Explaining the Forward Guidance Principle

Between two central bank meetings, an economy changes for good or for worse. A central bank’s job is to interpret the economic data released between two meetings and set the monetary policy for the period ahead.

forward guidance

The time interval between two central bank meetings differs around the world. In the United States, for example, the Fed meets every six weeks. The same in the Eurozone, where the ECB (European Central Bank) also meets every six weeks.

Australia and the United Kingdom differ. The two central banks use monthly and assess the state of their respective economies.

When the ruling bodies of these central banks meet, they don’t just set the interest rate, but the overall monetary policy. Moreover, sometimes they only make sure that the economy goes smoothly, and they re-assure the market participants that everything follows a plan.

That’s forward guidance: the process of communicating to the market the next moves in such a way that no turbulences appear.

It’s not an easy task. In fact, central banks were forced to implement such measures due to the increasing importance of high-frequency trading.

High-Frequency Trading and Forward Guidance

Robots dominate trading these days, both regarding the number of orders executed, and, recently, regarding “thinking” and interpreting future market moves. Such robots or trading algorithms run thousands or more trades per second (sometimes even per millisecond), with the intention of profiting from the slightest market move.

As such, the time frames became so small that the classic pattern the human eye sees, won’t do the trick in this world. There’s no head and shoulders or rising wedge pattern visible on the one-second chart, or even lower.

If the retail traders buy and sell on trading accounts with five digits on most currency pairs (even though the 4th digit is still the one that defines a pip), for trading algorithms things look fundamentally different: they trade on the 7th digit, or even more.

Because of these algorithms and the increase in the number of trades they execute, the market fluctuated more and more in the recent years. As such, something had to happen. Enter Fed.

The Federal Reserve of the United States Moves

The Fed was the first bank to introduce the term, and the concept known today as the forward guidance principle. Its move was a bold one.

It introduced a press conference to follow every second Fed meeting. During the press conference, the Chairwoman/Chairman, explains the FOMC (Federal Open Market Committee) Statement takes a question from the press representatives.

During the press conference, it provides “forward guidance” on the next Fed moves. That’s all that matters for the Forex market as it moves based on future expectations.

A recent example happened when the Fed started the so-called quantitative tightening program (selling the bonds bought under the quantitative easing program). At the press conference, Mrs. Yellen described the process as “boring as watching an oil paint dry.”

And so, it turned out so far, with little or no reaction from the market. It means the Fed provided the right forward guidance, and the market wasn’t surprised by the move.

Conclusion

Other banks quickly followed in the same footsteps. The first one was the ECB (European Central Bank).

It changed the number of meetings in a year (from once a month to once every six weeks) and added the forward guidance.

In fact, central banks did what retail traders had to do for years: adapt to the constant changes in the Forex market.

Correlations in the Forex Market

The Forex market moves in a correlated manner. The by-products, the currency pairs, act like being correlated too.

Correlation doesn’t refer only to two or three currency pairs, but also to a currency pair and a different financial product, like a stock index, or a commodity.

Today’s Forex brokers offer more than just currency pairs. Because of the fierce competition between different brokerage houses, every broker tries to differentiate from the crowd.

As such, they offer CFD’s (Contracts for Difference), commodities (gold, oil, silver), and other products like bonds and so one. Depending on the size of the broker and the resources available, a Forex trader has access to different products from different brokers.

Major and Cross Pairs

The first correlation comes from the way the Forex market is organized. Everything surrounds the world’s reserve currency, the U.S. Dollar.

When sovereign entities save their reserves, most of them keep them in American dollars. This makes the Federal Reserve of the United States the most important central bank in the world.

Moreover, it dictates the way the currency pairs appear on the Forex dashboard. As a rule of thumb, any currency pair with the U.S. Dollar in its componence is called a major pair. Every other ones are crosses.

Therefore, the dashboard divides the currency pairs into two parts: major and cross pairs. They have different volatilities and different ranges, even various factors that influence them.

However, they have all one thing in common: they’re correlated.

Of course, not all of them. But, three by three. For every cross moves based on the differences between the two crosses it represents.

Here’s an example the EURGBP cross depends on the moves two major pairs will make: the EURUSD and the GBPUSD. If the two majors won’t move or move the same percentage, the cross will remain flat.

Just like that, any other major pair depends on two crosses. I live you to find out the crosses for every major part of the Forex dashboard.

The Canadian Dollar and the Oil Market

The Canadian dollar moves in a direct relationship with the oil price. That’s normal if you consider the fact the Canadian economy is an energy driven one.

Forex Correlations

More precisely, it heavily depends on the oil price, it employs a lot of people in the energy sector and has one of the most significant oil reserves in the world.

Therefore, when the oil price dips, the USDCAD pair, the most critical CAD pair, will rise. Of course, it will fall when the oil price falls too.

The USDJPY and the U.S. Equity Markets

Perhaps the most interesting correlation is the one between the USDJPY pair and the U.S. equity markets. More precisely, they enjoy a direct relationship.

At different points in time, even the distances traveled are the same, percentage-wise. Some other times, the correlation breaks due to differences in the monetary policies between the two countries, but, eventually, the two markets will become correlated again.

Conclusion

While a correlation offers a healthy perspective over various financial markets, a rule of thumb says that a correlation holds right until it doesn’t anymore. In other words, it may be just a coincidence that two products are correlated for a period.

One thing is for sure, though: the real correlation that exists on the Forex market is the one between the cross and its true majors. If the financial system as we know it today (centered around the U.S. Dollar) exists, this correlation will stand the test of time.

 

US Inflation to Move Markets

After the Non-Farm Payrolls, last Friday showed the U.S. economy lost over 30k jobs, the focus shifts to the new set of economic data: inflation.

This coming Friday the Consumer Price Index (CPI) will show if the recent increase in the Average Hourly Earnings (AHE) translates into higher inflation. If yes, the dollar will be in demand.

However, a miss on the CPI on Friday will put the eventual Fed rate hike on hold.

US Inflation

Fed Minutes to Confirm the Bank’s Hawkish Statement

On Wednesday, the Federal Reserve of the United States will release the minutes corresponding to the previous meeting. Considering how hawkish the Chairwoman Yellen was, I wouldn’t be surprised to see the same message coming around.

It shouldn’t matter much for the dollar. As always, the minutes lag as they refer to something that happened three weeks ago.

In the last years, it became a habit for the Fed to hike rates in December. It did so on the previous two occasions it had.

Expect this 2017 to bring the same decision. And, it is not by chance that the Fed picks such a month.

End of years flows will be most likely gone by the time the decision comes. The market’s volatility will be subdued too.

As such, the current FOMC Minutes release this week will most likely reinforce the Fed’s hawkishness.

Therefore, the market’s attention will shift to the CPI data on Friday. While the actual CPI month over month is expected to show an increase from 0.4% to 0.6%, the Fed doesn’t look at it.

PPI to Offer a Clue

Instead, the Fed considers the Core CPI data as more relevant for the actual inflation. Just to be clear, the core inflation data doesn’t consider the transportation, food and energy prices. They are too volatile, and the Fed tends to focus on the core numbers.

Therefore, the dollar will jump only if the core data will surprise positively. The forecast, however, shows a 0.2% level, a steady one when compared with the September release.

One day earlier, though, we’ll have an educated guess about what the CPI will print. The inflation on the producer side (PPI) will come out.

Typically, if the PPI rises, it is only a matter of time until the CPI will catch up. As such, traders will open positions based on the PPI created expectations.

Inflation as Part of the Mandate

The NFP data last Friday, while disappointing, wasn’t accompanied by an increase in the unemployment rate. This one dipped.

Many voices put the weak number on the back of the three hurricanes that hit the States. They may be right.

In any case, the jobs data is only one part of the Fed’s mandate. The other one, the inflation-related part, is a much tougher one.

To bring inflation below or close to two percent, the Fed must be flexible enough with the rates. In doing that, it will try to have a balanced approach.

Conclusion

Expect the trading week to be a slow one until Friday. Already today the price action was subdued as the United States banks were on holiday.

The EURUSD pair moved in a minimal range, and other currency pairs followed suit too. Look for this environment to change as we go dipper into October trading, with inflation holding the key for the end of the year flows.

What Makes CAD Dependent on Oil Prices?

There’s no Forex trader that didn’t notice the strong relationship between the Canadian Dollar (CAD) and the oil market. The link is so strong that most of the times nothing else matters for the Canadian pairs.

Have you ever wondered why this correlation exists? What are the factors that drive it?

It all starts with the Canadian economy…

Canada – An Energy Driven Economy

A big chunk of the Canadian GDP (Gross Domestic Product – total values of goods and services an economy produces) comes from the oil industry. As a big producer and refiner, the Canadian’s economy depends on the oil price’s fluctuations.

Moreover, the energy sector employs the most people. As such, fluctuations in oil prices are not welcome.

When the oil price dropped from over a hundred U.S. dollars to around $30, where was the move felt first on the Forex market? On the CAD pairs.

The USDCAD reacted the most, reaching values that were unthinkable a few years earlier. 1.46 and something was the high, with an almost vertical move.

usdcad vs oil

As such, we can say the CAD and oil enjoy a relationship. The rule of thumb says that when the oil prices fell, the CAD falls too. And, when oil is on the rise, CAD jumps as well.

This is important because it is a one-way street. It all depends on the oil prices, not on the CAD value.

For the Forex trader, it means that the USDCAD moves based on the Canadian economic news only when there’s no oil related data to be released.

What Matters for the Oil Market?

Because of that, the oil data is important. It gives a quick look into the supply and demand imbalances. And, it generates huge market fluctuations.

US oil inventories generate spikes in CAD volatility. Why?

Over three-quarters of Canadian oil exports go to the United States. In a way, it’s normal. The two countries share a border.

Moreover, the United States is the biggest economy in the world. Hence, it has a big appetite for oil products.

Therefore, the oil inventories levels in the United States generate fluctuations on the CAD pairs. When inventories rise, the assumption is that the United States won’t import that much oil from Canada in the future. Hence, this is bearish CAD, and bullish USDCAD.

On the other hand, when inventories fall drastically, the oil price jumps. Together, the CAD jumps too, and the USDCAD will trade with a bearish tone.

OPEC (Organization of Petroleum Exporting Countries) meetings end up with oil fluctuating aggressively. Therefore, make sure you know when the economic calendar tells such a meeting will take place. Until traders find out the outcome, the USDCAD and the CAD pairs, in general, will simply not move.

Conclusion

The USDCAD is one of the most difficult currency pairs in the Forex market. There are several reasons for that.

First, it is a major pair. After all, it has the USD in its componence.

Second, it considers oil and all is volatile.

Despite all these, the pair is one of the most illiquid currency pairs.

To sum up, the key to master the CAD in Forex trading is to know what matters for the oil market. The correlation degree between the two is so strong, that the USDCAD and oil charts are almost identical in their moves.