Prices can be driven by either contrarian or momentum considerations. At any given time scale, traders are either expecting a reversion to the mean or the continuation of a trend. Bargain hunting, value investing, and profit taking are all examples of contrarian trading, while bandwagon buying, momentum investing, and panic selling are all examples of trend following.
One of my main hypotheses is that the FOREX market tends to be driven by contrarian factors more often than by momentum, and that this happens over several time scales. Some of my research in the past has indicated this on the lower time scales, and my more recent research with Relative Buying Power indicates the same thing on longer time scales.
The mechanism by which this happens for longer time scales is pretty clear; it’s all about economic forces, both macro and micro. Those forces drive political forces, which in turn drive policy decisions which affect currency prices.
So for example, when a country’s currency has been strengthening, its exports become more expensive overseas. This hurts export sales, causing shareholders and executives of export industries to become unhappy. The most powerful of these make their displeasure known to political friends on the golf courses and in the exclusive clubs of the nation. Politicians worry about losing donations to their campaign war chests, so they pull a few strings with the central bank and others in the banking industry.
Voila! Money supply increases, bonds are accumulated, yields drop and foreign investors desert the bonds for greener pastures elsewhere. This results in more of the country’s currency being supplied to the market, causing a break in the uptrend. Other foreign investors begin to see their stock and real estate investment values dropping in terms of their home currency. They either dump these investments or hedge by selling the currency short, bringing more supply into the market.
Eventually, we have a nice happy downtrend in the currency, which makes the exporters happy. But wait! Now the importers are annoyed as are consumers who are beginning to notice higher prices for imported goods. Riots! Bedlam! Cats punching dogs in the face!! And the whole thing starts again from the other direction.
So that’s my rather over-dramatized view of why contrarian trading drives the FOREX market rather than trend following.
That’s it for now, so until next time…keep pipping up!by