From the April 01, 2011 issue of Futures Magazine • Subscribe!

Currencies: Balancing inflation and world events

In most years, interest rates are the main drivers of the forex market. That paradigm was upset last year as historically low interest rates around the world created a market that was driven by events and central bank actions, and often saw some currencies strengthening by default. More recently, commodity prices also have become a factor (see "Top forex fundamentals").

Many of the forex moves in 2010 were triggered by major events such as the sovereign debt crisis in Europe and the announcement of a second round of quantitative easing (QE2) from the U.S. Federal Reserve. "Ever since our late, great financial crisis, we’ve pretty much been trading in an event-driven FX world," says Joseph Trevisani, chief market analyst at FX Solutions. "There are periods where that lessens, usually when there hasn’t been any event to drive it, but if you look at the big moves over the last two years, that’s it."

While world events are continuing to shape the forex market, as seen in market reactions to the Libyan crisis, they are diminishing in importance. According to Trevisani, it is because the markets are getting used to experiencing crises. "In effect, it’s because we keep having so many events. You can’t keep getting excited when we’ve seen it already three or four times before," he says. "The barriers have gotten increasingly higher to get a move out of the FX world these days."

As events are having a diminishing impact on forex trading, central bank decisions again are taking center stage in trade decisions. At the heart of central bank decisions is the impact of inflation on economies and the ways banks are choosing to handle that inflation.

A dichotomy is arising between two of the largest central banks — the U.S. Federal Reserve and the European Central Bank (ECB). "We’ve got this sort of clarity appearing in the world of forex whereby it is becoming almost accepted from the rhetoric of the ECB that they are going to shift from an era of easy money to the hawkish side of the fence," says Andrew Wilkinson, senior market analyst at Interactive Brokers. "The Federal Reserve keeps stating the opposite as the ECB insofar as it does not see a need to remold monetary policy. It doesn’t feel the economy is in good enough shape yet, as indicated by signals coming from the labor market."

The result is two central banks focusing on different sets of data. In Europe, inflation has become the focus, especially following historic rises in many commodities. "The strength of the rebound, especially in the heartland of Europe, has been quite stunning over the last 18 months. It’s almost to the point that you wouldn’t know there had been such a severe financial crisis. The legacy here is the sovereign debt crisis," Wilkinson says.

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