Fundamental Analysis – CPI and Its Importance in Forex Trading
Speculating on the currency market means to buy or sell a currency pair with the idea of making a profit. This statement means something else for different traders, based on various factors. One can be the size of the trading account. It is proven that traders with a small size trading account have the tendency to risk more as they can afford to lose the account, while traders with a bigger trading account are more conservative. From this point of view, the first category of traders will engage in scalping techniques and will end up overtrading the account, while the ones in the second category will adopt swing trading techniques and even looking at the bigger picture to invest in the currency market. Another way to make a profit in the Forex market is to trade the news. This is part of fundamental analysis, and even here traders are split into two categories. Retail traders, or the ones with a small trading account, will look at economic data as only an opportunity to add some quick pips in the trading account. While this may work from time to time, in the end, one small mistake and the trading account is gone. Professional traders, like fund managers and all, are looking at the economic data from a macroeconomic perspective. That is, comparing different economies based on the macro picture and take a trade in the direction of buying or selling a currency because of their fundamental view. The time horizon for these trades is bigger than in the case of retail traders, but these ones are rarely ending up on the wrong side of the market. Resources dedicated to the research trading department make the difference in this world. Previously on the articles dedicated to the fundamental section of this part of the Trading Academy we were introducing the economic calendar and its importance. As mentioned in other articles, everything on the economic calendar is about what a central bank is going to do with the interest rates and monetary policy the next time its governing body will meet. If for example, one is interested in trading the Euro, all the economic data as listed in the calendar is interpreted considering what the central bank, the ECB (European Central Bank), will do next time the Governing Council will meet. That’s it!
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What Matters for a Central Bank?
Having said all the above, the next thing traders do is to filter all the economic data about a currency. The filtering considers two central bank meetings. To be more exact, in the case of the ECB, the central bank is meeting on a Thursday, every six weeks. Traders’ task will be to look at every piece of economic data in the calendar that is going to be released in the six weeks between the two central bank meetings. The ones with the red color are the most important ones, while the ones listed in orange and yellow are second tier data. Nevertheless, they all, together, give an educated guess about what the central bank is going to do at the next meeting. Will it change the monetary policy statement? Will it raise or cut the rates? Will it change the tone and language? The example above is about the ECB, but the same is valid for every major central bank. The RBA (Reserve Bank of Australia) is meeting monthly, on a Tuesday, Bank of England (BOE) is meeting monthly as well, on a Thursday, the Federal Reserve of the United States is meeting every six weeks, and so on.
Consumer Price Index (CPI)
On top of every central bank’s agenda is the CPI or the inflation level. Changes in the inflation level are making the central bank shifting its monetary policy, from easing to tightening, from a dovish to a hawkish language, etc. This is because inflation is on the mandate of every central bank in the world. It is either the entire mandate or only part of it. A classical mandate is to keep inflation below or close to two percent. There is a live debate these days as to whether this inflation level is appropriate in the current times, but, until any changes, we’re sticking to it as it is the one that allows economies to grow at a normal pace.
To continue with the same European example, above is the inflation release in the Eurozone: the CPI Flash Estimate y/y. The y/y means that the piece of data is interpreted on a yearly basis. However, at the time of the release, monthly data becomes available as well. Changes in the CPI level will result in big swings in the currency market, namely, in the Euro pairs. The image above shows that this release was forecasted to come at 1.8%, with the previous number being 1.8% as well. In other words, no changes were expected. Nevertheless, the actual number was 2% (the one in green). Inflation ticked higher and this has consequences for the Euro as a currency. Traders will look at this moment at the ECB mandate: to keep inflation below or close to 2%! By this judgment, the mandate is fulfilled, but the interest rate is in negative territory in Europe and the quantitative easing program is still running at a fast pace. Based on the inflation release, chances were that the next time the ECB is meeting the monetary policy will shift, if not in hiking the rates, but at least in changing the tone of the statement with a more hawkish one. As a rule of thumb, if inflation is rising, the central bank will become hawkish and in the end, will start hiking the interest rates, while if inflation is falling, the central bank will become dovish and start cutting the rates. One week after the piece of information presented above was released, the ECB met and changed the language in a more hawkish one. Thus, the EURJPY, EURAUD and EURGBP pairs were all traded higher. But if you paid attention to the moment the rising trend started, it was NOT when the ECB delivered the hawkish statement, but ONE WEEK earlier when the CPI or inflation was released. Those who know what to look for, where having an early start into a profitable trade!
Sometimes central banks are not looking at the overall inflation data, but exclude some volatile items out of it. Such items are energy prices (oil, for example), food prices, and even transportation. It is well-known that the Federal Reserve of the United States (Fed)’s favored measure of inflation is the Core CPI. If that is not moving, the Fed will sit on its hands and won’t do anything. So far, we talked about central banks as the main drivers in moving a currency, and inflation, as the first thing central banks are looking at before changing rates. Moving forward, we’ll look at other economic releases central banks are considering and, hence, are important for traders to form an idea about what the next move will be.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is forex trading, generalities about trading the currency market.
- Pending Orders Explained
– Different types of pending orders, how to set them, where to find them on the MetaTrader platform, and much more.
- Forex Market Participants
– Who is participating in the Forex market, its structure, componence, and implications of different groups.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
Other Educational Materials
- “Consumer prices, the consumer price index, and the cost of living.” Boskin, Michael J., Ellen R. Dulberger, Robert J. Gordon, Zvi Griliches, and Dale W. Jorgenson. The Journal of Economic Perspectives 12, no. 1 (1998): 3-26.
- The consumer price index as a measure of inflation. Bryan, Michael F., and Stephen G. Cecchetti. No. w4505. National Bureau of Economic Research, 1993.