Factors Affecting the Foreign Currency Market
Investor psychology cycles influences the bullish or bearish mood of the foreign currency exchange market. How do words like "mood" and "sentiment" relate to the foreign currency exchange market? Presumably, emotions do not belong to a place where people buy and sell goods. Moreover, all textbooks recommend not to emotionalise markets and to minimise the influence of emotions in taking any business decisions.
All market players are living creatures and are driven by psychological factors. The market exists in the human society context and the mood and sentiment of all market participants reproduce a behavioural model similar to those of other societies.
Economic theory introduces a term known as "investor psychology cycle" which describes the changing mood of investors in deciding whether to buy or sell a particular currency. This mood is closely related to the overall market sentiment and can force a currency pair rate to rise or fall in violation of some basic rules of financial analysis.
In a typical investor psychological cycle, literarally all market players pass through several stages ranging from doubt and suspicion, through caution and confidence, which peaks in the enthusiasm stage. Later, this mood gradually transforms into indifference, dismissal and denial to end in fear, panic and contempt. Actually, such market behaviour resembles the everyday experience of all human beings who hesitate in coping with a particular situation. The situation can go either way; a happy end is as possible as a tragic end.
Financial dictionaries and encyclopedias use explanations like "from absolute euphoria to downright gloom and despondency" when trying to describe the market mood and sentiment. The prevailing emotion of market participants will determine what direction the foreign currency exchange market will follow and market players' decisions will be driven by this prevailing mood.
An outside market observer can identify easily the present market mood and to try forecasting the movement of the foreign currency market, relying on observations he made. But it is not that simple. Sometimes the market is confused and indecisive in addition to its natural volatility. Therefore, predicting the next market movement requires profound market knowledge, thorough market analysis, and – curiously enough – intuition.
Of course, there are also objective causes for the market mood to change. News on fundamental economic indicators like inflation, unemployment, trade balance, etc., will force the currency exchange rate to rise or drop depending on how good or poor figures are. In the case of a bearish market sentiment, when prevailing expectations are that the market will go up, good news about a particular currency will support the market mood and its exchange rate against other currencies will rise. In contrast, bad news in a bearish market will add to the prevailing market sentiment and the currency exchange rate will fall further.
However, those are very simplified formulations. Understanding the psychology of market players requires a broad market experience and expertise that successful dealers gain in the course of a long career.
Questions and Answers
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