There’s never a shortage of pundits and TV talking heads who are willing to tell you what stocks and bonds are going to do next. They use fundamental and technical analyses to chart and explain every wiggle in stock prices all day long. But, what about currencies? There are far fewer experts who are willing to go out on a limb to forecast future exchange rates.
The reason, as explained in this article, is that foreign exchange cross-rates are notoriously hard to forecast. After all, you don’t have corporate earnings, management calls, unemployment rates or other statistical tools to rely on. Those who do forecast exchange rates tend to rely on obsolete tools such as purchasing power parity, PPP, trade deficits or surpluses or interest rate differentials to do their homework.
Those tools worked back in the good old days of the Bretton Woods gold standard and the pre-globalization days of closed capital accounts. Today exchange rates are driven almost entirely by capital flows and those capital flows are driven largely by sentiment in terms of the risk on/risk off dynamic and the potential for “carry trades” where large investors borrow in one currency, (a short FX position), to invest in another currency, (a long FX position).
Despite the difficult of forecasting day to day moves (that really is impossible without inside information), investors can reliably predict exchange rates to a three- or six-month horizon by looking for trend reversals. Stocks and bonds can go to zero in the event of bankruptcy of the issuer, or they can go to the moon based on strong profits and bubble dynamics. But, major currencies trade in a range; they move up and down against each other but never reach extreme levels.
When you see a strong move in a currency pair, a temporary reversal is a good bet.
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