It all starts with the Central Banks

One of the key skills you need to acquire as a trader is the ability to identify good trading opportunities.

Now this is not simply being able to draw trendlines and understand technical analysis. That is a key component for sure but what I’m talking about is the step before, identifying currency direction and potential trading opportunities.

To get an understanding of what I mean I need to explain how the ‘Fundamental’ market works.

Long term currency direction (trends) come from the Central banks. They manage their respective economies by micro-managing the monthly economic data releases. Their overall plan has always been to keep inflation between a band of 2-3% per year. They know if they do that the economy will tinker away without any major issues. If inflation starts to get above 3% then they’ll look to take the steam out of the market by raising interest rates. People are encouraged to save and the higher cost of housing etc slows consumers spending. Likewise if it falls below 2% they’ll cut rates to try and pick up demand. People are encouraged to spend their money as they are now getting bugger all for it sitting in the bank.

Now each month the same economic data is released (except in Australia where the CPI & GDP are released Quarterly). Each economic data release (top tier mainly) is a ‘piece of the pie’ that makes up the central banks decision on monetary policy.They don’t just look at the CPI (Consumer Price Index) although it is of major significance. The Top Tier data is extremely important and make up a bigger component of their decisions. This is where ‘Currencies: The Inside Story’ comes into play as you’ll soon learn that Top Tier data is not the same in every country.

General Top Tier Data releases:

  • Consumer Price Index (CPI)
  • Gross Domestic Product (GDP)
  • Unemployment Rate & Change
  • Retail Sales
  • Manufacturing
  • Housing
  • Trade Balance
  • Average Hourly Earnings
  • Consumer/Business Confidence

At the next central bank meeting the ‘Board of Governors’ (to use the Federal Reserve as an example) discusses the results of the previous months data and makes decisions on interest rates based on their  monetary policy.

Simple huh!

Bear in mind there is generally a 6 month time lag from the time a rate change is made to the time it impacts the economy. So the central banks have their work cut out predicting economic conditions 6 months down the track. That’s why they generally wait until there’s absolutely overwhelming evidence before they change interest rates. This is a cyclical process that continues every day, week, month, year….and it’s the heart beat of the financial markets. Because traders know this ‘central bank process’ it enables them to actively trade the economic releases. I’ll explain this more in detail below.

OK that’s your ‘Central bank – Interest rate’ lesson for those without an Economics background.

How do they do it?

Every 4-6 weeks most central banks hold a meeting to discuss and potentially adjust monetary policy. In the past these meetings used to be sporadic but over time they realised by micro-managing their economies they could subtly adjust policy and avoid the rude shocks in the financial markets of changing rates by 2-5% at a time.

At the end of these meetings there are generally 3 releases:

  1. Interest Rate Decision (change or no change)
  2. Statement (An overview of the meeting: Discuss economic conditions, provide the reasoning behind their decision & ‘usually’ give their forecast for future monetary policy) &/OR Conference (They get to add some personal spin to their announcement)
  3. Meeting Minutes – finer details about the discussion by the Central Bank Board.

Each of these releases is a potentially huge trading opportunity.

Don’t forget on average the major currency pairs move 150 points from high to low over a 24 hour period. If the central bank makes the slightest change in policy we will see 250-300 point moves easily. I’ll break down each release so you have a thorough understanding of the impact and potential trading opportunity.

Interest Rate Decision

The interest rate decision is usually factored in before the meeting. So it’s often a non-event. The market does this by accessing the monthly economic data releases. If all the economic data has been particularly strong or weak (above or below forecasts respectively), then there’s a good chance we may see a change in rates. In this situation the market doesn’t wait for the meeting to ‘see if they change rates’, they actively predict (trade) the move by buying or selling the currency ahead of the meeting. This is called ‘factoring in’ the change in rates. So by the time the meeting comes around the interest rate decision, even if they change rates, may not be a big deal especially if it’s 95% factored into the market. That means traders have already bought ahead of the release maybe a week or two before the central bank meeting. In fact what usually happens in this situation is the currency actually moves the opposite direction to what you would normally think because everyone already has the same position. For example if they raise rates and everyone is already long then it can only go one way, and that’s down!

Where it gets tricky and exciting!

If the economic data over the previous month has been mixed. Say 70 – 30 in favour of stronger data results then the interest rate decision will be a line call and potentially a 50 -50 scenario. Don’t forget the central banks like to be certain that policy needs to change as they can’t exactly raise rates one month and cut them the next….well they could but they would lose respect in the market. If they lose respect, they lose control…and that’s what they don’t want. So they make sure they do it right!

The line call decisions are massive whichever way they go. The market reacts aggressively as ‘half’ of it has not factored in the result so they need to adjust their positions accordingly and this causes the big moves. Don’t forget those that got it right are adding to their positions at the same time. And that’s why the moves are huge.

Where you get extremely ‘wild off the charts moves’

We don’t see many of these any more because they created too much chaos for the financial markets in the past. But it occurs when the central bank changes rates completely unexpected. There may have been modest economic data in line with forecasts so basically no change in economic conditions. Yet the central bank for some unknown reason thought it was time to change rates. When this occurs because it’s completely unexpected by everyone may lead to at least a 300+ point move.

Where you get modest moves

If the potential for an interest rate hike is around 70% then you still have 30% of the market that didn’t think there was going to be a change in rates and that leads to a modest move in the direction of the rate change. If they cut rates it goes down and if they raise rates it goes up. It can be a good cash earner but the market will quickly turn their attention to the Statement for forward guidance on interest rates. Once the interest rate decision is out and has been traded the market quickly refers to the Statement for the next leg of direction.

The Statement

The statement explains the reasons behind the interest rate decision (change of no change), discusses current economic conditions and ‘usually’ provides forward guidance on what the central bank expects to do from here. No one really cares too much about ‘why’ as they already know its because the economic data was strong. The economic conditions they’ll come back to especially if they ‘focused’ on potential sensitive parts of the economy. That will provide separate individual trading opportunities when that economic data that they mentioned is released during the next month.

What traders really want to know is:

  • Are they expecting to change rates again (raise rates – Hawkish or cut rates -Dovish)
  • Are they finished raising rates (neutral)
  • Or are they sitting on the fence with potential to go again (slightly hawkish or dovish)

If the central bank is Hawkish or Dovish in their statement it means they are thinking they may have to change rates again in the not too distant future. This is like getting another change in rates immediately and usually occurs when the interest rate decision has been 95% factored in.

The Release of the Statement

The announcement usually sees the currency take off again like an unexpected change in rates. That’s why you may have seen the currencies ‘explode’ in the past even though they didn’t change interest rates. The Statement is often the most important component of the central bank release. It builds anticipation and provides forecasts for the market. Traders use it to place trades immediately as it’s released even though the next meeting may be 6 weeks away. A change from Hawkish or Dovish back to Neutral in their Statement will have the same impact as a rate chnage in the opposite direction. The move will be aggressive and big. A change from Neutral to Hawkish or Dovish will have the same impact as a change in rates to the bias they mentioned. Basically the slightest change in text in the Statement will cause a major move and that’s why the central banks are extremely precise with their wording so as to not  ‘confuse’ or give the ‘wrong impression’ to the market.

The Forecasts in the Statement

The forecasts in the Statement provide ammunition for traders with reference to the upcoming monthly economic data releases. If they have referenced specific data like Unemployment, then that data release will become the ‘key epicentre’ for the next central bank decision. We’ve seen the Federal Reserve for example on many occasions refer to the Employment data as the key to their future rate hikes. The Non-farm payrolls is already a major high impacting event. But when the FED singles it out as particularly important the release takes on a new life. The Non-Farm payrolls data basically becomes the ‘interest rate decision’. Any major variance and it has a huge impact either way and that’s why you see so much volatility around these releases.

Let me give you an example of how important the Statement is:

If the statement is hawkish – and the next months economic data is strong, then we’ll get a nice upward trend and this is great for trading. We should have longer term trading opportunities that are easy to identify, have clear entry zones and are generally lower risk trades. On the other hand if the Statement is hawkish – and we get mixed or weak economic data then trading will be extremely disjointed and unpredictable. No trends at all. This kind of sucks as we may have to revert to short term trading opportunities and they usually come with greater risk. That second type is what we’ve been experiencing for the last few years and that’s why trading has been a battle and you’ve really got to be on your game.

The Meeting Minutes

The minutes are usually released a week after the rate decision and statement. It’s a thorough record of their entire meeting just like a companies minutes from a board meeting. It is very rare these days to find anything unusual in the minutes so it’s 9.5 times out of 10 a non event. But you never know you luck so it’s still worth a look and is always recognised by most economic calendar providers as a ‘high impacting’ event even though nothing ever happens, because it has ‘potential’.

Understand the Central Bank Process for Changing Policy

Every time the central bank changes policy or even talks about changing policy, it is a trading opportunity. But before you jump the gun and put the house on an interest rate change be sure to understand the process. It’s simple and very methodical. If they are Neutral they will signal to the market through the Statement or speeches that they are thinking of changing rates. They go to a Hawkish or Dovish stance. They just don’t raise rates straight away. They may be hawkish/dovish for a few meetings which means there is potential every month for a change. They are just waiting for the final pieces of the puzzle to drop into place. In this situation trading can be very active and the market will respond aggressively to the economic data releases. Once they are certain of the outcome they will change rates. They then usually go back into a Neutral phase and the process starts again. If the numbers are sup[er strong they go Hawkish again or super weak they could go into a Dovish tone. If the economic numbers chnage back they go back to a Neutral phase again. It’s the economic data that makes them chnage their tone and eventually forces them to change rates.

They are methodical and transparent so it’s hard to miss the signals!

Let me Connect all the Dots

So as you can see the central bank has their hands full assessing interest rates and forward predicting the economic conditions 6 months in advance. But the fact is traders know this process inside out. It’s no secret to any bank traders and in fact the central banks want you to know what they are doing because that makes the transition from one policy to another smoother, instead of massive disjointed knee jerks on surprise results.

So the full cycle goes from Central bank meeting to Central bank meeting:

  1. The central banks provide the interest rate decision and forward guidance at each meeting.
  2. Traders then ‘trade’ the economic data releases in accordance with the central bank ‘forward guidance’.
  3. Then the central bank meets again and do it all over again.

The potential for the central bank to follow through on it’s promises depends directly on the economic data releases. So as the economic data is released over the month the market adjusts it’s positions according to the result in connection to the central bank guidance. This is why the currencies go up and down on the top tier data releases.

And it’s this cycle that creates the trading opportunities. You just need to be able to identify the components and that’s why we developed the Pro Trader course to explain this process to you.

trading cycle

If the economic data follows the central bank forward guidance then we get gorgeous trending markets and we make loads of cash. If the economic data is ‘all over the shop’ or ‘against’ the central bank forward guidance then we get choppy (crappy) markets and making money seems harder. In the latter situation what normally happens is the Central bank will wheel out one of their ‘less important’ guys to drop the bomb in a speech…either to let you know they are still on track or if they have had a change of heart. That’s why the market pays particular attention to Central bank speeches regardless if it’s the Governor/President or just Joe blow the analyst.

Also another scenario that creates really good reversal trades is when the central bank comes out hawkish for example and the next 2-3 big economic numbers after the meeting are weak, against the central bank forecast, well the chance for their plan coming off has pretty much gone and you get massive swing reversals.

The Significance of the FED versus other central banks

The USD is the global benchmark for all currency pairs and the USD is the most traded currency in the world. So the US Federal Reserve has a much bigger impact on global markets then any other central bank. It’s kind of obvious. So you need to factor this in when you are assessing the potential trading opportunities as you’re more than likely trading the majors. If the FED changes policy it will impact just about every currency pair. On the other hand if the Reserve Bank of Australia (RBA) changes policy then it will only impact the AUD. The other major central banks decisions impact their own economies and currencies. So the impact on other majors pairs may be limited to the simple correlations. Also when you are weighing up trading a major currency pair understand you should be considering the ‘stance’ of both central banks related to that pair. For example there’s no point getting long EURUSD if both the FED and ECB are both hawkish. As the currency pair won’t move. On the other hand if you know what both central banks stance is and one changes policy then you have a great trade on your hands. Keeping up to date on all central bank policy is hugely important and that’s why we feature it on our Analysis pages on the website.

So back to identifying the Best trading opportunities

You need to first of all understand the central bank processes and that’s why I spent so much time going through it. The anticipation and all the hype comes from the Central banks. This is the starting point from which you find all the best trading opportunities. Once you’ve got this under control then all you need to do is ‘review’ their last Statement and this will (should) provide the ‘guidelines’ (forward guidance) for identifying the best trading opportunities. This is why on our Daily analysis pages we have both the Long term trend and Short term bias close together…. if they match it’s game on! If they are mismatched it may be time to pause and wait.If there is a match in direction, then all we really need is to keep an eye on the economic data releases relevant to each currency pair as they will provide the driver! If we have the current sentiment (short term bias) moving with the Central bank forward guidance (the long term trend) then all we need is a strong Fundamental driver (the economic data) to be in the same direction and we are good to go! The icing on the cake would be a trendline in close proximity which would provide the ultimate low risk entry and high probability trade.

These are the trade set ups you dream about!

They do happen frequently, but not everyday. And this is where your patience and your diligence in completing your daily analysis pays off. So can you now understand why WE and the market follow the economic data releases so closely?

What we are actually trading is the next central bank decision and that’s where the cash is.

If you have any questions or find this too confusing please let me know in the comments section below.

Brad

NB: Oh and by the way “Geopolitical events” … if they arise, then all trades are off!

The central bank sentiment/policy doesn’t matter, nor will the economic data releases. It creates panic and uncertainty and central bank policy will be over looked completely.

With this in mind we always wait and stay out of the market until they subside.