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.

European Central Bank’s Interest Rate Preview

The most important economic event of the fall comes this Thursday. The European Central Bank (ECB) is poised to change the monetary policy for the Eurozone area, with all eyes on the Euro’s reaction.

It’ll be a landmark decision, as the central bank will alter the bond-buying program further. As always, it’ll do it in such a way to please both hawks and doves.

Almost a year ago, in last December, the ECB started a controversial process: scaling down the bond-buying program. To avoid the taper tantrum caused when the Fed began the same program, the ECB vowed to better-communicate its decisions and to exit the stimulus gradually.

It is no wonder, as the Eurozone economies perform better. Negative rates won’t fit the bill anymore.

With PMI’s (Purchasing Managers Index) pointing to stronger growth in both manufacturing and services sector, and with the unemployment rate looking better and better, the hawks in the Governing Council will try to push for a further stimulus reduction. However, if last December was confusing, expect this decision to be the same.

Current ECB Bond-Buying Program

Under the current program, the ECB buys 60 billion Euro worth of bonds each month. It announced the decision in December 2016 when it created much confusion: while it reduced the program from 80 to 60 billion a month, it extended it for a further nine months. Therefore, the question on everyone’s lips was: is the ECB tapering, or not?

Almost nine months later, this Thursday we should see something similar. The market consensus is for the ECB to reduce the bond-buying program with a further 30 billion/month. That’s tapering!

However, the central bank may pull another stunt and extend the horizon for a further nine months or so. As such, instead of abruptly ending the program, the ECB, while tapering, takes the foot off the gas slowly, not to disturb the markets.

As such, both bulls and bears will have something. The first ones will argue that the ECB reduces the stimulus as now they’ll buy fewer bonds. The other ones will say that fewer for longer is still easing and they’ll sell the Euro.

Long story short, expect the market to be volatile surrounding the press conference.

Euro Ahead of the Event

Euro traded in a range ahead of most of the other currencies for the past month or so. The best one to illustrate this is the EURUSD pair: it stays above 1.17, but below 1.19 for the same period.

Technical traders look for the range to break, with probably pending orders on both sides of the market. Fundamental ones, though, will wait to see the ECB decision. Therefore, it is unlikely that the pair will move much until the release.

The other Euro pairs had a similar trajectory. Ranging seems to be the name of the game, with EURGBP. EURAUD and EURJPY leading the way. Not even Mr. Abe’s re-election wasn’t enough to send the JPY pairs higher.

Conclusion

Expect the Euro pairs to range until Thursday’s event, and to break the ranges shortly afterward. The importance of the ECB communication strategy is obvious via the small ranges the Euro pairs held.

Moving forward, as we get closer to the end of year trading, there’s still time for some critical market moves. Market participants have an eye on the U.S. monetary policy too, so ending on the right side of the market may be a bit trickier this year.

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.