Market Psychology for Currency markets

Trading strategy in currency movement will depend largely on market psychology. It influences the forex market in a variety of ways:

Flights to quality

Bad international political conditions can lead to what is known as "flight to quality" in the forex market. A flight from an "uncertain" currency leads an investor to search for a "safe haven" currency. The Swiss franc is a good example of a safe haven currency because it is very stable during times of political or economic uncertainty.

Long-term trends

Although currencies do not have clear growth trends like commodities and stocks, they are often seen moving in long-term trends. Cyclical trend analysis can give us a look at longer-term price trends that may rise from economic or political trends.

Buy the rumor, sell the fact

This popular market maxim applies to many who try to anticipate a particular action and react in exactly the opposite manner. This is also referred to as the market being "overbought" or "oversold." This can be measured through technical analysis.

Market Movers

Stocks managed by hedge funds can influence the price levels to a certain degree. When the market approaches a support or a resistance level, the market behavior becomes more technical, which can result in a dramatic price swing. The movement of funds across asset classes like equity, commodities, real estate can influence currency movements.

Volatility

Generally, a high yielding currency tends to appreciate and the low yielding currency tends to depreciate. However, during times of high volatility, this statement reverses as the low yielding currency (USD, Euro, Yen, Swiss Franc, etc.) tends to serve as a safe haven for the investors. The fact that due to rising volatility in the global financial systems, equity inflows into emerging countries fall which can lead to a fall in the demand for that currency.

Since 2000, there have been 3 notable instances when the volatility of the global capital markets was very high, measured by the Volatility Index (VIX). Vix is a measure that measures short term market volatility, as conveyed by S&P 500 stock index option prices.

During the terrorist attacks of September 11, during the ongoing Sub-Prime crisis, and in 2020 the COVID-19pandemic has resulted in tremendous volatility levels. During these instances, it was seen that the USD strengthened significantly against most of the high yielding currencies like the Russian Ruble, Indonesian Rupiah, Philippines peso, Indian rupee, etc.

The primary reason behind this is that during the time of uncertainty the investors tend to favor low yielding but safer currencies/ investment destinations in comparison to higher-yielding but risky currencies/investments.

The above chart shows the Level of VIX vis a vis the levels of USDINR and the Dollar Index.

Current Account Balance

A current account is one of the components of Balance of Payments and also has a significant impact on the USDINR movement.

Current account Balance = Balance of Trade + Net Factor Income from Abroad + Net Unilateral Transfers from Abroad

A current account surplus increases a country's net foreign assets by the corresponding amount, whereas a current account deficit does exactly the opposite. Hence a current account surplus strengthens the economy and it means more of the foreign currency coming in than going out. But as we know an exchange rate involves currencies of two economies hence the relative strength of one economy's current account against another plays an important role in determining the strength of one's currency against another.

However, comparing the absolute balance of a current account of one country against that of another is not an appropriate measure of determining the growth of an economy. Hence comparing a current account as a percentage of GDP seems a more viable option.

In the above image, we can see that the Current Account BOP of India and USD/INR spot prices shows a positive relationship between them.

Current account differential also determines whether one currency would be at a premium or a discount to that of another.

Crude Oil

Crude oil is one of the most important commodities of a country's import or export bill. The US is the biggest consumer of oil and with India also moving up in that list, oil has become an important factor to analyze.

For a country like India which imports more than 70% of its crude oil requirement and crude oil being priced in USD makes it all the more important factor affecting USD/INR exchange rate. A rise in the0 price of oil can increase the demand for the dollar as oil is priced in the dollar, which can result in the dollar depreciating.

For example, an oil company imports 100 barrels of crude oil at $80/barrel. Now the price of a barrel is $100 instead of $80 and due to the rise in prices, the company now has to spend $10,000 instead of $8000 to import the same quantity of oil. This leads to an increase in demand for the dollar, which is compensated by supplying an additional rupee.