Fundamental analysis plays a big part in how economists look at a currency and its future value.
However, while some of these studies can be of assistance in the long term picture, in most cases, they provide little assistance in the short to medium term outlook.
In last month's post, we had a look at demystifying the relationship between the Rand and Gold
Let’s take a look at another of these theories –
Interest rates differentials and their effect on exchange rates.
So when the Reserve Bank increases interest rates or the US Federal Reserve decreases rates, the Rand should strengthen against the Dollar. Conversely, when SA interest rates are reduced or US interest rates increased, the Rand should weaken.
Makes sense in theory, right? But what is the reality?
The inserted Chart reflects the historical Dollar/Rand exchange rate since 1970, together with the differential between SA and US prime rates, colour-coded with positive (green), negative (pink) and negligible (white) correlation. Below this is the 200 day rolling correlation as well as a 5 year moving average.
Click to see full size...
Once again, this paints a very revealing picture.
What this Chart is telling us is the following:
- Historically, the past 43 years have shown periods of both positive and negative correlation, as well as periods of no correlation or virtually none at all.
- The average correlation for the whole period is 40% – which is not a high correlation. Furthermore, it is a positive correlation, which means that the Rand has tended more to weaken when rate differentials have increased, and strengthen when rates have decreased – exactly the opposite of what is generally accepted!
- The 200 day rolling correlation (blue area) clearly shows the periods of both positive (above zero) and negative (below zero) correlation, with the 5 year moving average (red line) showing the positive bias (on average 27% correlation).
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Highs and lows in the exchange rate have tended to lead (not lag) interest rate differential highs and lows in more recent years.
Once again, a fundamental theory, once put to the test, has failed miserably.
So what does this tell us? In summary:
In reality, there is no consistent historical correlation between interest rate differentials and exchange rates.
And using interest rate announcements to assist in forecasting or explaining Rand movements is clearly not a valid, reliable nor profitable methodology.
Whereas some fundamental analysis is helpful in looking at the long term picture, the most reliable method to predict future Rand (or any other) market movements is analyzing the patterns in that market itself.
The reason for this is simply explained (profound but simple):
And the markets, being merely a creation of man, therefore reflect human idiosyncrasies (yes, we all have them!)
The patterns in a market are therefore not random, but a perfect reflection of the mass psychology active in that market.
And because we as creatures are governed by the laws of Nature (and tend to make the same decisions under the same circumstances), these patterns tend to repeat themselves rhythmically - in smaller and larger degrees.
Knowing this, and understanding the laws that govern these price movements, can be very powerful in helping us make informed, educated and unemotional foreign exchange decisions – especially seeing our natural tendency is to do just the opposite!
But in order to do so, you need something that gives us that objective, scientific-based outlook to work from instead of our default herding instinct in times of uncertainty (do what everyone else is doing - often in panic-mode!)
And that is what our forecasting service does, assisting you to make educated, informed and rational decisions
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As always, would appreciate your feedback and comments.
To your success~
James Paynter
P.S. And if you are exposed to Rand currency fluctuations, and are feeling frustrated by the Rand's wild movements, let us assist you by giving you up-to-date forecasts so that you can better time your transactions, and save you time, money, stress and effort.
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