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Fx: Economists Vs Technical Analysts

There are two schools of currency forecasters – the economists and the technical analysts – and their methods are radically different. The economists have academic respectability and intellectual recognition. Sometimes however the technical analysts have the greater influence in the market.

Economists
The most important distinction to make is that between the current and capital accounts of the balance of payments. The current account broadly covers trade payments. The capital account is concerned largely with purchases of assets – foreign securities such as bonds, shares or physical assets like a factory. The notion of a balance of payments is that a surplus or deficit of a current account will be balanced by a deficit or surplus on the capital account.

In the long term a deficit government was expected to curb demand in the economy, so that domestic consumers cut back their expenditure on both domestic and foreign goods. Price of domestic goods would fall in response to this drop in demand, making them more attractive to foreign consumers and pushing up the country’s exports. Since imports would fall because domestic consumers could not afford to buy them, the net effect would be to restore the balance of payment equilibrium.

The study of the effect of prices on exchange rates has focused on the purchasing power parity (PPP) theory. At its simplest the theory argues that the exchange rate will tend towards the point at which international purchasing power is equal. In other words, a hamburger would cost the same in any country, something The Economist highlights in its Big Mac index. In turn that means differential inflation rates are the most important driving factor behind exchange-rate movements.

The level of interest rate is a major factor in the strength or weakness of a currency. High rates have generally boosted a currency’s value. This seems to be due to carry trade which sees speculators borrow money in a low-yielding currency and then invest the proceeds in a higher-yielding one. One popular trade was to borrow yen and to buy Australian or New Zealand dollars. Such a tactic would earn a postive carry, the difference between rates in the two countries, of several percentage points.

Techical analysis
Technical analysts or charists as they are often known, believe that all the factors which the economists studies – inflation, balance of payment, interest rate etc, are already known by the market and are thus reflected in the prices of goods and commodities. This is true of pork bellies, oil and currencies. The chartists study charts which represent the price movement of a particular commodity. Over long periods certain price patterns emerge, which cause the analysts to claim that further developments in the price patterns can be predicted.

The underlying rationale behind chart analysis is that the key to price movement is human reaction. Among the patterns that chartists see are the followings:

Head and shoulders. This pattern is made up of a major rise in price (the head) separating two smaller rises (the shoulders). If this pattern is established, the price should fall by the same amount as the distance between the head and a line connecting the bottom of the two shoulders.

Double tops. A double bottoms or top indicates a major reversal in the price trend. Both consist of two troughs (or peaks) separated by a price movement in the opposite direction.

Apart from pattern recognition, technical analysts also study momentum and moving average models. Momentum analysis studies the rate of the change of prices rather than merely price levels. If the rate of change is increasing, that indicates that a trend will continue; if the rate of change is decreasing, that indicates that the trend is likely to be reversed. One of the most significant rules for technical analysts is that a major shift has occurred when a long term movement average crosses a short term moving average.

Conclusion

Although technical analysis has very little intellectual respectability in the economists’ circles, it has a great impact on the foreign-exchange markets. Many believe it to be a useful forecasting tool in the short term. In the long term, economic analysis may yet prove a more successful forecasting technique.

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