Often new currency traders get confused and ask why a particular currency has rallied despite the negative economic figures about that country. Sometimes, the currency can decline on the release of positive news. You should understand the discounting effect in the forex market.
Commonsense tell that US Dollar should depreciate when there is bad economic news and there are signs of economic weakness, like unemployment and huge budget deficits. Likewise, commonsense says that US Dollar should appreciate when there is good economic news about United States. However, it can be the other way round. These types of effects confuse and bewilder new forex traders.
What is the reason that a particular currency goes up despite bad economic performance of that country or the currency goes down despite good economic performance of that country? This can be attributed to the discounting mechanism of the forex market.
Traders try to take into consideration the future expectations about the currency in their present trading decisions. Traders think long term. Markets function on the basis of expectations, what the traders think will happen in the future. The markets inbuilt discounting mechanism is formed by the anticipatory reaction of the traders.
The traders will be bullish on JPY and go long now, if they have a positive view of the Japanese economy, thus pushing up the currency. But traders will be bearish on JPY and go short now, if they think that Japan will suffer from the rising oil prices in the near or medium term, thus pushing down the currency.
In this way, currency prices integrate the markets expectations about the future. This is somewhat similar to the saying: Buy on the rumor and sell on the news. Even before the economic data is released for public consumption, market has already made up its estimates of those figures based on the work of analyst and economists in the major trading institutions like banks or funds.
Suppose, the market thinks that the US Consumer Confidence Index to show a worse figure than the previous month. Market has already compounded that information in the exchange rate of say EUR/USD way before the US Consumer Confidence Survey results are released to the public.
The currency pair EUR/USD was rallying due to poor market sentiment for UAD. When the US Consumer Confidence Survey figures are released, what will move the market is the amount of deviation between the expectation and the actual figures.
This is old news for the market if the released figures are almost the same as expected. No surprise was caused in the market. This information has already been compounded into the currency prices.
The release of the anticipated news or data can often cause the currency price to move in the opposite direction initially to where the market had positioned itself before the release of the news. After sometime the market adjust itself and the status quo prevails.
Suppose the US Consumer Confidence Index figures turn out to be almost the same as expected. EUR/USD pair may even end up declining with the USD strengthening even in the face of a negative consumer confidence number.
This contrarian market reaction is the result of traders who had gone long on EUR/USD closing their positions and taking profit on the news release. Thus the lack of any deviation between the expected and the actual figures may cause the currency pair to move sideways or even move in the opposite direction as the status quo remains.
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