Fundamental vs. Technical

A major debate in financial market analysis is the validity of each of the two major forms of analysis: fundamental and technical.  Several studies have concluded that fundamental analysis is more appropriate in predicting trends for the longer periods (one year or more), while technical analysis is more effective for shorter periods (less than ninety days).  These studies suggest a combination of these approaches for periods between 3 months and one year.  Conversely, more evidence shows that technical analysis of long-term trends helps identify longer-term technical waves and that fundamental factors can trigger short-term developments.

A good example of this is the declining USD/JPY exchange rate in 1999.  USA and Japan both lost 16% in the second half of the year, reaching a year low of 101.90.  Believers in both fundamental and technical analysis alike could explain the reason for the downward move.  Fundamentals attributed it to the continuous capital inflows into Japanese assets, which reflected investors' increased optimism with the recovery of the Japanese, while technical analysts explained the move with the simple argument that the language of the market voiced a clearly downward tone that became clearer with the breach of key technical landmarks (115 yen and 110 yen).

Therefore, in different ways, the technicals and the fundamentals reached the same conclusion.  Yet it is in the detail that the true difference is discerned. Fundamental analysts with a technical blind spot could risk missing key market turnarounds after the breach of an important support/resistance level.

On the other hand, a technically inclined analyst with no regard for fundamentals and news releases would have missed the rebound in EUR/USD (triggered by the release of a surprising German business sentiment survey (IFO) in July 19, 1999).  Until then, the euro had lost 15% and finally reaching an all-time low of $1.010.  Many observers of the market (both fundamentals and technicals) were predicting that the euro would break below $1.00.  Technical analysts cited that moving averages, momentum and psychology would lead to further downfall.  However, fundamentally-inclined analysts who paid attention to the strong survey would have been able to promptly exit their long dollar positions in favor of the euro.  That day, the Euro jumped 200 points against the dollar.  It gained an additional 260 points the following day and yet another 150 points in the third day.  In just two weeks, EUR/USD soared more than 800 points.

It is obvious that the release of IFO's survey was not the only reason behind the Euros 7% rebound.  Over the subsequent weeks, other factors also helped prop the currency, including a broadening improvement in economic fundamentals throughout the Eurozone and increasingly hawkish stance which favored higher interest rates from the European Central Bank.  Nonetheless, it is still clear that the release of the IFO survey was the turning point in shifting expectations of the Euro.

Many times is has been said that combining fundamentals with technicals can be counterproductive.  Due to the act that they are contrasting types, technical and fundamental analyses are often regarded as mutually exclusive.  Yet, a large number of traders often combine these two approaches, sometimes even instinctually.  Thus, technically inclined traders do pay attention to central bank meetings and give heed to the latest inflation numbers.  Similarly, many fundamental traders are trying to determine the percentage of retracement formations and discern the major and minor levels of support.

There is no a specific formula that can create an optimum approach of combining fundamental and technical analysis in the foreign exchange market.  Several software packages claim to be able to calculate such decisions, weighing one approach against another depending on economic, technical and quantitative parameters.  Yet these decisions are based on models from previous patterns of inter-market dynamics and past technical and fundamental behavior.  It is clear that the FX market is far too dynamic for such pre-formatted frameworks.

It cannot be denied that fundamental and technical factors are an essential factor in determining foreign exchange dynamics.  There are, in addition to these two additional factors that are important to understanding short-term movements in the market: expectations and sentiment.  Although they may sound similar, they are fairly distinct.  Expectations are generated prior to the release of economic statistics and financial data.  It has been shown that monitoring only the figures released does not suffice in grasping the currency's future course.  For example, if the US GDP came out at 7.0% from 5% in the previous quarter, then the dollar may not necessarily move as you would expect it to.  If market forecasts had expected an 8% growth, then the 7.0% reading might come as a disappointment.  This could cause a very different market reaction from the one that was expected there was no awareness of the forecast.

Nevertheless, market sentiment can supercede expectations.  That is the prevailing market attitude in relation to an exchange rate; it can be a result of the overall economic assessment towards the country in question, general market emphasis, or several other factors.  Using the previous example of the US GDP, even if the resulting figure of 7.0% undershot forecasts by a full percentage point, markets could possibly show little or no reaction.  One possible reason for this is that sentiment could be dollar positive regardless of the actual and forecasted figures.  This could be due to poor fundamentals in the counter currency (Euro, Yen or Sterling) or solid US asset markets.

There is a term that is commonly interchanged with "sentiment," and that is "psychology."  In first two months of 2000, the Euro dealt with fierce selling pressure against the Dollar, even though it was persistently improving fundamentals in the Eurozone.  This may be due to the fact that market psychology favored US dollar assets due to continuous signs of non-inflationary growth, and sentiment that further increases in US interest rates would work in the advantage of US yield differentials without ruining the economic expansion.