By Vadim Pokhlebkin
The theory, in a nutshell, goes like this. When a central bank starts raising interest rates, it makes that country's assets more attractive to foreign investors. And since the country's assets are denominated in that particular country's currency, the currency also becomes "more attractive" – i.e. it gains. When the central banks cut rates, the opposite happens.
Surely, you've heard this theory before. Last time I heard it was yesterday (June 6), on NPR. They were interviewing an economist who was explaining why U.S. stocks had a strong sell-off yesterday. You see, on Wednesday the European Central Bank raised interests rates, further narrowing the spread between the EU's and U.S. rates and thus making foreign investors – in theory – salivate more over the euro-denominated assets than over the dollar-denominated ones.
Granted, that explanation fits Wednesday's action in the U.S. stock market just fine. But it doesn't explain why European stocks also sold off on Wednesday. Shouldn't they have gained instead? Or was it the "geo-political concerns" that got them down?
And, more importantly for our discussion, it doesn't explain why the euro sold off against the U.S. dollar on Wednesday, too. In fact, if you didn't know which central bank raised interest rates and had to guess based on the markets' reaction, you would think it was the Federal Reserve that did it!
And do you know why the EUR lost to the USD on Wednesday? I hope you're ready for this – apparently, because while the ECB's president, Trichet, did say they would "continue to monitor closely" the inflationary trends, he "didn't use the term 'very closely,' disappointing some in the market." (The WSJ)
Apparently, the will of those "some in the market" turned out to be stronger than the will of those who weren't following Trichet's semantics that closely.
Look, the bottom line is that if you want to trade forex successfully, you need to stop paying too much attention to the "fundamentals." It's not the first time when the currency market reacted "illogically" to the news, and it won’t be the last.
You can go retro-fitting economic "explanations" to the market action all you want, but at the end of the day, what matters is only one thing: your P&L. And if you trade expecting the markets to "behave" as various economic theories say they should, you will likely be disappointed.