The main goal of every forex trader is to correctly predict future price movements of currency pairs. Unfortunately, anticipating where the exchange rate is going on a consistent basis is far from easy, as dozens of different factors impact the forex market.
As Alan Greenspan, former Chairman of the Federal Reserve once said, “Having endeavored to forecast exchange rates for more than half a century, I have understandably developed significant humility about my ability in this area…”
The approach used to predict exchange rate movements also depends on the analyzed time-frame, i.e. short-term exchange rate movements are influenced by a different set of factors than long-term exchange rates.
Video: How to Predict Price Movements in the Forex Market
That’s why we’ll group the prediction tools into two categories:
- Short-Term Predictions
- Long-Term Predictions
Predicting Exchange Rates in the Short-Term
While the majority of fundamental-based models have proved to be able to predict exchange rates in the long-term, their results in short-term predictions are rather mixed. That’s why investors and traders came up with a range of tools in trying to predict short-term price movements, such as technical analysis, sentiment surveys, order flow data and analyzing prices of the futures market.
Technical analysis proved to be one of the most popular tools used by short-term traders. Although it’s grouped into short-term tools, the basic principles of technical analysis can be used on all timeframes. It’s based on the presumption that historical prices and patterns tend to repeat themselves, prices move in trends and market action discounts all available information.
The main objective of the technical approach is to identify trends in their early stages and to trade in the direction of the trend until it reverses. All technical tools such as chart patterns, trendlines or support/resistance zones serve the purpose of early identifying trends and have returned great results in the forex market so far.
Sentiment surveys try to sense the broader sentiment of market participants in order to anticipate price movements. In theory, if the sentiment of market participants becomes increasingly bullish or bearish towards a currency, it should rise or fall in the short-term.
Order flows are a major factor that impacts exchange rates in the short term, as the basis of all exchange rate movements are shifts in their demand and supply. By having a reasonably large customer base, banks and other large FX players can try to use information of their customers’ order flows to predict price changes. Unfortunately, order flow data is not available to the public and retail forex traders can hardly rely on its benefits.
The futures market is another tool traders use to predict price changes in the short term. Basically, by identifying the trends in the prices of currency futures, traders can anticipate how the futures market feel about a certain currency – bullish or bearish.
The Commitment of Traders report of the CFTC can be used in this regard, as it shows the total long and short positions taken by futures investors by currency.
Predicting Exchange Rates in the Long Term
Exchange rates tend to gravitate to their fundamental equilibrium level in the long term. However, there is no universal agreement on what represents a currency’s long-term equilibrium exchange rate and how it should be calculated. In order to explain this complex part as simple as possible, let’s base on the PPP (purchasing power parity approach) to predict exchange rates in the long run.
Please note that there are a few more long-term currency valuation models besides the PPP, such as the balance of payments approach, interest rate approach, monetary approach or portfolio approach, and all take different factors into consideration in their calculations.
Purchasing Power Parity
The PPP (purchasing power parity) approach seems to have the largest following, and it’s based on the presumption that the prices of goods and services tend to be equalized among countries in the long run. Let’s take an example.
If the same car type and model costs $50,000 in the United States, and €45,000 in the eurozone, the EUR/USD exchange rate needed to achieve PPP equilibrium would be $1.11 ($50,000 / €45,000).
If the current EUR/USD exchange rate is $1.50, the German car buyer could order the car from the United States at the price of $50,000 and pay only €33,333 in euro terms – a considerable saving of almost €12,000.
With the arbitrage opportunities arising from this situation, many Europeans would intend to buy the car in the United States, which in turn increases demand for the US dollar and eventually returns the $1.50 exchange rate towards its equilibrium rate of $1.11.
However, as you can imagine, the PPP approach has many drawbacks. Not only needs the car in the US to be the exact same car as in Europe, but one must also calculate the costs of transportation and import taxes from the US to Europe. Furthermore, this approach works only for tradeable goods, and exchange rates can deviate a lot from their supposed equilibrium level.
Big Mac Index
Another interesting approach to the PPP is the Big Mac Index, a survey done by The Economist magazine that uses the price of McDonald’s Big Mac as a basis for exchange rate determination.
Interestingly, the Big Mac Index has returned some fascinating results since its formation, such as predicting euro’s 13% overvaluation against the US dollar in 1999 – at a time when the big players in the FX market were overwhelmingly bullish on the euro. The euro fell like a stone soon after that.