasury Secretary Paulson’s comments that global economic conditions are very healthy, I think the signs of recovery are clear.

This reminds me of a quote by Coleridge, “In politics, what begins in fear usually ends in folly.” I think that same advice lends itself to the markets. My advice to everyone facing this situation in the future is not to lose your head. Do some thoughtful research into the situation and make your own, fact-based decisions.

Fundamental and Technical Approaches

What moves forex? Traders seem to be divided into two camps – those who swear by fundamental analysis and those who swear by technical analysis.

Technical Analysis

Technical analysts presuppose that the information needed to evaluate the market and its subsequent fluctuations is contained in the price chain and that any factor that has an influence on the price (be it economic, political or psychological) has already been considered by the market and has been included in the price. Technical analysis has been described as a statistical and mathematical analysis of the price data and a projection of upcoming prices. Sound intimidating? It’s not really. Simply put, technical analysis is the study of prices in order to make better trades using charts as the primary tool.

Technical analysis has its roots in the Dow Theory developed by Charles Dow around 1900, and includes principles such as the trending nature of prices, confirmation and divergence, support / resistance,a nd the application of indicators on charts.

Support and resistance is the key to most technical analysis chart patterns. Support and resistance levels represent key junctures where the forces of supply and demand meet. Think back to basic economics – the support and resistance (supply / demand) lines show what the supply and demand will be at a given price.

Technical analysts also watch the direction of the trend. A trend is a representation of the change of prices over time, while support and resistance levels represent barriers to change. Technical traders apply all sorts of indicators and line studies to a chart to try and determine the trend. The moving average is one of the oldest and most popular of these technical analysis tools. A simple moving average is the computation of the average price of a currency pair over a specified number of periods.

Along with moving averages, technical traders will use indicators to predict price movements in the market. Essentially it is a mathematical calculation applied to the price field displayed as a line or a graph overlaid on a chart or displayed in an adjacent window.

Technical analysts look to limit their risks by studying historical price data and making projections about how the market will react in the future.

Fundamental Analysis

Fundamental analysts consider current situations in the country of the currency. They endeavor to watch the factors that make a country tick: factors such as inflation, government policy, the employment cost index, political events and even individual events such as news.

The forex market is also strongly influenced by general expectations, expectations of the traders themselves and their assessment of those expectations. Some expected and unexpected news releases have strong influences on expectations.

Watching Those Moves

Fundamental analysts watch the movements of capital between countries and consider it to be a major factor determining the current state of the market. Two key components affect the balance of mutual payments. First, the county’s trade surplus/deficit and second the amount of foreign investment. In other words, if a country has more money flowing out than coming in the value of the currency will be affected.

Among those economic factors watched by fundamental analysts, discount rates and inflation can considerably influence currency exchange rates. The higher a country’s discount rate, the more favorable the currency becomes for foreign investors. For instance, if you were interested in investing in government bonds and considering two different countries, everything else being equal the country with the higher discount rate would usually provide a higher bond yield and be a more attractive investment.

Inflation can also play an important role in the currency value. Still looking at government bonds, if two countries have the same or close to the same discount rate and country A has a 3% rate of inflation , while country B has only a 1% rate of inflation, you would look a the net return, which will influence the investment choices and possible adversely affect the value of the currency.

Most countries have a regulatory body in place that tries to keep some form of balance to the economic conditions. In Europe there is a European Central Bank (ECB) and in the US there is the Federal Reserve Bank.

There are two main ways states can control the market. The first is just control and the second is so-called intervention. Currency control prevents citizens from doing anything that can have a negative influence on the exchange rate. The second and more common method is intervention, either by changing the discount rate, which makes the currency more or less attractive for foreigners, or by selling or buying the currency in order to increase or reduce its cost on the market.

Playing Politics

Politics also play a role, especially political uncertainty. War or civil unrest, for example, can render countries currencies virtually worthless.

Psychological factors can account for the fact that sometimes the anticipation of some economic changes alone exerts much more influence on the exchange rate than actual events. Often, when an actual event takes place (such as the Federal Reserve Bank or ECB raising the discount rate) the market has already anticipated this event and the movement in the currency is not very substantial.

The activities of large financial funds also influence the market greatly. Though all of them can make moves on their own, they are at least well aware of all the peculiarities in the changes of exchange rates for each main currency. Almost every company or government body employs technical analysts who follow and chart the currencies so that, when a graph describing how some exchange rate floats reaches some support or resistance level, the currency should be bought or sold.

The market’s behavior has become technically predictable and, therefore, managers of major financial funds react in a predictable way, which often means the same or a similar way. As a result, there is a sudden and powerful upsurge in prices and large financial volumes get invested into the same positions.

Summary

All the factors mentioned above can cause sudden and dramatic changes on the market. Along with the fact that in recent years, more professional investors, it makes the forex market a dynamically developing one. As the market continues to expand, we will need constantly to evaluate and re-evaluate the factors contributing to the major market moves.

In spite of the different approaches, both forms of analysis complement one another. Fundamental analysts have to consider some technical characteristics of the market and supporters of the technical approach must track the major new releases.

Read the article in pdf. My story starts on page 56.