By Daniel Archibald | CFA
"We have two kinds of forecasters, those who don't know and those who don't know they don't know." John Kenneth Galbraith
"Only a fool would forecast exchange rates, though apparently there are quite a few who are happy to be given that description." Mervyn King, the Bank of England governor
The foreign exchange market is the largest financial market in the world, being about 30 times bigger than all global equity markets combined and with over a quadrillion dollars in currencies traded every year (that's a 1 followed by 15 zeros). Currency rates obviously affect trade and travel, and its overall affect on the economy can be sizeable, especially for countries that are heavily dependent on global interactions.
Therefore, predicting movements of currencies is of great importance to countries, corporations and citizens alike. However, as history has proven, forecasting of FX rates with any great accuracy is difficult, if not impossible.
FX traders - that is, those who look to profit from speculating on currency movements - are especially invested in FX forecasting. With the use of currency derivatives (FX futures, FX options, etc), speculators can gain leveraged exposure to most currencies. Margins on many of these derivative contracts are relatively small to the extent that $1,000,000 of exposure can be created from only $100s.
Such FX positions are generally held for short periods of time and the forecasting tool of such traders is technical analysis or charting. This involves analysing at price charts and using techniques such as trend following, finding support and resistance levels, tracking oscillators and following moving averages. Technical analysis, which looks to take advantage of price patterns, may provide some speculating success, but is not going to help with medium-to-long term currency movement estimations.
Fundamental FX analysis tries to provide forecasts regarding currency fluctuations based on factors such as interest rates, inflation levels and trade levels. As with the price of any commodity, the demand and supply of a currency is going to be the main driver of price movements: More buyers than sellers will increase the price and more sellers than buyers will cause a price drop. Fundamental forecasters, thus, want to understand how demand and supply of a currency might change.
However, to make matters confusing, the same underlying fundamental may lead to a move in a currency in either direction. For example, consider the case of high inflation. When inflation is high, the purchasing power in the economy erodes over time, which effectively means that the currency is not worth as much. When inflation in a country is higher than other countries, its currency should depreciate to ensure that purchasing power across borders remains the same (e.g. So that buying an ipod in one country is the same price as in any other country).
Higher inflation, on the other hand is likely to mean higher interest rates. This means that investors are likely to want to hold savings in such a country instead of in countries with lower interest rates. To do so, investors need to sell other currencies and buy the domestic currency, which will cause the domestic currency to appreciate. Thus the same fundamental factor can lead to opposite outcomes.
Forecasting can indeed be a fool's errand, especially in the world of foreign exchange. Best estimates (or guesses) can provide some help for those with currency exposures, however, it might be unwise to put too much faith in the power of FX prophecy.