CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
These days markets are moved by algorithmic trading. Super-computers are programmed to buy or sell financial products based on various aspects, mostly fundamental ones.
Such robots are taking thousands of trades per second, and they are the reason why markets are moving so fast. Therefore, human traders are adapting to this environment.
To diminish the effect of the trading algorithms on prices, the forward guiding principle was introduced. Federal Reserve of the United States first came up with the idea, and it was quickly embraced by other major central banks in the world.
In Forex trading, it is all about a currency’s interest rate. As a rule of thumb, a higher interest rate brings higher values for that currency, while lower rates are negative.
However, trading is not that straightforward. It is based, mostly, on expectations, rather than actual facts.
These expectations are more difficult to manage as the way the market interprets an economic event is different every time. Let me give you an example.
Suppose the European Central Bank (ECB) is cutting the rates. This is a dovish move for the Euro and the currency should head lower.
In Eurozone, every interest rate decision is followed by a press conference. It could happen that at the press conference, the central bank signals the rate cut was the last in a row and from here on the bank is expecting growth to pick up and inflation to overshoot the target.
Such a statement will be super-bullish for the currency, and it will be aggressively bought even though only forty-five minutes earlier an interest rate cut was delivered.
Under the forward guiding principle, this can never happen. The idea behind forward guidance is that market participants are timely prepared for changes in the monetary policy.
Sometimes, central bankers are over-communicating a policy shift that when it finally happens, it becomes a non-event. It means that the forward guidance principle worked and communication was exact.
This, in turn, leads to expectations being built. The perfect example comes from the United States of America again.
This March 2017 saw the Federal Reserve raising the interest rate and announcing other hikes for the rest of the year, providing the economy will deliver strong growth and jobs numbers. Yet, the U.S. dollar was sold.
Yes, in a world of negative interest rates (Japan, Eurozone, Nordic European countries, Switzerland, etc.), the most powerful central bank in the world, the Fed, is raising the interest rate on the world’s reserve currency (the U.S. dollar), and the reaction is the opposite than the logical one. How is this even possible?
The answer comes from the expectations that were built and how forward guidance was implemented. Market participants focused on something else rather than reacting to an event that was well communicated and understood ahead of its release.
As mentioned earlier, the Federal Reserve is the first central bank that introduced forward guidance. Together with this concept, the Fed started to hold regular press conferences.
The FOMC (Federal Open Market Committee) is meeting on a regular basis. Every six weeks the ruling body of the Federal Reserve System is meeting to set the interest rate on the dollar and the monetary policy for the period ahead.
But a press conference is held only every other meeting. So far, the Fed didn’t move on rates when the interest rate decision was not followed by a press conference.
This press conference is the main forward guidance tool. It has two parts: in the first part the Chairman/Chairwoman will read the statement and present the future projections.
These projections are based on the medium-term economic trend and the level of future interest rates. This level is projected by every voting member and a pictogram formed by dots is presented.
The higher the median value of this dots, the more the dollar will be bought. Again, traders are reacting to expectations, rather than current, present stance of the economy and monetary policy.
Questions and answers are following. In this part, press representatives are asking questions about the current monetary stance and what will come next. It is now when the Fed is announcing or hinting at changes soon. The dollar will react now, on future expectations.
The model proved to be a success and was quickly embraced by other central banks jurisdictions around the world. Bank of England and the ECB started similar programs.
While the ECB is clearly following the Fed’s steps (the interest rate decision and press conference was changed from every four weeks to every six weeks, the minutes are released in Eurozone too, etc.), Bank of England had some troubles in doing that. The problem comes from the very rules Bank of England is functioning by.
In its status, Bank of England is not supposed to hold a press conference if the interest rates are not changed. For more than eight years now the interest rate on the pound is unchanged.
But how to communicate to market participants and how to implement the forward guidance principle? The answer comes from the Inflation Letter.
There is a press conference that takes place when the Inflation Letter is released in the United Kingdom, and this is associated with forward guidance. The current Governor, Mr. Carney, answers questions from the audience and gives clues about what the Bank of England is expecting next.
So far, forward guidance proved to be a success. That is, depending on the point of view that is considered.
Central banks strive for price stability, traders look for volatility. A good market to trade is one that is moving, and central banks are trying to make the journey from a monetary policy stance to another as smooth as possible.
More than 65% of the time markets are ranging, and even when they are not, on the bigger timeframes ranges still prevail. For traders, it is equally important to understand the reasons why this is happening, as well as the future market expectations.