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lesson number
24

3.3. Forex dependence on financial and sociopolitical factors

Financial factors are vital to fundamental analysis. Changes in a government's monetary or fiscal
policies are bound to generate changes in the economy, and these will be reflected in the
exchange rates. Financial factors should be triggered only by economic factors. When
governments focus on different aspects of the economy or have additional international
responsibilities, financial factors may have priority over economic factors. This was painfully true
in the case of the European Monetary System (EMS) in the early 1990s. The realities of the
marketplace revealed the underlying artificiality of this approach.

The role of interest rates.

Using the interest rates independently from the real economic
environment translated into a very expensive strategy. Because foreign exchange, by definition,
consists of simultaneous transactions in two currencies, then it follows that the market must focus
on two respective interest rates as well. This is the interest rate differential, a basic factor in the
markets. Traders react when the interest rate differential changes, not simply when the interest
rates themselves change. For example, if all the G-5 countries decided to simultaneously lower
their interest rates by 0.5 percent, the move would be neutral for foreign exchange, because the
interest rate differentials would also be neutral. Of course, most of the time the discount rates are
cut unilaterally, a move that generates changes in both the interest differential and the exchange
rate. Traders approach the interest rates like any other factor, trading on expectations and facts.
For example, if rumor says that a discount rate will be cut, the respective currency will be sold
before the fact. Once the cut occurs, it is quite possible that the currency will be bought back, or
the other way around. An unexpected change in interest rates is likely to trigger a sharp currency
move.

Other factors affecting the trading decision
are the time lag between the rumor and the fact,

the reasons behind the interest rate change, and the perceived importance of the change. The market
generally prices in a discount rate change that was delayed. Since it is a fait accompli, it is neutral
to the market. If the discount rate was changed for political rather than economic reasons, a
common practice in the European Monetary System, the markets are likely to go against the
central banks, sticking to the real fundamentals rather than the political ones. This happened in
both September 1992 and the summer of 1993, when the European central banks lost
unprecedented amounts of money trying to prop up their currencies, despite having high interest
rates. The market perceived those interest rates as artificially high and, therefore, aggressively
sold the respective currencies. Finally, traders deal on the perceived importance of a change in the
interest rate differential.

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