Market psychology is the root cause of the unpredictability of this financial market, and it has an important impact on currency exchange rates that is often unrelated to the economy. This is because market psychology is essentially the sum of traders’ perceptions and reactions to various events.
One good example is the unpredictable and volatile reaction of Forex exchange rates to economic data. This is because, more often than not, the market begins to move long before the data is released due to traders listening to rumors regarding the expected figures. Therefore, if there is a rumor that unemployment in the U.S. has risen, then traders will begin to sell off USD in an attempt to protect themselves from a significant fall in price, even if there is no basis to the rumor.
Likewise, Forex exchange rates can fluctuate significantly in reaction to other rumors including those pertaining to the political situation of a country. For example, if a rumor hits the mainstream that there is talk of political instability in Switzerland, however unlikely that may be, traders will begin to trade accordingly even if there are no facts to back the rumor.
Unfortunately, rumors regarding the economic strength of a country can have a much bigger backlash than just the fluctuation of Forex exchange rates. A country’s economy is mainly driven by the confidence of the consumer and their spending habits. Thus, the less confident the consumer is in the economy, the less money they will spend. This, in turn, leads to lower demand, which will eventually lead to higher levels of unemployment and, ultimately, to a serious economic downturn as people can no longer spend even if they wanted to. This is why governments are very careful regarding the statements they make.
Market psychology can have a serious impact on Forex exchange rates and is, in fact, the driving force behind the market. If there weren’t a human element involved in the Forex market, then it would be highly predictable as there would be no emotions involved in trading, only logic and cold, hard facts.
