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.

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!