As barriers to trade and capital have broken down in the last two decades, so capital flows have become increasingly important, both in terms of their impact on the economy and in turn on the exchange rate. At USD1.2 trillion in daily volume, the currency markets trade the equivalent of annual global merchandise trade every day of the year. Like any market, the currency market is affected by demand and supply, which in this case is reflected by order flow. It has been found that tracking order flow can provide both a useful explanation of past price activity in currency markets and — more importantly — can be used as a predictor of future price action. The basic premise behind this is that changes in order flow, if sufficiently large, can have predictable and sustainable impact in the currency markets in terms of price action. There are several short- and medium-term flow indicators which the reader should be aware of. Short-term flow data:
The IMM Commitments of Traders report Medium-term flow data:
US Treasury “TIC” capital flow report
Euro-zone portfolio report
IMF quarterly report on emerging market financing
IIF capital flows report
In addition to flow data provided by the trading exchanges as in the case of the IMM and by official sources as with the TIC and Euro-zone reports, there are also proprietary flow models created by commercial and investment banks to analyse client flows going through the bank’s currency dealing rooms.
Order flow/sentiment models
Flow data and models provide direct evidence of the effect of order flow on market pricing. A more indirect but no less useful to way to do that is to look at market sentiment indicators such as:
Option risk reversals
These are a very useful gauge of the market’s “skew” or bias towards an exchange rate. Analysing risk reversal trends over time relative to the spot rate may allow one to make predictions as to future spot rates based on the risk reversal.