Reaction to news events in foreign exchange trading is driven by expectations. A headline result that is above expectations leads to strength in the respective currency, while a headline result that is weaker than estimations results in a weakening of the respective currency.
Unfortunately, life isn’t that easy and there two general exceptions that traders should be aware of.
The Risk Factor
First, the US indicators tended to produce the opposite result for the dollar. The reason was the risk on / risk off mentality, whereas a weaker than expected US indicator leads to a strong US dollar (and a stronger Japanese yen).
The explanation is that a weaker US will lead the world down, and therefore, it is better to fly to safety – the safety of the US dollar. And when indicators exceed expectations, the world is set to improve as a whole, and no safety is needed and the dollar is sold. Risk is sought after.
This kind of behavior was seen for long periods of time in the period after the financial crisis. However, the never ending expectations for QE3 resulted in a return to “normal” behavior. Weak data raised QE3 expectations. Creating more dollars to buy bonds weakens the US dollar. And positive figures lowered the chances, strengthening the dollar.
If QE3 turns into reality (even though the Fed could take a different path), the question of QE3 will not exist anymore. So before QE4 will loom, we could see a swift return to the “abnormal” behavior.
Sell the Fact
The second exception is usually seen on a big event that has fewer possible results: an event such as a rate decision, where there is usually one main scenario. Of course, high expectations that don’t materialize lead to a disappointment. This is a natural fact of life.
There is another scenario, where high expectations do materialize. However, these expectations were priced in or even “over priced in” that any result leads to a sell off. This is often dubbed “buy the rumor, sell the fact”, and is relevant also when the event isn’t a rumor but a well-known scheduled and thoroughly debated event.
For example, a future rate cut in Australia may result in a rally for the Australian dollar if this event would be priced in. This is despite the usual behavior of a rate cut hurting the respective currency and despite reality meeting expectations.
Further reading: 5 Most Predictable Currency Pairs – Q3 2012Get the 5 most predictable currency pairs