The Foreign Exchange Matrix. Barbara Rockefeller

      If these matrices were on a set of cards and you could fan them in order, you would get a moving picture that would show first the interest rate expectation gaining dominance, then bleeding to the other players, and then the geopolitical factor taking over. In other words, you’d get a moving picture showing how the weight of factors increases and then bleeds into other factors.

      Flickering off to the side would be the technical factors. Technical factors never really go away but can always be trumped by institutional factors. This is a useful way to think about how and why exchange rates move – better than two dimensional charts labelled with world events – but obviously it is too cumbersome and impractical for anyone but a programmer to attempt.

      That brings us to the thorny problem of factors that are temporarily not at the top of the list but which are still present; a form of known unknowns. On the day in January 2011 when the Egyptian riots took over the imagination of traders in all markets, nobody was talking about fiscal sustainability in Greece, Ireland, Britain, Japan or the US. In fact, S&P had downgraded Japan’s sovereign rating just the day before, but the yen didn’t move an inch on the downgrade. Still, a new geopolitical issue coming along does not kill a factor, it just supersedes it for a while.

      Perversity of the FX market

      While the various matrices are a handy metaphor for market behaviour, not everything can be explained in a rational way. On any day, a sane interpretation of events may suggest the dollar should move up when in fact it goes on to move down. In the middle of the worsening euro zone peripheral debt crisis, the euro rose for almost a full year (June 2010 to May 2011).

       What’s going on here? Why does the FX market behave in this perverse fashion?

      Understanding this perversity

      In a way, perverse FX responses to events are a form of irrational rationality, like the prisoner’s dilemma. Both parties (bulls and bears) would benefit if they both stay silent, but often the first prisoner will confess because he doesn’t know whether the second prisoner appreciates that his self-interest lies in staying silent. Translated to FX, it pays to jump to conclusions on the assumption that others will jump to those conclusions, even if they are nonsensical conclusions. One such perversity, after the 2008 global financial crisis, is the dollar reliably, consistently and persistently falling on good economic news – it occurs because good US data implies the environment is safe for risk-taking in non-US dollar currencies and assets.

      To get oriented in trying to answer the perversity question, you have to accept two ideas mentioned in the Introduction: the first is that the price of a currency is set at any one moment in time by traders whose only goal is to make a profit. FX traders usually do not know, nor do they care about, fair value. They want to buy low and sell high, or buy high and sell higher. The second idea is that a key tool in this quest for profit is technical analysis.

      Technical analysis in the FX market

      Like the addition of hitherto exogenous variables to the basic FX matrix, the spread of technical analysis is relatively new. While technical analysis has been used since right after the dollar was first floated in 1974 – as a remedy to mass confusion over the determinants of FX prices – it was the advent of the personal computer in the 1990s that made it widespread. Technical analysis is more efficient than fundamentals – you use three or four indicators on a single chart against a complicated, interactive matrix of fundamental and institutional factors.

      Moreover, technical factors can drive and override fundamentals, at least sometimes, even if in the end the fundamentals always have the last word. Unlike in other securities fields, in FX there is no clear-cut dividing line between the fundamental and the technical. Fundamental and technical effects are as interactive with one another as fundamental and institutional factors. For example, once the euro bottomed in June 2010 and started rising, it had upward momentum and upward-pointing patterns that set a new stage for evaluating the later worsening of sovereign debt and the banking crisis.

      This is called Bayesian analysis, wherein what you think you knew is changed by subsequent knowledge. You literally go back and remember your original thinking differently from what it really was at the time. In a nutshell, everything is relative. The first appearance of a crisis is more shocking (and causes a bigger price move) than a later worsening of the same crisis, when the effects of the first shock have worn off and the first shock has become part of the background environment. In the case of the euro, the second shock was buffered significantly by its healthy image, which was both cause and effect of the first rebound.

      Pinpointing how multiple factors – fundamental and technical – interact is tricky because in FX there are no absolutes. We might postulate that at the beginning of a price move, fundamentals drive the technicals, but once the fundamental event is known, the technicals can lead. For instance, a key level will be resisted solely because the probability of a negative news release is high, even when traders don’t have anything specific in mind. The trader has an existing position to defend and therefore a bias against reversing from pessimism to optimism – unless and until it becomes profitable to drop the position.

      Technical analysis is so important in FX trading that we can say that a FX market event gets some of its importance from what is happening on the chart at the time. Untangling what is technical and what is fundamental in any specific move thus becomes complex. Unlike the situation in equities, where price-earnings ratios are a fixed (if evolving) number, fundamental events do not have a fixed hierarchical ranking in FX but rather gain or lose power over the minds of traders depending on how the chart looks. A bad news release will be dismissed if a currency has just made a decisive upside breakout, but the same news may be fatal to an existing upmove if it comes when the price is already flirting with reversal.

      It’s a mistake to dismiss technical analysis as some strange sideline of a minority. Professional traders bet hundreds of billions of dollars per day using technical analysis and they would not do that if technical analysis failed to help achieve profits and avoid losses. Virtually everyone in FX applies some concepts from the technical analysis world, even if they are not self-described techies; a trader who does not subscribe to technical analysis concepts will still be aware that others in the market are using them.

      Every once in a while, you may meet a brilliant, intuitive trader who uses no technical indicators at all and yet succeeds in generating winning trades. He is almost certainly using the same ideas as the technical trader, just not measuring and labelling the ideas with the same terms. After all, most of the indicators in technical analysis derive from long-standing trading practices. Ask an intuitive trader why he changes from long to short, and he may say “I couldn’t see any more buyers out there – the bid was gone.” The technical trader will point to three or four indicators and say “It was overbought.” Same thing.

      The pinball effect

      Sometimes a price change comes out of left field and we literally cannot find an explanation for it in the fundamentals, technicals or what little information we have on professional positioning. It’s as though one deep-pocket trader had an epiphany that inspired him to take a huge new position. Some of these initiatives fail and are never heard of again, but in the time-honoured way of crowd behaviour, others take a profitable ride. As recounted in the many books about the Soros 1992 sterling trade, many other FX players declined to believe the statements of UK officials and instead put their money on the same trade as Soros, short the pound, because they could see a clear trajectory on the chart. Soros did the hard work of analysing the situation, but it was his positioning that everyone could see, even if they didn’t know exactly who was behind it. ^[2]

      Where do these inspirations come from? Oddly enough, they often come from outside the immediate conditions in the financial markets themselves, from perceiving a historical analogy, from maths, or even from superstition. Thus is created a pinball effect, where a new idea (or an old idea resurrected) shoots around several markets along multiple interconnecting and criss-crossing pathways.