Fundamental Analysis – Explaining the Forward Guiding Principle
Central banks all over the world are dealing with two things: setting the monetary policy for that specific region and communicating it. Both are extremely important for the central bank’s mandate and 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 would be done, the financial system will be subject to disruptions. These days traders are following robots and not the other way around. Because of this, aggressive market moves are happening in a few milliseconds. Flash crashes are melting accounts and the value of a currency before anyone can react. Financial trading is subject to quant analysis and trading and traders, as humans, can only adapt. Fortunately, these robots are, in the end, programmed by human beings too, so the human part is still there. The two most recent examples come from the Swiss National Bank (SNB) and Bank of England. When the SNB dropped the 1.20 peg for the EURCHF pair, the whole Forex dashboard experienced a mayhem moment. EURCHF fell below 0.87 in an instant, while other currency pairs witnessed increase volatility. Brokers were busted and traders on the wrong side of the market received margin calls. After the Brexit vote, the GBPUSD crashed in one Asian session when liquidity was poor. So violent was the move that the pound dropped almost a thousand pips against the dollar. These two events are telling us that even though central banks are aware of a possible disruption (the SNB knew, of course, that they are going to drop the peg and prepared beforehand), the exact course of the action cannot be controlled and anticipated because of the high-frequency trading and the trading algorithms involved in today’s trading.
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 FOMC (Federal Open Market Committee). As such, the market was left only with the statement, and that one is traded aggressively by trading algorithms when is made public. So, the Fed introduced a press conference that follows every other FOMC decision.
The press conference is having two parts. In the first part, the Chairman/Chairwoman is reading the statement. This is already known as the press conference starts thirty 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. Still, in the first part of the press conference, Fed’s projections for the next years are presented in the form of charts. These projections are referring to the two parts of the Fed’s mandate: inflation and jobs creation (unemployment rate). It is accustomed for the next two years to be considered, as well as a medium and long term period. The further the projections are deviating from the mandate, the bigger the volatility will and 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.
Still, part of the first part of the press conference, short to medium term interest rate projections are being made public. These projections are coming in the form of dots representing the interest rate level each FOMC member sees appropriate in the next two years and beyond. The median of these dots is important. The higher it goes, the more bullish for the currency is. 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 to bring transparency within the monetary policy decisions. If this is achieved or not, it is the subject of another discussion.
Fed Members Speeches
An important part of the forward guiding principle is made 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 is happening because sometimes the market is not fully understanding the Fed’s intentions and these guys are coming to clarify things. The clearest example comes from the March 2017 Fed meeting when the Fed raised the rates. However, two weeks earlier, the implied probability of the Fed hiking rates in March was around thirty percent. The Fed members that were scheduled to speak ahead of the actual meeting made sure that the market truly understands that a rate hike is 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 one hundred percent one week before the actual FOMC meeting to start. This way, the forward guiding principle worked like a charm: markets new a rate hike is coming so when the hike did come, the market reaction was a muted one. This is the idea behind the forward guiding principle: to keep price stability during extraordinary events.
The image below shows such a speech that is part of the forward guidance principle. In this case, one of the FOMC members, Evens, 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 are further reiterating the Fed’s intention. Such speeches are known in advance, both the time and the subject, and traders position accordingly. Volatility is on the rise if the expected message is different than the general market consensus. In the case of the event listed above, as you can see it is listed as having a medium impact. The orange color suggests that. However, this is not necessarily true, as sudden spikes in volatility during these kinds of events are a 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 did the same and followed the Fed’s path. In some jurisdictions, the principle is different in some details, but the idea is the same: a better communication so that market participants will know in advance what the central bank is thinking and plans to do with the monetary policy next.
Recommended Further Readings
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- Fundamental Analysis – Economic News that Influences Markets
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- Fundamental Analysis – Central Banks Mandates
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- Fundamental Analysis – NFP – What is it and How to Trade it?
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– Covering all data that matters from the United States – 1st part