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.

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.