Currency movements reflect multiple dimensions of the world economy. Technical forex traders make decisions based on charts. The justification of these “chartists” is that the price reflects all known information, so it’s the best indicator for shaping trading strategies. But if price were such a good indicator, then there would be few surprises in the market. By focusing on technical analysis alone, they risk missing leading fundamental indicators of currency direction.
Fundamentals, however, are multidimensional. In mathematics, a dimension is the number of coordinates needed to describe the state of any object. A line is one-dimensional. Length and width have two dimensions. We can move into the third dimension which has length, width and depth. Time adds another dimension. Now let’s move this analysis into the world of economics. When we try to accurately describe the state of the global economy or that of any country, it requires thousands of dimensions such as productivity, consumer sentiment, interest rates and politics. No one knows how to do it with sufficient accuracy to avoid surprises.
Short of the impossible task of constructing input-output matrix that takes all of the factors as inputs, and then producing projected prices ranges, there are several dimensions a trader can use to judge the state of the currency market and then to select an appropriate trading strategy. “Dimensions of forex” (below) itemizes 15 key dimensions that affect currency price movements. It is by no means exhaustive, but each one represents a main input or force that influences market direction. There also is a domino effect where one dimension is activated by a preceding dimension. The list can be used to determine what fundamentals are moving a market. From this a trader can determine what to look for and what to look at next.
The first dimension listed is the deflation-inflation dimension. As inflation increases currency prices tend to increase because of expectations of tightening by central banks. A related dimension is commodity prices. Commodity prices indicate global demand. Global demand for commodities reflects anticipation of growth. The next dimension maps the economic cycle stage. Is the economy in a recession or growth mode? If growth is expected, then risk appetite becomes favored over risk aversion and the inflation dimension is affected, which makes the interest rate expectation more important to consider. This leads to the housing dimensions. A growing housing market fuels expectation of increases in interest rates. The credit dimension represents the ease of credit. This dimension totally collapsed in September 2008 and led to a large shift in the risk aversion-risk appetite dimension.
China is a dimension of increasing importance. Chinese growth impacts the world economy because 35% of the Chinese economy is based on consumption. Increased Chinese growth requires increased imports of resources. Countries that supply China will benefit greatly from growth in China. This landscape is complex but it is not incomprehensible. A market will tell us what dimension it is currently following and we can learn what other dimensions should be watched based on this. Let’s derive some specific strategies for the coming months using our roughly constructed list.
1) The interest rate recovery strategy: Global interest rates have been in a stage of decline. One strategy would be to buy currencies of countries expected to be the first to tighten interest rates and sell currencies which will lag in tightening. Israel was the first country to increase rates. Who will be next? Current speculation focuses on Norway and New Zealand. Long euro and short sterling is a common play based on the expectation that the eurozone will recover before Great Britain.
2) China growth strategy: Those playing the China growth dimension have a direct link to buying or selling the Australian dollar, which has displayed an 86-93% correlation to the Shanghai Index and can even consider the Brazilian real because it is highly correlated to the import needs of China.
3) Commodity complex: If the commodity complex has bottomed out, the Canadian and Australian dollars will have strengthening potential.
Forex is an irregular landscape, reflecting more closely the fractal properties of nature. Don’t be trapped into a one- dimensional definition of fundamental. Learn them all and understand how they play off of each other and you will be better prepared to act on them.
Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at firstname.lastname@example.org.