It’s all about expectations. Few people trade the economic numbers. Most people trade what they think the market expects the economic numbers to be. And for good reasons.
Since portfolio capital flows dominate the foreign exchange market it can be said that it is today’s expectations of future price movements that play the most important role in determining the current foreign exchange rate. Agents are not, as in rational expectations, forecasting an event that is independent of their actions – they are creating the event. Realized outcomes clearly affect the exchange rate but even then the current structure of the currency market means that they do so primarily through expectations. The dollar moves more in reaction to the announcement of a trade imbalance rather than from the pressures created by the imbalance itself.
Soros has some good stuff on expectations and how they shape perceptions, market prices, and ultimately even fundamentals in his theory of reflexivity. Will probably extract some stuff from there as well in some future posts.
Keynes has a famous example which underlines how expectations drive the markets and how a trader’s job is not necessarily about predicting what the true fundamental value is, nor is it about predicting what the market thinks the true fundamental value is, but rather about predicting what the market thinks the market thinks. I’m talking about Keynes’ beauty contest. It sounds funny and/or convoluted but it’s rather true.
professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
Heuristics and other tendencies
With availability, which is used to estimate frequency (in the past) or likelihood (in the future) the more available something is in memory (either through imagination or recalling pas instances) the more frequent or likely that event is deemed.
In forecasting, traders may overrate the importance of events that were more recent or dramatic or fit preconceptions.
Representativeness is used when one is concerned with the probability that object A belongs to class B. The more A resembles B, so the heuristic goes, the more likely that it belongs to class B. The series of coin tosses T-H-T-H-T may be deemed more likely the outcome of a random coin toss than T-T-T-T-H because the former better represents randomness.
In the markets, representativeness means that traders expect every currency movement to have a very specific cause, whether they can discern it or not. As Keynes put it, because our knowledge of the future is “vague and scanty” the information of which we are aware plays a disproportionate role in our forecasts.
Anchoring occurs when the individual must make a forecast. When this is done by starting at some initial estimate and then adjusting, people tend to anchor to that first value regardless of the process used to generate it.
Since most of the time, the most recent time series inform the current forecast, traders, especially technical traders, will tend to anchor to levels in calm markets and to rates of change in volatile ones.
Except Keynes’ beauty contest example, all quotes come from Currencies, Capital Flows and Crises: A Post Keynesian Analysis of Exchange Rate Determination. It’s a rather small economics book written by an academic that addresses the foreign exchange markets from the perspective of a practitioner rather than that of a close minded impractical academic. It presents economics stuff that is rather useful.