Fundamental Analysis – Explaining the Forward Guiding Principle

Central banks all over the world deal with two things: setting the monetary policy for that specific region, and communicating it. Both are extremely important for the central bank’s mandate as well as for the overall financial system. Bankers cannot be blunt when talking about monetary policy. A central banker cannot openly say that at the next meeting the bank will hike or lower the rate corridor. If this was done, the financial system would be subject to disruptions. These days, traders follow robots, and not the other way around. Because of this, aggressive market moves happen in a few milliseconds. Flash crashes melt accounts and the value of a currency before anyone can react. Financial trading is subject to quant analysis, and traders, as humans, can only adapt. Fortunately, these robots are, in the end, programmed by human beings too, so the human element is still there. The two most recent examples come from the Swiss National Bank (SNB) and the Bank of England. When the SNB dropped the 1.20 peg for the EUR/CHF pair, the whole Forex dashboard experienced a mayhem moment. EUR/CHF fell below 0.87 in an instant, while other currency pairs exhibited increased volatility. Brokers were busted, and traders on the wrong side of the market received margin calls. After the Brexit vote, the GBP/USD crashed in one Asian session when liquidity was poor. So violent was the move that the pound dropped almost 1,000 pips against the dollar. These two events tell us that even though central banks are aware of a possible disruption (the SNB knew, of course, that they were going to drop the peg and were prepared beforehand), the exact course of action cannot be controlled and anticipated because of the high-frequency trading and the trading algorithms involved in today’s trading.

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What is Forward Guidance?

The idea came from the United States; from the Federal Reserve (Fed), to be more exact. Until a few years ago, the Fed didn’t hold a press conference after the Federal Open Market Committee (FOMC) meeting. As such, the market was left only with the statement, and that was traded aggressively by trading algorithms as soon as it was made public. So, the Fed introduced a press conference that now follows every other FOMC decision.

Fed Projections

The press conference has two parts. In the first part, the chairman/chairwoman reads the statement. The content of this is already known, as the press conference starts 30 minutes after the statement is released. This is to give time for market participants to adapt to the new statement, and for prices to have time to calm down. The correct interpretation is key. In the first part of the press conference, the Fed’s projections for the next years are presented in the form of charts. These projections refer to the two parts of the Fed’s mandate: inflation and jobs creation (unemployment rate). It is customary for the next 2 years to be considered, as well as the medium- and long-term period. The further the projections are deviating from the mandate, the bigger the volatility will be and the more the dollar will move across the board. Such times are the most vicious in trading the Forex market, because wild moves appear out of nowhere.

The Dots

Still part of the first part of the press conference, short- to medium-term interest rate projections are made public. These projections come in the form of dots representing the interest rate level each FOMC member sees as appropriate in the next 2 years and beyond. The median of these dots is important. The higher it goes, the more bullish it is for the currency. If it is revised lower since the previous projections, the dollar will suffer. Both the dots and the staff projections are part of the Forward Guiding principle the Fed implemented. The idea behind it is to better communicate to market participants the Fed’s intention, and so to bring transparency with the monetary policy decisions. Whether this is achieved or not is the subject of another discussion.

Fed Members’ Speeches

An important part of the Forward Guiding principle consists of the Fed members’ speeches. The members are scheduled to deliver speeches and to appear in the financial media multiple times between two Fed meetings. This happens because sometimes the market does not fully understand the Fed’s intentions, and these guys come along to clarify things. The clearest example comes from the March 2017 Fed meeting, when the Fed raised the rates. However, 2 weeks earlier, the implied probability of the Fed hiking rates in March was around 30%. The Fed members who were scheduled to speak ahead of the actual meeting made sure that the market truly understood that a rate hike was coming. In other words, after a few members gave speeches or appeared on financial news and other financial channels, the implied probability of a rate hike reached 100% a week before the actual start of the FOMC meeting. In this way, the Forward Guiding principle worked like a charm: markets knew a rate hike was coming, so when the hike did come, the market reaction was a muted one. This is the idea behind the Forward Guiding principle: to maintain price stability during extraordinary events.
Forward guidance - 1
The image shows an example of such a speech that was released as part of the Forward Guidance principle. In this case, one of the FOMC members, Charles Evans, was due to speak about current economic conditions and monetary policy at the National Association for Business Economics luncheon in New York. Note that questions from the audience were expected. This is the time when these central bankers further reiterate the Fed’s intention. Such speeches are known about in advance – both the time and the subject – and traders position accordingly. Volatility rises if the expected message is different from the general market consensus. In the case of the event listed above, as you can see it is listed as having a medium impact, suggested by the orange colour. However, this is not necessarily true, as sudden spikes in volatility during these kinds of events are the norm when trading the Forex market. In other words, the best approach is to try to be proactive rather than reactive. Other central banks in the world have done the same and followed the Fed’s path. In some jurisdictions, the principle is different in some details, but the idea is the same: better communication so that market participants will know in advance what the central bank is thinking and plans to do next with its monetary policy.

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