8.1 The nature of forex markets

concentrated on the current account of the balance of payments, but later theories

have placed much greater emphasis on the determinants of the capital account.

One major effect of this was to increase greatly the role of expectations in attempts

to forecast likely future exchange rates. Market participants became concerned more

with what might happen to interest rates and ination rates than to their current

values. This implied a greater concern with what other people in the market were

likely to do and introduced a strong psychological element into decisions as to which

currency to buy or sell and when to buy or sell it. Under these circumstances, each

piece of economic news that comes to the market needs to be carefully interpreted

to try to discover its meaning for the future and the impact it is likely to have on

other market agents.

Further, the attempt to outguess the market requires judgements about the future

behaviour of policy-makers and the likely impact on economies of political and other

news that might inuence the composition and/or behaviour of governments.

Any reading of market reports quickly makes it clear how difcult it is, in practice,

to interpret news and to decide what information is relevant to the determination

of the exchange rate. It is common, for instance, for a market to adjust to ‘news’

but then to go through a process of reinterpretation, sometimes drawing different

inferences from it, other times discarding it altogether as irrelevant. Again, different

sets of economic indicators often provide apparently conicting information about the

state of different aspects of the economy and hence of exchange rate fundamentals.

There is always a degree of uncertainty as to what is genuine news and what is not.

Box 8.2 provides an example of the difculties of interpreting news in the foreign

exchange market.

Box 8.2

The market interpretation of news

The following example is taken from the Currencies market report of the Financial Times,

25/26 March 2006, p.33

The US dollar this week recovered its losses of the previous ve days as traders again revised

up expectations for the peak in US interest rates. Ben Bernanke, the chairman of the Federal

Reserve, played his part in the dollar’s recovery...Mr nanke delivered a broadly upbeat

Ber

assessment of the world’s largest economy, playing down fears that the at US yield curve was

a portent of doom. Data ow was limited, but the bulk of the economic numbers that did emerge

played into the hands of the rate hawks, with core producer price ination beating expectations

and strong existing home sales data attesting to the robustness of the housing sector...The

dollar wobbled yesterday as data on new home sales came in weaker than expected, allowing

dollar bears to revive their view that a slowing housing market would force the Fed to start cut-

ting rates before the year was out, dragging the dollar lower in the process. Such concerns were

limited, allowing the dollar to rise 1.3 per cent on the week to $1.2028 to the euro...

The usually headline-averse Swiss franc, the Swissie, has fallen 2.2 per cent against the euro

since early January, hitting a two-year low of SFr1.5788 yesterday. The Swissie has been under-

mined by rate expectations, with the market forecasting just two quarter-point rises this year,

which would keep its yield well below that of the eurozone where three increases are increas-

ingly being predicted.

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Chapter 8 • Foreign exchange markets

Comment

Here we are given reasons for the strengthening of the US dollar and the weakening

of the Swiss franc. In both cases, the principal factor was market expectations about

future interest rate movements. We have no explanation of those expectations for the

Swiss franc, being told only that the market expected Swiss interest rates to rise by

less than eurozone interest rates, making eurozone assets more attractive to investors,

causing a movement out of Swiss francs.

For the US, however, we are told of a number of inuences on interest rate expectations:

the generally optimistic view of the US economy given by the chairman of the Federal

Reserve, the nature of the US yield curve, and statistics on the ination rate of producer

prices and on house sales. Some of these favoured the view that interest rates would

continue to rise (Mr Bernanke’s comments, producer price ination, sales gures for

existing houses); others favoured the reverse view (the yield curve – that is, expected

future interest rates implied by the interest rates currently available on assets of differ-

ent maturities) – and data on new house sales). Over the week, the view that interest

rate rises would continue (held by the ‘rate hawks’) was the stronger and so the dollar

strengthened. Yet, there were people in the market who interpreted the news coming

to the market differently (the ‘dollar bears’) and thought interest rates would begin to fall

before the end of the year. For a short time during the week (immediately after the release

of gures on new house sales) they held sway, causing the dollar to wobble (that is, to

fall a little before again starting to rise). Thus, we have here an example of news coming

to the market and being interpreted and re-interpreted; and an example of different

groups of market agents interpreting the news differently.

Read the following quotation and comment upon it in a similar way to the example above:

The US dollar fell sharply this week, hitting a seven-week low against the euro yesterday. The

dollar’s reversal came in the week it emerged that the US current account decit ballooned to

a record 7 per cent of gross domestic product in the fourth quarter of 2005 and that, for the

second month running, foreign purchases of US assets, as measured by the US Treasury, failed

to cover the burgeoning trade decit.

FT

Financial Times, March 18/19 2006, p. 33

It is hardly surprising that there are difculties in interpreting news since economists

employ a variety of models to explain the formation of prices in any market – and no

one model can claim always to produce the best forecast of future market behaviour.

Particular problems with the impact of news arise when market participants are using

different models or are switching from one model to another. Information that is

irrelevant to market price and that succeeds in confusing market participants is

called noise, since it interferes with ‘price signals’. Some economists who continue

to believe in long-run equilibrium acknowledge the existence of ‘noise’ and thus of

short-term disequilibrium.

However, in nancial markets in which there are many participants and informa-

tion is rapidly transmitted through modern technology, the period of disequilibrium

is commonly held to be short. The period may be shortened further by the opera-

tion of arbitrageurs and speculators. Firstly, disequilibrium produces inconsistencies

in relative prices or in different parts of the market. These give rise to potential

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