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Anticipating Trends

By : Monise
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A FOREIGN-EXCHANGE TRADER, whether speculating, investing, or hedging on behalf of a corporate client, is constantly trying to anticipate trends in the market. To do this he must look at a wide range of factors, including relative interest rates, inflation, and political and economic factors in leading-currency nations. Government, treasury, and central bank policies also affect price action in the market. In addition, it is important for a trader to be aware of the psychology of markets in general-to understand, to whatever degree possible, why certain trends develop and which facts, rumors, and events are likely to influence other participants.

To focus on just one of these factors, a U.S. trader must consider what portion of capital flows in and out of the United States is in the form of investment dollars seeking favorable real interest rates. The real rate is the nominal rate minus the effects of inflation. If someone invests in a U.S. interest-bearing vehicle when the nominal interest rate is 10 percent and inflation is 5 percent, the real interest rate is just 5 percent. International investors in general are looking for currencies in countries where economic growth is strong, inflation is low, and real interest rates are high.

The perfect combination of all three rarely exists-and then only for brief periods of time. However, to the degree that a nation's economy offers these attractions, more people are likely to purchase that nation's currency in order to take advantage of investment opportunities.

Once a trend gets started, it becomes a habit. The saying "Big ships turn slowly" is especially applicable to the forex market-the biggest ship in the world. Once it starts moving in a powerful way, it is unlikely to reverse quickly. People do not give up their habits easily.

When the market starts to develop a trend, traders get used to certain kinds of habitual price and trading behaviors. For example, when the dollar is in a bear market against the yen and it starts going down, people feel fairly safe that the market movement is likely to continue that way. Traders sell the dollar first with the hope of buying it back later for a profit. Even if they sell at slightly lower levels and the dollar rallies against them a bit, they feel sure that the dollar will come back down again. When a lot of traders are selling, they combine to create tremendous downward pressure on a currency.

At a certain point, however, the ship has gone as far as it can, and it has to refuel. In other words, the market has to assess whether the trend is going to continue. One factor that might influence that assessment is whether fundamental economic conditions have changed. Has the United States moved out of a recession and started a growth phase? Have relative interest rates started to shift? If so-if traders anticipate a shift in relative interest rates or relative economic performance-that anticipation may itself have a large effect on currencies.

To take an example from recent history, in early 1991 the dollar cost rose sharply against other leading currencies. Though the domestic U.S. economy was in bad shape, investors became convinced that growth in Europe was slowing and the U.S. recession was about to end. They also expected that relative interest rates and relative growth rates were going to shift in favor of the United States. Therefore, dollar-denominated assets became more attractive, because investors thought fundamental market conditions would improve in the United States and decline elsewhere. Capital began pouring into the United States, and traders were forced to purchase dollars as the demand for dollars created a surge of its value against other currencies in the market.

However, any trader who is dealing in a number of currencies must consider which currency seems most promising and when he should time his activities. To say "The dollar is strong" is an oversimplification. While it might be strong against some currencies, it could be weak against others.

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