Inflation has become a growing concern for investors in recent years. As prices rise faster than wages and returns on investments, inflation eats away at wealth and decreases purchasing power over time. This poses a major threat to long-term financial goals like retirement. As a result, investors are looking for ways to protect their assets against inflation. One potential solution that has gained popularity is trading foreign currencies (forex). Some forex traders claim certain indicators can be used to select currencies poised to appreciate versus currencies of countries with higher inflation rates. But can forex indicators really help investors beat inflation over the long run? This article will examine that question.
What is Forex Trading?
The foreign exchange (forex) market is the global, decentralized marketplace where the currencies of different countries are traded 24 hours a day, 5 days a week. Over $7.5 trillion worth of currencies are traded every single day on the forex market. The values of currencies fluctuate relative to one another based on supply and demand. Factors like interest rates, inflation, economic growth, political stability, and more impact currency valuations.
For example, if the U.S. Federal Reserve raises interest rates while the European Central Bank leaves rates unchanged, demand for the U.S. dollar would likely rise versus the euro. Traders attempt to profit by speculating on these shifts in currency valuations. Those who think a currency will increase in value versus another currency would go long. Traders who anticipate a currency losing value would short-sell. With leverage, forex traders can enter larger positions than the capital in their trading accounts. While this amplifies potential gains, it also significantly increases risks.
Top Forex Indicators Used by Traders
Here are some of the most popular technical indicators used by forex traders:
- Moving Averages. Plot the average price over a defined period to identify support and resistance levels as well as trends. Crossovers of different moving averages can generate trade signals.
- MACD (Moving Average Convergence Divergence). Compares short- and long-term moving averages to identify momentum and signal changes in the direction of a trend.
- Bollinger Bands. Plots price volatility to identify tops or bottoms of ranges when prices reach the upper or lower bands. Bandwidth expansion during big moves and contractions during consolidations also aids analysis.
- RSI (Relative Strength Index). Compares the magnitude of recent gains versus recent losses over a defined period to determine whether an asset is overbought or oversold. Divergence between price and RSI can signal trend changes.
- Stochastics. Compares closing price to price range over set time periods to determine overbought or oversold conditions in a security. It can signal trend changes when the indicator crosses over itself.
There are over a hundred popular forex indicators used by traders for analysis and generating signals. The most widely followed technical indicators focus on identifying trend direction, momentum, areas of support/resistance, and overbought/oversold conditions. Traders often combine multiple indicators to look for concurring signals and filter out bad trades. They may also use indicators to confirm price action analysis. However, while indicators can aid trading when used properly, they come with downsides.
Limitations of Relying on Forex Indicators
Here are some drawbacks of overemphasizing forex indicators:
Lagging. Technical indicators use past price data and thus always lag current prices. Signals are often late coming at major turning points.
- Subjectivity. Setting parameters like periods, overbought/oversold levels, and more requires subjective decision-making by traders. Results can vary widely based on settings.
- False signals. No indicator is 100% accurate. Whipsaws can result in losses from acting on incorrect signals. Combining indicators and filters helps avoid bad signals but also typically reduces total trading opportunities.
- Repainting. Some dishonest forex brokers, trading platforms, and coders present indicators that alter past signals to create the illusion of accuracy. This unethical “repainting” provides traders with inaccurate information.
- Automation bias. Traders may become overreliant on indicators and fail to incorporate critical thinking. Key factors like news events may be overlooked, leading to losing trades.
- Optimization bias. Fitting indicators to past price data can produce excellent backtested results. But markets continually evolve, and the future often diverges from the past. As a result, settings optimized for backtesting generally fail going forward.
Therefore, indicators can help in analysis, but when the trader blindly relies on the signal without discretion, forex traders are likely to suffer big drawdowns. Markets are dynamic environments that are led by human choices. And human behavior also keeps changing. Consequently, price behavior is likely to demonstrate new dynamics as opposed to the repetition of a predictable pattern, on which the formulas of the indicators are designed on.
Can Forex Indicators Beat Inflation?
Savvy investors look to generate returns that outpace inflation over the long run. This helps safeguard purchasing power so money retains value decades into the future. Due to the limitations detailed above, attempting to rely on forex indicators for long-term inflation-beating returns faces substantial challenges. Here is why:
Forex Lacks Reliable Trend Persistence
Unlike stocks tied to the growth of underlying companies, currencies fluctuate based on relative economic factors and speculative trading. These drivers lack long-term directionality. As a result, forex trends tend to persist for shorter durations compared to long-term stock market trends. This makes profitable trend following more difficult. Strategies dependent on indicators struggle in ranging markets.
Carry Trades Have High Failure Rates
One popular long-term forex strategy is carry trading, which attempts to capture differences in interest rates between currencies. But the currencies with the highest yields often come from the most economically unstable countries. During crises, these high-yield currencies tend to crash as capital flees into safe-haven assets. Studies suggest >30% failure rates for carry trades over extended periods, jeopardizing principal.
Leverage Is a Double-Edged Sword
The ability to buy larger forex positions with borrowed capital can quickly multiply returns as well as losses. While leverage may boost gains in the short run, over the long run, it has destroyed many accounts. Even the best indicators will inevitably produce strings of losing signals. Leverage turns those losing streaks into career-ending drawdowns for many traders.
Transaction Costs Take a Toll
Banks, brokers, and trading platforms charge fees for spreads, commissions, rate charges, data fees, and more that eat into trader profits. These transaction costs significantly erode long-term returns.
Taxes Drag Down Compound Growth
In many jurisdictions, short-term trading profits are subject to high ordinary income tax rates rather than the lower long-term capital gains rates for buy-and-hold investors. This deduction inhibits the long-run compounding essential to outpacing inflation.
So while currencies of countries experiencing high inflation may lose substantial purchasing power over 5-10 year periods, most retail traders lack the tools to reliably profit from forex trading over those extended horizons. The big banks that dominate short-term currency flows exploit advanced technologies and tactics unavailable to most individuals attempting to use indicators. This market edge enables the banks to extract reliable profits well over transaction and leverage costs over the long run, albeit with increased tail risks. But for retail traders, transaction costs, leverage risks, taxes, and the lack of persistently tradable trends in forex markets hinder the compound growth essential to beating inflation.
Alternative Strategies With More Potential
Few traders in forex managed to overcome inflation through indicators in the long term. This is an unlikely direction to maintain account balances above inflation since the combination of these drawbacks includes limitations of lagging, repainting indicators with whipsaws, and false signals. Other trading instruments and strategies, however, have greater potential in the protection against inflation. Some of them are the following:
Trend Following Systems
Trend following tries to capture long-term moves in stocks, bonds, commodities, and volatility products with price action, not indicators. These systems utilize risk management to withstand drawdowns as a result of unavoidable losing trades. The track records of successful managers and mathematical models show long-term sustainability of inflation as well as beating returns. However, transaction costs may render short-term trend following a challenge to small retail traders.
Buy and Hold Blue Chip Stocks
Investing in shares of dominant companies with pricing power in essential industries can provide inflation protection. Rising prices allow these companies to grow their earnings. Dividend reinvestment also accelerates compounding. However, investors must hold through inevitable bear markets. This requires stoicism, as paper losses can exceed 50%-80% during recessions, and panic selling at market bottoms locks in losses.
Real Estate Investment Trusts (REITs)
REITs own profitable commercial and residential real estate properties that generate rental income and appreciate with inflation. REITs offer investors exposure to property markets, inflation protection, and dividend income without the hassles of being a landlord. However, property market declines have exceeded those of the stock market during some recessions.
The key to beating inflation boils down to owning productive assets over the very long run, not trading forex using indicators. Assets like profitable companies, rental properties, and commodities gain value as prices rise due to inflation. Savvy investors focus on acquiring these types of inflation-resistant assets at reasonable prices during stock market corrections and recessions.
Patience allows the long-term appreciation and compounding of these assets to overcome temporary declines during periodic downturns. Risk management in the form of portfolio diversification across asset classes preserves capital so it remains available for redeployment into assets trading at fire sale prices following future crashes. This process, repeated over a decade, protects wealth from inflation far more reliably than attempting to trade forex using lagging indicators.
Conclusion
Forex trading offers traders opportunities to profit from short-term and medium-term fluctuations in currency valuations. However, economic drivers lack the persistence and directionality needed for reliable long-term trend-following strategies. Lagging indicators struggle to sustainably outperform transaction and leverage costs over extended timeframes for most individual traders.
Taxes also kill compound returns that are necessary in beating inflation. Consequently, most retail market players find it unlikely to succeed in protecting wealth against inflation through forex trading signals. Long-term investors concerned with beating inflation are more likely to be able to amass and retain worldwide, diversified portfolios of stocks, real estate, and commodities during bear market sell-offs. This enables the appreciation and compounding of these tangible assets to surpass short-term paper losses of the periodic corrections and recessions over decades.
Therefore, although engaging in speculation in the forex with the help of indicators may be exciting and yield short-term profits in cases where the market is favorable, other methods that focus on the ownership of productive assets prove to be more reliable in outpacing the increasing prices in the long run. The point is that indicators can only assist forex trading, but wealth creation needs a different method to beat inflation.
