Technical analysis has posed a challenge to economic analysis in its ability to predict exchange rates. As a result, considerable research has been undertaken by the economic community on how technical analysis works, both in practice and in theory. It is not for here to go through this research or literature in detail. Rather, we look at one such study as symptomatic of a general inquiry by the economics profession into the workings of technical analysis. More specifically, no less than the Federal Reserve undertook to examine this phenomenon, apparent confirmation of an ongoing change in theway both private and public institutions are approaching the field of technical analysis. Indeed, the reader can find no more useful and detailed investigation of the subject matter, starting from a macroeconomic perspective, than two reports by Carol L. Osler of the Federal Reserve Bank of New York, which examine how technical analysis is able to predict exchange rates. These papers go a substantial way in explaining how technical analysis works and are particularly useful as they undertake this investigation from an economic perspective. In line with work done on studying order flow, they suggest customer orders “cluster” around certain price levels and that such “clustering” creates specific price patterns depending on whether or not those levels hold. To a technician, this makes perfect sense given that a price represents the consensus of market supply and demand at any one time. Below the price, there should be “support” levels at which demand is expected to exceed supply and conversely above the price there may be “resistance” levels, where supply may exceed demand. From my perspective, I would suggest the following reasons why technical analysis has gradually taken on a more prominent and important role in predicting exchange rates:

1. Over the short term, the currency market is essentially trend-following.
2. The majority of market participants are speculative, that is they undertake currency transactions that have no underlying trade or investment transaction behind them.
3. Nature abhors a vacuum—currency market participants have to trade off something whether or not there has been any change in macroeconomic fundamentals.
4. Traditional exchange rate models have had relatively poor results, therefore another analytical discipline was needed that was able to achieve better results.
5. Exchange rate supply and demand create price patterns, which in the absence of other stimulus may provide clues for future exchange rate moves.

There does appear to be a crucial self-fulfilling aspect to technical analysis, which is to say that because a large number of people see a particular price level as important, therefore de facto it becomes important. Needless to say, this is an aspect that critics of technical analysis regularly seize on. While this may be the case to an extent, it does not answer the obvious question of why such a number of people find those levels important in the first place. Technical analysis is the discovery of patterns within price action, patterns which can be used to predict future prices. The predictive results of technical analysis consistently exceed those suggested by a random walk theory.2 Indeed, such have been the results achieved that there is now a sizeable and ever growing community of traders and leveraged funds that trade solely on the back of technical analysis signals. In short, technical analysis “works” to the extent that it produces results consistently for market participants who are trying to predict short-term exchange rate moves.