Forex Investment and Currency Trading

At any given moment in the Forex market, several themes dominate the market’s attention. Market themes are the essence of the real-world driving forces currently holding sway in the market. Themes are what market commentators and analysts are talking about when they explain what’s happening in the market. But most important, themes are the filters through which new information and data are absorbed by the market. Or to put it another way, they’re the lenses through which the market sees events and data.

Market themes come in all shapes and sizes, and have differing impacts on the market over time. Some are long-term themes that can color the market’s direction for months and years; others may hold sway for only a few hours, days, or weeks.

Market themes come in two main forms that coexist in parallel universes but that also frequently overlap. The two types of themes that we like to focus on are fundamental themes and technical themes.

Driving fundamental themes

Each currency has its own set of fundamental circumstances in which it’s being evaluated by the market. The basic fundamental environment is ever-present, but it’s also subject to change over time, just as economic conditions will change in the course of business cycles. Fundamental themes will also shift in relative importance to one another, with certain themes being pushed to the side for a period when news or events focuses the market’s attention on other, more pressing themes.

Rising or falling interest rates

Interest rates are usually the single most important determinant of a currency’s value. But it’s not just about where interest rate levels are now, though that’s still important (higher interest rate currencies tend to do better against lower-yielding currencies). What matters most is their overall direction (whether they’re getting up or down), their future level (how high or low they’re likely to go), and the timing of any changes (how fast rates are likely to change).

Markets are constantly speculating about the direction of interest rates, even though interest rate changes are relatively infrequent. Speculation over the direction and timing of interest rate changes is one of the primary drivers of a currency’s value on a daily basis as well as over longer time frames.

The information inputs that drive the interest rate outlook are centered on economic growth data and inflation reports. The stronger the growth picture is, or the higher inflation pressures are, the more likely interest rates are to move higher, normally improving a currency’s outlook. The weaker the growth outlook or the lower the inflation readings, the more likely interest rates are to remain steady or move lower, typically hurting a currency in the process.

Bond markets also have a lot to say about the direction of interest rates and are probably the best real-time barometer of the market’s interest rate expectations. Central banks can really influence only short-term interest rates, which are essentially based on the central bank’s official rate. But longer-term bond yields, with the ten-year maturity as the benchmark, reflect the market’s long-term view of an economy’s outlook and the direction of future interest rate moves. Falling bond yields (lower interest rates) point to a weaker economic outlook and the probability of lower interest rates ahead, typically denting that currency, which higher bond yields point to economic optimism and likely higher rates, usually supporting that currency.

The effect of interest rate is most powerful when the interest rates of two currencies are seen to be diverging – when one currency’s interest rate is expected to move higher and the other lower.

When you’re looking at economic data or monetary policy rhetoric, always assess the incoming information first in terms of what it means for the interest rates of the nation’s currency – the interest rate theme. A currency that is expected to see lower rates in the near future, for example, is likely to stop declining and may even rebound if an economic growth report or an inflation reading comes in higher than expected. The market will pause to consider whether its outlook for lower rates is correct. By the same token, a currency facing the prospect of lower interest rates ahead, when hit with weaker economic data or lower inflation readings, is likely to weaken further. We say “weaken further” because it was probably already under pressure and moving lower before the latest batch of data hit the market.