Trading Fundamentals
I personally follow 4 central banks in detail: FED (USD), ECB (EUR), BoJ (JPY) and BoE (GBP). Knowing the monetary policies of these banks and how they differ, helps me in trading the following 6 major pairs: EU, GU, UJ, EJ, EG and GJ. I also follow three other central banks, be it more at a distance and with less detail: SNB, RBA and BoC. The banks to follow would normally depend on your trading portfolio.
Central banks monitor the following five economic areas:
I) Growth. Referring to whether an economy is expanding or contracting. On the economic calendar, there are several indicators on the health of the economy such as (not a complete list):
-Business climate
-Gross domestic product
-Personal spending index
-Retail sales
-Consumer confidence / sentiment
II) Inflation. Referring to how costs of goods and services develop. On the economic calendar, you will find:
-Consumer price index
-Producer price index
-Retail price index
-Core price index
III) Employment. Referring to a countries labour force. On the economic calendar, you will find:
-Unemployment change
-Unemployment claims
-Jobless claims
-Non farm payroll
IV) Production. Simply put, this refers to the things a country makes. On the economic calendar, you will find:
-Factory orders
-Core machinery orders
-Building permits
-Industrial production
-Purchasing managers' index
V) Geopolitical. Referring to anything non-economic that could cause risk in the market. Think of things like elections, natural disasters and wars.
Central banks watch these areas and have specific targets for them (for instance inflation 2%, unemployment 8%). If a central bank is focussed on an indicator and sees it´s off target, there are several tools it can use to affect the indicator.
A) Changing interest rates. Raising them cuts inflation and encourages investors to come in, thereby increasing demand for the national currency. For example the FED is believed to plan a rate hike this year that will further strengthen the USD.
B) Setting price limits. The value of a currency impacts exports, so banks can make sure a pair will not drop below a certain amount and will spent millions buying foreign currency the weaken their own. For example the SNB until recently had a cap on EURCHF to artificially weaken their currency. We all know what happened when that cap was suddenly removed.
C) Quantitative easing. This is basically printing money to spur the economy and inflation. It weakens the currency by increasing the availability of it. Good example is the recently announced powerful QE programme by the ECB, leading to selling pressure for the Euro.
D) Using certain language. With press conferences, minutes of meetings, speeches or written statements a central bank can influence the market and thereby the value of its currency. Good examples are public statements by Draghi, president of the ECB. The EU pair can move hundreds of pips while he speaks.
The key to trading fundamentals, is understanding what a central bank might do to move the value of an indicator towards its target. So when news comes out, you can asses if it will make the central bank more or less likely to use a certain tool and consequently if that news event weakens or strengthens the currency.
For example: towards the end of 2014, the inflation in the Eurozone had fallen to very low values. The ECB had tried several things (like lowering the rates) to up the inflation (for which it has a target of 2%), but to no effect. The only thing left to do, was a QE programme. So with every new Eurozone cpi that came out lower than expected, the probability of a QE program increased, so the euro weakened instantly upon the release of that cpi data.
Central banks monitor the following five economic areas:
I) Growth. Referring to whether an economy is expanding or contracting. On the economic calendar, there are several indicators on the health of the economy such as (not a complete list):
-Business climate
-Gross domestic product
-Personal spending index
-Retail sales
-Consumer confidence / sentiment
II) Inflation. Referring to how costs of goods and services develop. On the economic calendar, you will find:
-Consumer price index
-Producer price index
-Retail price index
-Core price index
III) Employment. Referring to a countries labour force. On the economic calendar, you will find:
-Unemployment change
-Unemployment claims
-Jobless claims
-Non farm payroll
IV) Production. Simply put, this refers to the things a country makes. On the economic calendar, you will find:
-Factory orders
-Core machinery orders
-Building permits
-Industrial production
-Purchasing managers' index
V) Geopolitical. Referring to anything non-economic that could cause risk in the market. Think of things like elections, natural disasters and wars.
Central banks watch these areas and have specific targets for them (for instance inflation 2%, unemployment 8%). If a central bank is focussed on an indicator and sees it´s off target, there are several tools it can use to affect the indicator.
A) Changing interest rates. Raising them cuts inflation and encourages investors to come in, thereby increasing demand for the national currency. For example the FED is believed to plan a rate hike this year that will further strengthen the USD.
B) Setting price limits. The value of a currency impacts exports, so banks can make sure a pair will not drop below a certain amount and will spent millions buying foreign currency the weaken their own. For example the SNB until recently had a cap on EURCHF to artificially weaken their currency. We all know what happened when that cap was suddenly removed.
C) Quantitative easing. This is basically printing money to spur the economy and inflation. It weakens the currency by increasing the availability of it. Good example is the recently announced powerful QE programme by the ECB, leading to selling pressure for the Euro.
D) Using certain language. With press conferences, minutes of meetings, speeches or written statements a central bank can influence the market and thereby the value of its currency. Good examples are public statements by Draghi, president of the ECB. The EU pair can move hundreds of pips while he speaks.
The key to trading fundamentals, is understanding what a central bank might do to move the value of an indicator towards its target. So when news comes out, you can asses if it will make the central bank more or less likely to use a certain tool and consequently if that news event weakens or strengthens the currency.
For example: towards the end of 2014, the inflation in the Eurozone had fallen to very low values. The ECB had tried several things (like lowering the rates) to up the inflation (for which it has a target of 2%), but to no effect. The only thing left to do, was a QE programme. So with every new Eurozone cpi that came out lower than expected, the probability of a QE program increased, so the euro weakened instantly upon the release of that cpi data.
You don´t need to be a weatherman to know which way the wind blows - B. Dylan
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