Posted on: 07 Jun, 2019
A common debate when it comes to the proper interpretation of currency valuations involves the question of which element leads price. Is it fundamentals that play the main role as a precursor to establish price discovery or is it technicals that we should play the most attention as the gauge?
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A common debate when it comes to the proper interpretation of currency valuations involves the question of which element leads price. Is it fundamentals that play the main role as a precursor to establish a fair price or is it technicals that we should play the most attention as the gauge?
Fundamentals reveal the 'whys' to make sense of the movements in currency valuations, while technicals are more about the route taken to get there, in other words, the 'hows'.
An important subtlety to this discussion, nonetheless, is that it is highly advisable that one accounts for a third factor that often goes unnoticed but should be equally relevant. I am referring to intermarket analysis, which is a critical addition to deconstruct the future prices of a currency.
Some consider intermarket as a branch of technical studies since it involves the observation of correlations, while another camp sees intermarket as falling under the umbrella of fundamentals as it reflects, via bond yield spreads, policy divergences between Central Banks, or via risk profiles, the willingness to allocate capital in certain currencies like the Yen, the Swiss Franc or the US Dollar in times of tightening financial conditions or support commodity currencies when risk appetite flourishes.
Secondly, I will state right off the gate that I find this parley of technicals vs fundamentals, for the most part, preposterous in nature. As an experienced forex trader, I simply cannot envision how one can be equally equipped to trade the currency market if ignoring one camp. You need to know as much the 'why' as the 'how' in every endeavor.
Of course, you can have a propensity for one aspect to play a greater role in your decisions as part of how you get in and out of the market, but strip out the value of either is, simply put, walking (trading) while limping of one leg.
With that out of the way, let’s dig in...
Fundamentals, at the very core, is the science of price analysis that intends to measure the right valuation of a currency by assessing a plethora of economic data as it relates to a country’s economic health. From there, most importantly, it’s all about understanding the influence that these data/events have on a central bank monetary policy outlook. The more volatility a currency is exposed to in response to an economic event, the greater the influence the outcome has on the perception towards CB policies.
Central Banks will try to emphasize their course on monetary policy based on the premise that they have a mandate to stick with, that being, in most cases, price stability and full employment. In other words, economic indicators such as CPI or jobs data become critical. However, consumer spending, economic growth via GDP readings, business confidence, just to name a few extra ones, are also directly intertwined to the ultimate readings obtained on inflation or employment.
As an example, let's look at the Australian inflation readings on a quarterly basis for the last few years. You will agree the downtrend is pretty clear, right?
To evaluate economic news, market participants with the greatest say to influence currency movements (big banks, institutions, high-frequency traders, hedge funds) deploy complex models aimed at measure intrinsic valuations to update the perceived fair value of a currency, which also results in changing probabilities on monetary policy stands.
It will be precisely through a component of intermarket studies via the sovereign bond yield spread between two countries that will act as the best barometer to decipher the attractiveness to diversify capital into specific currencies with the most yield*.
*Note, however, that due to some Central Bank having resorted to ultra-low or negative rates, this has temporarily distorted these dynamics.
So, let's look at what's the perception of the AUD value vs the US Dollar based on the depressed inflation trend in Australia. The chart also overlaps the bond yield spread.
Hopefully, you are starting to appreciate the value that exists in developing a base of fundamental knowledge to understand why price valuations vary.
Interestingly, the fundamental-led adjustments in currency prices via auction processes, in light of the technological advancements, for the most part, has been taken over by algorithm activity. That fight to update price valuations to new levels has become far faster than what the human eye can react to, as each millisecond counts! that’s how efficient forex trading has turned to be. Clearly, a fight no longer worth fighting for in the human domain until the dust settles and liquidity/spreads stabilize.
That initial fundamentally-induced change in price serves as an opportunity for the fastest algorithms to front-run the rest of the orders, with entities investing millions of dollars to relocating computer systems near exchanges and data serves in order to shave milliseconds off execution times.
This lighting speed trading activity is conditioned to higher or lower intensity based on valuation models. The greater the disparity between expectations and actual data, the more reaction in the price as the market must transition to re-adjust an initially wrong assumed outcome.
Another important aspect of understanding the logic behind the abrupt movements in a currency on the immediate aftermath of an economic event has to do with liquidity. The widening of the spread in a currency pair about to face a volatile economic event is a direct function of the evaporation in liquidity (trading activity) available as the data is about to be released. It means that the amount of trading volume it takes to move price from point A to the next perceived fair value point B is comparatively smaller. These initial markups or markdowns in the price comes as a result of what’s referred to as removal or withdrawal of liquidity, thus allowing algos to dominate price movements.
The more seconds and minutes that go by, the more liquidity returns back to normal levels, as a larger pool of bids/offers come through the books. It is this gradually increasing wave that aims to jump on the bandwagon of the potential trend based on how far the outcome differs from the expectations built up ahead of the data release or similar impactful event such as a speech/policy statement. Alternatively, this wave can also fade the initial move if the event fails to materially surprise. Sometimes, it will be a key technical level that may stop price on its tracks. It really depends on the combination of both, the fundamental surprise or lack thereof and the technical landscape faced.
The claim or assumption that all known fundamentals are factored into the price, which implies that there is no need to pay close attention to them, it’s a fallacy. Thinking otherwise would essentially imply that price manipulation to obtain liquidity and build positions does not exist.
Yes, algos will take a front seat in influencing the price movement to mitigate any market inefficiencies in fair value perceptions but the re-evaluation of fundamentals is dynamic and ongoing rather than fixed in stone. Make no mistake, market participants will resort to every possible trick and deceiving tactic to serve their best interest, which can easily lead to price value temporarily out of whack with its true valuation based on fundamentals.
To prove the above point, one of the best leading indicators that exist to measure the fair valuation in a currency pair, as I mentioned, is the bond yield spread. This combination of yields comparison indicates how investors are viewing different economies. The widening of spreads when comparing two countries’ sovereign bond yields indicate the perception that a particular economy and interest rate settings are improving against the other.
I will also reiterate that unless a country faces negative yields, which tends to undermine the ability to attract capital even if the spread moves in favor of the currency with the negative bond yield, the script in forex pans out by fundamentals leading price, only for yields to re-anchor and lead again.
When we observe major disparities in a currency pair vs its bond yield spread, an important distinction to make is that the fundamental models will take price to its next fair value, and as the normal auction process resettles, the bond yield spread then tends to act again as the true indicator to gauge capital flows, which is a constant update on monetary policy expectations.
Parallel to yield spreads, we should also think of ‘risk on, risk off’ conditions as another key component of intermarket analysis and thus a major influencer of the price setting mechanism in a currency pair. Are we trading an environment conducive for a reshuffling of portfolio strategies into riskier-currencies? Or does fear, uncertainty, and doubt rule the behavior of market participants?
Trading off fundamentals or intermarket analysis alone, however, even if your approach is to trade from bigger timeframes such as the daily or above, has its limitations. At the bare minimum, as I stated at the beginning, one should develop a basic understanding of technical analysis, which orbits around the study of price formations or patterns to gauge the next directional bias.
It’s then up to you to decide which route you take to analyze price fluctuations in order to get in and out of the market. The most popular forms include moving averages, support, and resistance, fibonaccis, trend lines, volume, momentum-based indicators or market structure to name a few.
You can then throw into the mix the study of intermarket correlations as a hybrid extension of technicals, since the convergence and divergences between price and correlated assets can tell you a lot about the evolution of fundamentals via, as I mentioned, the bond yield spread for instance.
If a trading approach is orphan of fundamentals, you may understand how a pair evolves its pricing from one location in the chart to the next, which may be caused to a breakout of a technical level, followed by a retest, only to see the auction process continue in the bullish direction. Unfortunately, you will lack the idea as to why the pair is stimulated to be moving the way it does. Similarly, if one trades with the sole focus on fundamentals, you are falling short to identify potential best pricing opportunities.
As an analogy, we could think of a race car driver without the skills to interpret the communications sent via the team’s box or a pilot unable to make sense of the instructions coming from the control tower. They may know the patterns it takes to drive or fly the apparatus, hence how to get from point A to point B, but they lack the understanding to interpret the information flow to keep them safe or on track. Similarly, if you are unable to follow a certain path due to the absence of technical attitude to navigate through the roads or the skies, the chances are that you may either crash or get way off track.
That’s why I cannot emphasize enough the importance of thinking of financial markets in a holistic approach, accepting as true that the traders or investors best equipped to make consistently informed decisions, embrace following their pre-determined trading systems (technicals) while accounting for the fundamental events taking place.
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