Ahead of the FOMC Meeting – September 19, 2017

The Federal Reserve of the United States is about to announce the start of the so-called “quantitative tightening” program. Also known as QT.

It is the exact opposite of the quantitative easing (QE). Under the easing program, the central bank bought U.S. Government bonds. As a consequence, it flooded the financial system with liquidity.

The new program should have the opposite effect. Slowly but surely, it will drain liquidity from the markets.

FOMC Meeting

However, there’s the catch. The Federal Reserve of the United States may be the U.S. central bank. But, when setting the rates on the dollar, it sets the rate for the world’s reserve currency.

The Fed and the Federal Rates

The problem for the rest of the world is that it borrowed massively during the 2008 financial crisis. And, it borrowed in dollars, because the interest rates were down to zero.

Now with the Fed already raising the interest rate to one percent or more, and with the upcoming QT program, the world will experience a dollar shortage.

As such, the dollar should increase in value. That’s the usual effect of a tightening monetary policy. And this one in the United States looks like delivering a double blow to dollar bears.

So far, the markets couldn’t care less. The EURUSD has the 1.20 in view, AUDUSD flirts with 0.8, and the GBPUSD broke 1.36. It even recovered into the Brexit move’s territory.

Monetary Policy Transmission Mechanisms

In a way, this isn’t surprising. The monetary policy transmission mechanisms lag current prices.

The fact that the dollar is so weak is unusual. For the Forex market never expects the actual monetary policy decisions to make their way into the real economy. It’ll act on expectations.

For example, when a central bank becomes dovish and loosens the monetary policy, the currency will react on the spot. Market participants won’t wait for the effects to appear in the real economy. They’ll sell the currency right at the moment the new measures were announced.

What Next for the Rest of the Year?

The world is in limbo. The North Korean showdown puts the JPY on fire, even though it is interesting why the market looks for shelter in a currency that belongs to a country that sees ballistic missiles flying over the population heads. Perhaps the market discounts the North Korean threat.

In any case, the USDJPY looks bullish. If anything, the USDJPY and USDCHF seemed to have been kept at current levels only by the risk off environment lately.

Take that away, and 116, respectively parity are in focus. As for the Euro, the ECB looks to end its quantitative easing program. However, it’ll have a long way until normalizing the monetary policy.

Now that the EURUSD almost broke the 1.21 levels, fewer people favor shorting the common currency. But, if the EURGBP tells us anything, it is not a bullish story.

Conclusion

A higher Euro was the central theme over the summer. It grew against the American dollar and the Great Britain pound, without correcting much. However, summer trading isn’t always relevant for the year. Expect the dollar to fight back, and the current monetary policy differential across the globe might be just the reason for its bounce.

Euro and the ECB

Yesterday’s ECB (European Central Bank) meeting was the main event of the week. All eyes were on Draghi and the monetary policy conditions to be announced.

As such, the Euro was in focus starting with Monday. And, it didn’t disappoint.

For the whole summer, the EURUSD pair moved in an almost vertical line. It rose from 1.05 to 1.20 in less than five months.

Euro

While such moves are not uncommon in the Forex market, they’re not that common for a dollar pair. Many traders tried to fade the move and sold new highs. However, new buyers stepped in on each and every dip.

But why would the EURUSD surge so dramatically?

The Interest Rate Differential

One reason would be the interest rate differential. The only thing is, it should have favored the dollar. Not the Euro.

While the interest rate in the United States rose to 1%, it is still negative in the Eurozone. As such, the interest rate differential should favor the U.S. dollar. Not the Euro.

Yet, the EURUSD pair rose dramatically. The thing is that Forex traders focus on expectations more than on the actual situation.

And, for the whole summer, the signs from the Eurozone economy were positive. Unemployment dropped, GDP (Gross Domestic Product – the total value of goods and services) rose, industrial production as well, PMI’s look good…all signs of a strong and healthy recovery.

Because of that, trader’s expectations grew that the ECB will react. And, that the Fed won’t do anything moving forward.

As such, if the ECB will start tightening the monetary policy (reducing the size of the quantitative easing program), the interest rate differential will shrink. And that’s what drove the Euro higher.

This Week’s ECB Meeting

To many people’s disappointment, the ECB didn’t deliver. Not that traders expected new measures to be announced this week.

But, at least a hint at what’s about to come. Instead, the ECB chose the path of least resistance. Let’s sit and wait and see what will happen.

All bets are now on the October meeting. It is supposed to bring a schedule for the ECB to reduce the bond buying program.

This, alone, is bullish for the Euro. Will send the EURUSD skyrocketing higher. However, only if the Fed won’t change anything. But this is unlikely.

Comes Fed into Discussion

Following the 2008 financial crisis, the Federal Reserve of the United States (Fed), embarked on various monetary policy programs. All destined to ease the monetary conditions.

As a result, the dollar weakened. Moreover, the Fed’s balance sheet increased exponentially.

Now, the Fed started to tighten the monetary policy. It hiked the interest rates four times, lifting it from zero to 1%.

Furthermore, it vowed to start unwinding the balance sheet. Therefore, it will start selling the bonds in its portfolio.

Of course, this will be a gradual process. But, it has a tightening effect on the monetary policy.

Conclusion

No matter how you put it, the Fed seems to be, again, ahead of the curve. While the Euro buyers base their trades on future expectations, dollar bulls look at what happens with the Fed’s actions.

However, there’s one wild card that doesn’t shows up neither in Eurozone nor in the United States. That’s inflation.

If, when and were inflation will pick up first, that’s where the money will flow. Because expectations will grow that the respective central bank will tighten the monetary policy faster. Hence, the cost of money will rise.

Interest Rates and the NFP – What to Expect This Week?

The US dollar is in a free fall lately as sellers emerge on every spike higher. Despite the fact that the Fed is the only major central bank raising rates, nobody wants the dollar. Not even for a safe-haven status.

When investors look for shelter, they buy safe assets. Typically, in the Forex market, these are the JPY and the CHF currencies. But also the US dollar.

Not this time. It turned out this summer it was the Euro’s turn to squeeze. And, it did that in quite a fashion.

While the EURGBP cross pair moved almost vertical for the last four months, the EURUSD did the same. But what would be the reason for the EURUSD to move so aggressively against the dollar?

For sure, not the interest rate differential.

interest rates

Interest Rates in Eurozone and the United States

A quick comparison between the two leaves us with a huge interest rate differential. Favorable to the USD. Yet, it is sold across the board.

Being long on the EURUSD pair this summer paid the price. Even if the pair is one of the most expensive ones to keep over night. Because of the interest rate differential in favor of the dollar, the EURUSD longs have to pay a negative swap.

Effectively, at the end of each trading day, brokers deduct a small amount from EURUSD longs trading accounts. But it didn’t matter as the EURUSD pair overly compensated with such a strong bullish move.

However, the interest rate in the Eurozone is negative. Yet, investors favor the European currency instead of the USD.

On the other hand, in the United States, the Fed hiked the rates multiple times. Only this year, it did so twice.

While not much, the federal funds level sits at a solid 1.25%. And, the expectations are for the interest rate to rise still.

Friday’s NFP in Focus

With the recent decline over the summer, the USD is in the longest losing streak in the last fourteen years. That’s quite something considering the interest rate differential with other currencies.

The NFP this Friday has the potential to be a game changer. It may open the gates for the next rate hike in the Fed funds rate.

A solid print, however, is not something new. The strength in the US jobs market is evident for quite some time now. Unemployment rate keeps falling.

It must be accompanied by a rise in inflation. Then and only then, market participants will favor the dollar.

Because the Fed has a dual mandate, it looks at both inflation and jobs creation before hiking the rates. But those shorting the dollar must not forget the Fed is in the middle of a tightening cycle. It means the interest rate differential will rise. Eventually, traders will give up in search of the ever higher yields.

Conclusion

The market moves based on the fundamental and technical analysis. And, on supply and demand imbalances. But the Forex market is so liquid, that only when big players, or when macro economic dynamics change, the market will change.

Until then, it may still remain irrational. When this happens, usually retail traders get stopped. Almost all of them.

High-Frequency Trading in Forex

High-Frequency Trading or HFT refers to automated machines (supercomputers) that buy/sell thousands of trades per second. The idea is to profit from even the smallest market move.

The industry exploded lately. It is dominated by big players that invested massively in computers able to automatically execute trades as fast as possible.

Why do retail traders care? Well, the Forex trading environment changed for a fact.

Patterns do not look anymore as they did before. And with technological advances, the trading arena will change still in the years to come.

high-frequency trading

Fundamental Analysis and HFT

These supercomputers buy and sell a currency pair mostly based on fundamental inputs. Quant firms use complicated math algorithms to buy and sell currencies on news releases.

The economic calendar helps. Everyone knows the news ahead.

It includes the previous data and the forecasted one. And, on top of it, the way a currency should react.

For a programmer, these inputs are enough to instruct a trading algorithm to buy or sell. And when they do that, they beat any retail trader due to:
– higher execution speed
– bigger volume

Now you have an explanation as to why the Forex market makes sudden moves. Why, when the news gets out, the market makes huge spikes in a blink of an eye?

The answer comes from HFT and automated trading. While humans cannot buy or sell a security at the same time, computers can. Hence, all trading algorithms are instructed to buy or sell a currency based on the same inputs.

As such, the supply and demand balance changes. So, even the most liquid market in the world, the Forex market, gets to move when the volume increases.

Technical Analysis and HFT

As for the technical analysis, HFT’s fast execution changes influences patterns. These days it is hard for a market to form a double or triple top.

Such classic patterns have clear rules, but those rules won’t work today. A top may be an area, rather than a level. And, the examples can continue.

Even trading theories changed. The Elliott Waves Theory is made of patterns that appear on various cycles. Cycles of different degrees.

But it is also strongly depended on Fibonacci levels. However, at the time it was developed, in the 1940’s, the Fibonacci numbers were applied from the end of the move.

Yet, today, the end of a move differs. Only a few years ago the EURUSD pair had three pips spread. Nowadays, the spread is 0.02 or even less for some brokers.

This changed the end of a pattern. Or, the end of a candle. Almost three pips difference may mean a lot for a trader that has a ten pips target. That’s thirty percent!

Conclusion

Statistically, over eighty percent of the trades are executed automatically. Traders place stop loss orders and take profit ones, pending order to enter/exit a market, etc.

On top of that, HFT trades with fabulous speeds. If the retail trader calculates a pip as the fourth decimal in the EURUSD pair, the HFT robots trade for the ninth or even tenth one. Sometimes, even more.

Unfortunately, this spells trouble for the retail trader. The trading game is not fair.

However, it doesn’t mean that retail traders cannot make it in this market. It only means that the gap, instead of closing, is getting larger by the day.

Why is Forex Trading Difficult But Profitable?

Why Is Forex Trading Difficutl

Forex trading involves buying or selling a currency pair to make a profit from its movement. But, why do currency pairs move in the first place?

Except they’re in a monetary union, like the Eurozone, every country has a currency of its own. The US dollar in the United States, the Canadian dollar in Canada, the Pound in the United Kingdom, and so on.

A currency reflects the shape of that respective economy. A stronger economy has a stronger currency.

The Forex dashboard comprises different currency pairs. Or, pairs two currencies with one another.

They reflect the differences between the two economies. As such, they move a lot.

This is what matters for Forex traders. When the currency pairs move, there’s scope for some profit to be made. Or, a loss.

Why is Forex Trading Difficult?

Forex is the most difficult financial market in the world. If you make it here, you can make it in any other market.

Other markets have their technicalities, specific conditions, and so on. In some cases, they are even limited.

Not the Forex market. Over five trillion dollars change hands every day in this market.

This is both a blessing and a curse. Blessing, because traders can virtually sell or buy unlimited amounts.

Do you want to dump a hundred lots of a currency pair? Not a problem in the Forex market.

Liquidity is there. But, with liquidity, comes risk.

Prices change in a blink of an eye. On no new, no nothing. Simply, they stretch for some stops.

The players in the Forex market make it very difficult for traders to succeed. Central banks, Forex brokers, liquidity providers…all have an interest in this market.

Some apply the monetary policy, like is the case with central banks. Others, simply trade in the opposite direction of their clients, like some Forex brokers.

But, the most important factor comes from the algo-driven conditions in the Forex market. High-frequency trading, or algo-trading, is king here.

Why is Forex Trading Profitable?

Retail traders didn’t have access to the interbank market until relatively soon. A decade ago or so, technological advances allowed for brokers to target retail traders.

As such, every trader’s dream of financial independence come closer to reality. Not that everyone wins.

But, at least the idea that one can make it on the financial markets attracts people. And, some do make it.

With knowledge and a disciplined approach, trading is profitable. It may be the most time-consuming and full of stress job on earth, but it is worth it.

Fortunes can be made virtually overnight. That is, in a shorter period than working a regular day job.

But, careless traders can lose too. Unfortunately, retail traders fall into the second category most of the times.

Conclusion

Even though conditions are against retail traders, the fact that now they can access the interbank market at a very low cost offers an amazing opportunity. One that didn’t exist some time ago.

As such, the possibility is there. Hence, only the idea that huge profits can be made, attracts and will still attract people to Forex trading. No matter how hard it is to make it in this industry!