Political risks

Politicians control the economy and their policies can change the future growth
trajectory of an economy. Political risk that fundamental forex traders need to be
aware of comes in a few forms:
1. Changing of governments.
2. When policies change that could affect economic growth.
3. When unexpected circumstances arise that the market had not anticipated.
The key thing to remember with political risk is that traders like certainty – they like
to know who is in charge of an economy and that they will take the right decisions to
boost economic growth. Thus:
A low level of political risk tends to be currency positive
A high level of political risk tends to be currency negative
Greece is a good example of political risk and how high levels of political
uncertainty can weigh on a currency. In early 2010 a new government was elected
and it uncovered a huge gap in the budget deficit – Greece had been borrowing more
than it could afford to pay back and the country was nearly bust. The previous
government had covered this up.
This sent the markets into shock and since Greece is part of the euro zone the price
of the euro was sent tumbling from 1.45 to below 1.20 by mid-2010 (see Figure
1.19). Not since the end of the Second World War had a Western country defaulted
on its debt, and now Greece needed to get financial assistance from its European
partners, the International Monetary Fund (IMF) and the ECB to prevent this from
happening.
The market’s view that the euro zone was stable and therefore a safe investment was
shaken to the core. If Greece was in trouble, could it spread elsewhere? Indeed it did
and Portugal and Ireland also requested bailouts.

Once a country is labelled as being politically risky it can be a difficult mantle to
shake off. In the period April to June 2012 Greece had to hold two elections before
the new government came to power. This heightened political risk yet again and also
weighed on the euro as the markets fretted that Greece would vote in politicians who
did not want to stick to the terms of its bailout loans, which could have seen Greece
thrown out of the currency bloc.
Greece eventually did elect a political party who would comply with bailout terms,
but this was a difficult period for the euro, as you can see in Figure 1.20. It sold off
sharply from 1.34 in March 2012 to 1.24 during the second Greek election in June
2012.

Political instability can cause excess volatility in the FX market. When this happens
investors put their money in the safest place possible – such as cash or cash
equivalents like Treasury bonds – and sell risky assets that could fall in value.

The concept of safe havens and risky assets

An important trick of the trade in the foreign exchange market is the concept of the
safe haven and the risky currency. Traders should acquaint themselves with risky
currencies and safe havens since during periods of market panic – such as financial
crash, a geopolitical event or a natural disaster – the market tends to divide the
currencies into these two groups.
When the market panics there is typically liquidity flow out of risky currencies and
into safe havens. Conversely when the markets are stable and growth is good, when
there are no financial or geopolitical crises on the horizon and there haven’t been
any natural disasters, then this can be an environment that allows risky currencies to
appreciate.
Both risky and safe currencies can move on domestic factors that have nothing to do
with the overall market environment, but when the going gets tough the herd
mentality can take over in FX, so domestic fundamentals go out of the window and
fear takes over.

The safe havens

Safe havens are the currencies that traders tend to buy in times of distress in the
financial markets. Safe haven currencies have certain characteristics:
1. Political stability
2. Financial stability
3. They are usually deep and liquid, which means that they are frequently
traded.
The most important safe havens are:
The US dollar
The Japanese yen
The Swiss franc
The US dollar is the ultimate safe haven for a couple of reasons:
1. The US is the world’s largest economy and is thus considered stable
2. The US government has never defaulted on its debt.
The dollar is also the most widely owned currency in the world, which makes the
dollar attractive to hold in a crisis. If you need money fast you want to own assets
that are easy to sell, like the US dollar.

What this means for FX markets
When panic and uncertainty hit the markets traders want to buy the dollar, which
causes it to rise. For example, when Lehman Brothers filed for bankruptcy in
September 2008 the dollar sky-rocketed (see Figure 1.21). But how can that be, when
Lehman Brothers was an American company? That is the funny thing about the
dollar; it can rise even when the problem is the US economy.

Risky currencies

The opposite of a safe haven is a risky currency. This is a currency that tends to sell
off in times of market panic. A currency can be classified as risky if it has one or
more of the following characteristics:
1. Political instability.
2. The central bank does not do a good job of keeping growth stable.
3. The economy is reliant on commodities.
It’s fairly easy to see why the first two points can lead to a currency being described
as risky. This covers a lot of emerging market currencies like the Indonesian rupiah
and the Indian rupee. South Africa may no longer be strictly an emerging market
currency, but the rand is also considered risky due to continuing political uncertainty
and also its economic reliance on commodities including platinum and gold.
That leads me to the impact of commodities on certain currencies. Australia and
Norway are both politically stable and their economies are fairly healthy. However,
the Aussie dollar and the Norwegian krone are considered to be at the risky end of
the FX spectrum. This is because their economies rely heavily on their commodity
sectors for growth.
Norway relies on its oil industry while Australia relies heavily on its minerals and
mining sector. Commodity prices tend to be volatile and they are closely linked to
the economic cycle – when the economy is booming commodity prices rise, when it
slows down commodity prices tend to fall. Thus, countries that have large oil,
mining, or other commodity sectors tend to suffer from extremes. This causes
traders to worry as it gets harder to predict future growth, which can cause the
currency to be volatile.
For example, during the financial crisis in 2008, the Aussie dollar sold off against
the US dollar sharply as commodity prices crashed (see Figure 1.22).

The same happened to the Norwegian krone, as you can see in Figure 1.23. Risky
currencies tend to sell off particularly sharply against safe havens like the dollar
during periods of market panic like the financial crisis in 2008.

The concept of safe haven and risky currencies can make life a little easier for the
FX trader as there is some certainty about what currencies will do when markets
panic:
Safe havens tend to be bought
Risky currencies tend to be sold

Interest rates and central banks

Central banks control interest rates and interest rates are important for a currency.
That is what you should take away from this section of the book. In the following
section I will explain what central banks do, show using real-life examples why they
are so pivotal to FX and thus why I watch them to inform my trading.

The major central banks

Most countries in the world have a central bank. They tend to meet monthly, or at
least seven or eight times a year, to decide policy. The most important central banks
in the G10 are:
US Federal Reserve (Fed)
European Central Bank (ECB)
Bank of Japan (BOJ)
Bank of England (BOE)
Reserve Bank of Australia (RBA)
The People’s Bank of China (PBOC) is also one to watch, even though it does not
stick to a rigid timetable to announce policy decisions.

What central banks do
Central bank operations are complex, with a variety of different roles and
responsibilities. I am going to give you a simplified version here and then explain
what their work means for FX.
Central banks are the government entities involved in controlling a country’s money
supply; they have the power to take money out of the economy or pump it back in. In
doing so, they have a few main tasks:
1. Manage economic growth
2. Keep the currency stable
3. Some central banks also have a mandate to move the workforce towards full
employment (the US Fed has this duty).
Essentially central banks monitor the economy. They like nice, steady economic
growth and when they see things moving too fast or slow they need to get involved
to try and steady the ship.
So, if an economy is growing too fast there will be a fear of overheating. When this
happens asset bubbles can form, which tend to pop and then cause recessions. A
central bank wants to avoid this. Symptoms of an overheating economy include
rising inflation and a fast pace of growth. When they see this the central bank can
hike interest rates. By doing this they try to remove some of the heat from the
economy by making money more expensive, thus trying to limit investment, cool
consumption and cause a managed slowing down.
When central banks raise interest rates they make money more expensive. People
prefer to save rather than spend because they earn more on their deposits. The
amount of money in circulation tends to fall, which means that the value of money
tends to rise.
Let’s say the economy starts slowing down sharply, as we saw during the financial
crisis in 2008. Back then major central banks around the world cut interest rates as
they wanted to make money cheap to disincentivise people from saving, instead
encouraging people to spend and invest in the economy to try to boost growth. This
means that central banks are putting money back into the system by making it cheap
– this increases the money supply and tends to cause the currency to fall in value. In
crude terms:
Central banks raise interest rates = currencies rise
Central banks cut interest rates = currencies fall

Central banks in action

The trader should always be interested in what the central banker will do next: what
will be the next policy decision, will they tighten or loosen interest rates and will
currencies go up or down? There are three particular things traders should watch out
for when it comes to central banks:
1. Monetary policy decisions and any press conferences held by the president or
governor of the bank (this is particularly relevant for the ECB and the Fed).
2. Minutes from central bank meetings, which give an insight into the thought
process behind policy decisions and can be useful for predicting what central
banks will do next.
3. Central bankers make speeches throughout the year that give an insight into
what they are thinking, how they see the economy and what they might
decide at the next policy meeting. Economic calendars usually include data
for central banks, when bankers are speaking, etc.
There is also a bit of lingo that traders need to be aware of when it comes to central
banks:
Hawkish: when central banks are concerned that the economy may be
growing too fast and may be about to hike interest rates they are referred to
as hawkish.
Dovish: when central banks are worried the economy is slowing down too
fast and may be about to cut interest rates they are referred to as dovish.
So, FX markets are sensitive to changes in monetary policy and also to minutes and
speeches from central bankers that give an insight into their thoughts.
Here are a couple of examples of this.

Minutes from the RBA and AUDUSD

Figure 1.12 shows AUDUSD in the aftermath of dovish minutes from the RBA’s
September 2012 meeting in which it sounded worried about economic growth,
making a cut in interest rates more likely than a hike.
This caused an immediate dive in the Aussie. The circled area indicates the point of
release of the dovish RBA minutes and the impact they had on AUDUSD – it caused
the Aussie to sell off for most of the day. If I wanted to trade around the minutes
there were a few things that I could do:
1. Check what the market was expecting. In this instance the RBA had left rates
on hold in September so the markets expected the minutes to be fairly
neutral.
2. Once the minutes had come out and the dovish message had been digested, a
short AUDUSD trade could be placed around 1.0470-80 with a target of
approximately 60 pips, with a 20 pip stop (see the risk management section
for more on trade set ups).
This would have made a nice intra-day trade: the market was taken by surprise by
the RBA sounding so concerned about the state of the economy, so placing a short
AUD trade could make a small profit. It could also work as a long-term trade,
especially if you thought the RBA may cut rates later in the year.
In that case a short position could be entered with a much wider stop and lower
profit target. A long-term trade would require more preparation: for example it
would be worth looking back over recent economic data from Australia to see if the
economic data had started to deteriorate and thus would justify a cut in rates by the
RBA.

Fed monetary policy and USDJPY

Some currency pairs are particularly sensitive to central banks’ monetary policy. For
example, USDJPY is very sensitive to changes in stance by the Federal Reserve.
Figure 1.13 shows USDJPY and US Treasury yields. Treasuries (US government
debt) tend to move closely with changes in Fed policy and are a good way to gather
the market’s view on whether the Fed is dovish or hawkish.
The first thing to note about government debt is that price moves inverse to yields:
so when central banks are hawkish, Treasury bond prices fall and yields rise; and
when banks are dovish, Treasury bond prices rise and yields fall. This relates back to
the earlier section when I described how central banks control money: when the
economy is strong they hike rates, which pushes up interest rates and pushes down
the price of debt as fewer investors want to borrow money. When interest rates fall
this pushes up the price of debt as more investors want to borrow, but it also pushes
down interest rates.
The main thing you should know is this: falling Treasury yields (the Fed is dovish)
tends to be dollar negative, while rising Treasury yields (the Fed is hawkish) tends to
be dollar positive.

Why is this relationship so close?
US Treasuries are very popular investments to hold and are the most traded
government securities in the world. The Japanese are some of the world’s largest
holders of US government debt, holding nearly 1 trillion dollars’ worth. Thus, when
Treasury yields fall, as they had been doing since the first quarter of 2012, it means
that the price of Treasuries rises. This means that the USD value of Japan’s holding
of Treasuries rises, and to hedge themselves some Japanese traders start selling
USDJPY.
Of course, the forex market is influenced by so many factors it can be hard to claim
one group of people cause the movement in a currency cross, however this
explanation is well known in the currency markets and I believe it goes some way to
explaining the traditionally close relationship between Treasury yields and USDJPY.

Unconventional central banking

In 2012 the pace of global growth had slowed after the recovery from the financial
crisis in 2008 had been weaker than expected. Since central banks in the UK, US,
Japan and the euro zone had already cut rates to extremely low levels they then had
to use unconventional measures to try to boost growth.
This included quantitative easing (QE), whereby the central bank buys government
debt to try to depress long-term interest rates and interest rates on mortgages. The
Federal Reserve in the US embarked on its third round of QE in September 2012 in
another attempt to boost the US economy. This is a largely untested strategy in the
history of central banking, and time will tell if it has an effect on the economy.
The intended impact of QE is to limit currency strength; however it depends on how
aggressive the central bank is. As you can see in Figure 1.14 – where QE2 and QE3
are circled – the dollar is very sensitive to QE and it tends to lead the currency
weaker.

Interest rate differentials

Interest rate differentials are a fairly sophisticated strategy for the retail FX trader,
but this is a popular technique with large investment banks and hedge funds so it is
worth the retail trader being aware of it so they know how the big guys make
decisions in the FX market.
Since two currencies are always traded together and interest rates can determine the
value of a currency, a popular trading strategy is to buy a currency with a higher
interest rate and sell a currency with a lower interest rate. This is called the carry
trade.
For example, interest rates in Australia were 3.5% in June 2012; in contrast, US
interest rates were at 0%. Due to this, the Aussie dollar was a more attractive
currency to hold relative to the dollar. Indeed, this was the case for most of the
period from 2010 to 2012 and as a result AUDUSD has been in an uptrend in that
time, as you can see in Figure 1.15.
But you will notice that this pair has been extremely volatile, with some large
swings up and down. The carry trade is volatile so traders need to be on their guard.
Part of the reason for this volatility is that central banks can change policy
unexpectedly and their movements can be hard to predict with accuracy.

Here is another example. Although interest rates in the euro zone in autumn 2012
were higher than they were in the US, EURUSD did not present a good opportunity
for the carry trade as the rate differential was only 75 basis points. However,
changes in the difference between US Treasuries and German Bunds (using Germany
as a benchmark for the entire currency bloc) can impact the direction of EURUSD.
As you can see in Figure 1.16, the difference between German and US bond yields
had been trending lower at the start of the year and again from June to October. This
means that German bond yields were lower than US bond yields, which weighed on
EURUSD.
But how can that be when euro zone interest rates are higher than US interest rates?
The currency market can also react to the expected change in rates – thus, as the euro
zone economy deteriorated at a faster pace than the US economy in 2012 German
bond yields fell, which weighed on EURUSD.

Central bank intervention

As you may have gathered, the US Federal Reserve is the most influential central
bank. However, currency traders need to keep an eye on other banks as well.
The Bank of Japan (BOJ) and the Swiss National Bank (SNB) in recent years have
directly intervened in the forex market to weaken their currencies and thereby
protect their export sectors and boost growth. I will use two examples to show the
different effects that central bank intervention can have on the FX market.

1. Bank of Japan intervention to weaken the yen in
March 2011
The BOJ wanted a weaker currency to stimulate growth in the country after a major
tsunami and earthquake caused an economic disaster in March 2011. The BOJ and
other central banks decided to sell yen in a multilateral attempt to weaken Japan’s
currency.
Although the exact amount of yen sold is unknown, it was not enough to keep the
yen weak for long. Instead this type of FX intervention was more of a gesture to
show solidarity with Japan in its hour of need. This was not deemed aggressive
central bank intervention.
As you can see in Figure 1.17 where the timing of central bank intervention has been
circled, although USDJPY jumped from 79.00 to 86.00 in a matter of days, it soon
started to weaken again.

2. Aggressive intervention by the SNB
In contrast, the Swiss National Bank (SNB) embarked on an aggressive bout of
intervention in August 2011 after EURCHF fell to its lowest ever level. This caused
the SNB to worry about Switzerland’s export-dominated economy that relies on a
weak exchange rate to make its exports competitive.
Thus, the SNB decided to instigate a floor in EURCHF at 1.20. That meant that it
would buy EURCHF to ensure that the pair got back to this level and stayed there.
The cost was that the SNB had to buy billions of euro, but the upside was that it
helped to protect the Swiss economy.
This is extremely aggressive action from a major central bank and is very rare. As
you can see in Figure 1.18 – which shows the aftermath of the intervention from
December 2011 onwards – the FX market took the SNB’s action seriously and
EURCHF has barely budged from 1.20 since the floor was put in place.

How currencies are affected by the various economic data

Some currencies are more sensitive to particular economic indicators than they are
to others. Here is my very quick guide to which major economic data releases affect
particular currencies.
Euro: PMI data for the euro zone, inflation data, German factory orders,
retail sales and sovereign debt auctions
Sterling: PMI surveys, public sector borrowing figures, retail sales, GDP and
GDP revisions. For example, the August 2012 manufacturing PMI survey
(released 3 September 2012) beat expectations, causing a sharp jump higher
in GBPUSD, as you can see in Figure 1.10. The arrow indicates the point of
the data release.

Australian dollar: Chinese PMI survey, Chinese GDP projections, domestic
terms of trade data and quarterly inflation report (Australia is unusual in that
it only releases inflation data every three months). For example, the
Australian dollar is extremely sensitive to developments in China because of
the close trade links between the two economies. When important Chinese
data is released – like GDP – it can have a big impact on the direction of
AUDUSD. Figure 1.11 shows how Chinese GDP growth in 2009 came at the
same time as a rise in AUDUSD, while moderation in Chinese GDP growth
coincided with a slowing rise in AUDUSD in the period from late 2010 to
2012.

US dollar: NFP, ISM surveys, consumer confidence, retail sales and CPI.
Yen: US NFP, domestic inflation data, the Tenkan survey of manufacturing
activity (a quarterly version of the ISM and PMI surveys) and central bank
meetings in the US and Japan.
I have covered the most important indicators that I believe you need for effective
fundamental analysis. Of course there are second, third and even fourth tier
indicators that some traders follow avidly; such as terms of trade, factory orders and
inventories. However, the purpose of this book is not to give you a step-by-step
guide to all economic data because there are plenty of other books that will do that
for you.
These include Richard Yamarone’s The Trader’s Guide to Key Economic Indicators ,
which is an easy to use and comprehensive look at most US economic indicators (but
it can be applied to indicators used in other parts of the world).
You may have noticed that I did not include interest rates – and the central banks
that set them – in the list of four economic indicators above. I like to think of these
as a cousin of the monthly economic data statistics and use them in combination
with all of the other indicators. Interest rates have a big impact on the direction of
currencies and they are worth looking at in detail, so I will move on to this next.

Quarterly GDP

What is it?

This data is the ultimate snapshot of an economy’s health. The technical definition
of GDP is the market value of all goods and services produced by a country. It is
also considered to be a measure of a country’s standard of living.
Although it is reported quarterly, the data in the major economies usually includes
an annual growth rate, so you can see how the economy performed in the past 12
months.

When is GDP data released?

GDP is reported quarterly for most countries in the world. Usually a GDP report is
released in the first month of a new quarter, but consult an economic calendar to get
the exact date and time. Also, there are usually a couple of subsequent revisions to
GDP data after the main release, especially in the major economies.

Why is GDP significant?

GDP data tells the story of how an economy performed over a period of time – its
change relative to previous quarters gives a good indication of which direction the
economy is moving and where it may go in the future. A strong positive reading is
good news for an economy, while the opposite is bad news. The annualised data is
extremely useful for detecting changes in the economic cycle, which can have big
implications for FX markets.
Since GDP data is used to determine a country’s position in the economic cycle, it is
of use for a longer-term trader. Like inflation data, GDP data is of more limited use
for the short-term trader – they would be watching to see if the actual figure exceeds
or misses the consensus estimate by a large margin. Usually if GDP data is in line
with estimates then it barely moves the FX market.

FX market example

GDP can cause volatility in the FX market if it is wildly different to consensus
estimates. Let’s look at two examples of data surprises and see how it impacted FX.

Example 1: UK
Third quarter UK GDP in 2012 was much stronger than expected, rising 1% versus
expectations of a 0.6% rise. This data was even more important than usual since it
meant that the UK had exited recession for the first time in 2012. This was difficult
to predict, so the better trading strategy, in my view, would be to digest the data and
then make your move. This was my strategy:
1. I asked myself what caused the UK to grow so strongly (it ended up being
one-off factors like the Olympics and the Jubilee bank holiday, which
weren’t expected to contribute to growth later in the year).
2. This made me think that GBP strength on the back of this report may be short
lived.
3. I wanted to trade the pound, but I had to be clever about it. A long GBP
position would most likely only work against a currency where growth is
weak. The euro was an obvious candidate. As you can see in Figure 1.8,
EURGBP declined 190 basis points in the two weeks after the data release.

Example 2: Japan
Japan’s economy contracted sharply in the third quarter of 2012, in contrast to the
UK. It contracted by 3.5% on an annualised basis in Q3, a sharp slowdown relative
to the 0.3% expansion in the second quarter.
Japan’s economy was weaker than expected, but rather than cause the yen to sell off,
it actually caused the yen to strengthen by 100 pips versus the USD in the immediate
aftermath.
How so?
The yen is a safe haven currency and even when there is a negative domestic
economic shock it can cause a flight to its perceived safety. However, it would not
have paid to remain short USDJPY for long, as you can see in Figure 1.9.
The price action after the data release is circled, but in the following three weeks
USDJPY rallied 300 pips. Thus, the rush to the safety of the yen was only temporary,
and once the market digested the news the yen reacted as you would expect, and
started to weaken.

Inflation data

What is inflation data?

Inflation is an important part of a country’s economic picture. Fundamental traders
should always know what direction inflation data is moving and the pace of change
for the economies of the currencies they are trading.
There are two types of inflation to look out for: CPI (consumer price index) data and
also PPI (producer price index) data. The CPI data measures price changes paid by
the consumer at the supermarket, shopping centre, etc. The PPI data measures the
change in prices of items as they leave the factory gate.
There are also two components to the inflation picture to be aware of: headline and
core prices. Headline inflation includes the price of food and energy, while core
inflation strips food and energy prices out. Some central banks prefer to focus on the
core measure as it is considered more stable. This is because energy and food prices
can be extremely volatile – for example, the price of corn or vegetables can be
impacted by a freak weather pattern that causes their price to soar one month over
the next. This could cause a big spike in headline inflation, but it is likely to be a
temporary phenomenon (hence the volatility).
Central banks don’t want to change the direction of monetary policy based on a
single factor affecting the price of corn, or any lone item, so they look at the core
inflation rate instead, which is considered to be a smoother measure of price changes
and trends in the economy.

When is inflation data released?

Inflation data is usually released in the middle of each month, but it does depend on
the country. The euro zone, UK, US and China tend to release inflation data monthly,
while Australia and New Zealand release it quarterly.
Be sure to consult an economic data calendar so that you know the date and time of
these releases.

Why is inflation data significant?

Changes in price data are an important way to determine the state of the economy.
Usually falling prices mean that activity is slowing, which can be currency negative,
while rising prices can mean that the economy is expanding, which can be good
news for a currency.
Inflation data becomes interesting when it gets to extreme levels. So if a country’s
prices are deemed to be rising too fast it may cause the central bank of that country
to adapt its policy to try to get the prices back under control. Central banks like
steady increases in prices, and if prices rise or fall too quickly they usually react.
This can have implications for the direction of currencies (see the section on interest
rates to find out more).

FX market examples

Example 1: US inflation and USDJPY

While a single inflation data point may not be a major market moving event, its

change over time can have huge implications for monetary policy and thus the

direction of a currency. Figure 1.6 for the period late 2010 to summer 2012 shows

core inflation in the US and also USDJPY. As you can see, as inflation rises it tends

to mean a strong USDJPY rate. In contrast, when inflation started to fall in spring

2012 it dragged USDJPY down with it.

The trend in inflation does not follow the currency cross perfectly, as you can see in

this chart, so this data point is better for the long-term trader with a multi-month

view. If you are a short-term trader, make sure you keep up to speed with inflation

data and which direction it is going, but it will be harder (if not impossible) for you

to trade off inflation data alone.

Example 2: Chinese inflation and AUDUSD

From April 2012 to November 2012 the Chinese inflation rate started to decline.

This decline accelerated from July 2012. Declining inflation can be bad for a

currency as it can suggest that the economy is slowing down. China does not have a

free-floating exchange rate, so domestic economic data does not have a huge impact

on the renminbi. However, the Aussie dollar has close trade links with China, and

signs that growth and inflation were slowing in its important trade partner initially

weighed on the AUDUSD, as you can see in Figure 1.7.

The Aussie sold off sharply from April to the end of May as the market digested

signs of a Chinese slowdown. However, after that the Aussie recovered, but it didn’t

manage to break above a key resistance level of 1.06. Thus, although the relationship

between AUDUSD and Chinese data is not perfect, Aussie gains were capped while

Chinese data remained subdued.

Inflation data is also useful for trading other fundamental events including central

bank meetings and GDP releases. This means that even if I don’t want to trade the

inflation release itself I usually make a point of keeping an eye on the latest inflation

release for currencies I am interested in.

Purchasing Managers Index (PMI) and Institute of Supply Management (ISM) surveys

What is it?

Purchasing Managers Index (PMI) surveys in Europe and China, and Institute of
Supply Management (ISM) surveys in the US, are arguably the second most
important pieces of economic data after NFPs.
They are useful for the currency trader for a couple of reasons. Firstly, they are used
around the world and are not just US centric like payrolls, thus they can be a good
gauge of global growth. Secondly, they are a snapshot of business sentiment in a
wide variety of areas like exports, new orders and inventory levels. The results can
be used to predict hiring patterns and also the strength of consumer demand.
PMI and ISM surveys originally focused on the manufacturing sector but as the
manufacturing surveys evolved and grew in popularity they have expanded to the
services and construction sectors. Each country’s PMI survey polls hundreds of
domestic businesses on the level of new orders they have received, order backlogs,
shipment orders, the prices they pay for materials, employment, new export orders
and imports.
In the euro zone the fusion PMI Composite index is an important indicator of the
overall performance of the currency bloc’s economy.
These surveys are conducted around the middle of the month before the data is
released. The result is a diffusion index that measures expansion or contraction in
service and manufacturing businesses. These indexes have values between 0 and
100, with 50 acting as the line between expansion and contraction. A strong release
is above 50, a weak result is below 50.

When is the data released?

Usually the first week of every month (the exact day depends on each country).
China and Europe do things differently and release first and second readings of their
PMI surveys. The first reading is usually the third week of the survey month; the
second reading usually takes place the first week of the next month. However, check
your economic calendar as sometimes the timings can differ.

Why are they significant?

These surveys tend to have a close relationship with GDP data and are a timely
signal of the growth (or lack of) in an economy. As I mentioned at the start of the
chapter, the currency trader is always looking for where growth is strong and also
where it is weak in order to find the best opportunities to go long or short a currency.
ISM and PMI surveys provide this information.

FX market example

The actual PMI and ISM data releases can be good economic data to trade, in
contrast to payrolls. For my part, I find it easier to read them. The index is either
strong (above 50) or weak (below 50). Revisions are only relevant for the euro zone
and China and they tend to be small, thus this is a well-respected and reliable gauge
of economic strength or weakness.
When I trade the actual data release I tend to follow these steps:
1. I know what day and time the data is being released.
2. I find out what the market consensus is – does the market expect a strong or
weak release?
3. I come up with a trade plan. A number around consensus may only have a
limited impact on the market; it’s the outliers that tend to have the capacity
to change trend. I find out the current trading range and look for support and
resistance levels (see technical analysis chapter) that could double up as
breakout zones. I may leave a buy order at the top of the range and a sell
order at the bottom of the range just in case an outlier causes the cross to
change trend.
4. At the time of the release I digest the number and make changes to my orders
if necessary. Your broker should allow you to change orders without a
charge.
A negative surprise in euro zone PMI data
Figure 1.3 shows EURUSD after the release of a weak preliminary reading of the
September 2012 PMI data. The survey was below 50, which dashed hopes that the
euro zone’s struggling economy was starting to recover. This weighed heavily on
EURUSD. As you can see this cross fell from 1.3040 all the way to 1.2920 in the
aftermath of the news.
Although the euro recovered some of the losses during the next day’s trading, this
data is significant for the direction of the euro in the long term. The continued
weakness in the euro zone economy could make some traders think twice before they
put on a long euro trade in the coming weeks as the economic fundamentals look too
weak to support the currency at a higher level.

GBP is also sensitive to PMI data releases. Let’s take a closer look at the UK’s
October manufacturing PMI release on 1 November 2012. There are two ways to
trade this piece of data:
1. Trade the data release itself, or
2. Wait to digest the data and then make your move.
Here is a trade set-up for trading the actual data release.
1. Homework: growth had been strong in the third quarter but the signs
suggested that October had been weak and the strong performance could not
be matched. Thus, there was a growing fear that the data may be even lower
than broad expectations. Indeed, as it happened the data was weaker than
expected for October as it came in at 48.4, whereas the market had expected a
reading of 49.0. Also important to bear in mind was that GBPUSD had traded
higher in the second half of October.
2. A data miss is likely to weigh on GBPUSD, so a sell order could be left
around 1.6100 to benefit from this. As you can see in Figure 1.4, GBPUSD
sold off sharply in the immediate days after the October PMI data miss.

Remember that trading around the data release can be volatile and extra risky, so
this is usually a short-term strategy. A longer-term trader may prefer to trade once
they have digested the release. However, in this example that would have only been
profitable for a couple of weeks. In mid-November market sentiment shifted as risky
currencies like the pound started to rally and the trend changed (see Figure 1.5).

Labour market surveys

What is it?

Without a shadow of a doubt the most important economic statistic for me is the US
nonfarm payrolls (NFP) report. It is published by The Bureau of Labor Statistics and
measures the number of jobs created in the nonfarm sector of the US economy each
month.

When is NFP data released?

The first Friday of every month.

Why is NFP data significant?

American labour market statistics are important because they give an idea about the
confidence of American businesses for the future. If a company believes growth will
be strong for their product or service going forward they will hire more workers to
meet the expected increase in demand. If they think demand is going to contract they
will reduce their employee numbers.
Hiring by firms also has an impact on consumer confidence. If people have stable
jobs then consumer confidence should be high and they will spend money, whereas
if people are losing their jobs the first thing they usually do is cut their spending.
Since consumption makes up 70% of the US economy (a level that is far from
unique in the West) and jobs are a key component of whether or not consumers are
spending, you can understand why the market is so obsessed by this indicator.
NFP data has an enormous impact on all financial markets. Currencies can move
more than they customarily would on any normal day and it’s not unusual for the
major dollar crosses to move a couple of hundred pips in either direction. Stock
markets across the globe are also on high alert. Due to the huge amount of volatility
that this data can generate, many traders in Asia and Australia stay awake or get up
in the middle of the night to place a trade.

FX market example

Lots of people trade before, during and after nonfarm payrolls, and for some of the
major FX brokers it can be their busiest day of the month. But I will let you in on my
secret: I don’t trade the NFP release.
A colleague of mine used to sit patiently looking at his Bloomberg terminal on NFP
Friday, as the payrolls report is called by the street, and when the number was
released he looked at it, digested it and went about doing something else. He chose
not to trade the actual figure itself.
This is an important lesson to all traders – economic data like the NFP can produce
extremely volatile movement in the markets so some people prefer to wait for the
dust to settle and trade when they have a better idea of what effect the NFP data has
had. I follow this strategy (or non-strategy) over an NFP release.
Figure 1.1 shows you how volatile the immediate aftermath of an NFP release can
be. I have chosen to show the impact the August 2012 data (released on 6
September) had on EURUSD, but it has a similar effect on USDJPY, AUDUSD,
GBPUSD, etc. This was the EURUSD’s initial reaction to a disappointing payrolls
number; the forecast was for a 130k gain in the number of jobs created, but the
reality was that only 96k were created and this was considered a disappointment.
The data was released at 13.30 BST and the initial reaction was that the euro sold off
sharply, dropping from 1.2650 to 1.2590 in a matter of seconds. It then meandered
lower to 1.2570 before rebounding strongly to 1.2650 – back to where it started! –
before the end of the London session. This shows you how erratic the market can be
during this data release.
There are many reasons why the market can be so erratic on NFP Friday. Firstly,
NFPs are one of the earliest releases each month and they are a bit like a new piece
of the US economic jigsaw. Since the economy in the US is a complex beast, new
information about its strength or weakness can cause shock waves in the financial
markets, particularly the FX market. Secondly, hundreds of billions, if not trillions,
are being traded during the release, which also causes excess volatility.

In the above example it would have been so easy to get caught on the wrong side of
that trade. NFP data can be particularly hard to predict so rather than take a bet on
whether the number will beat or miss expectations, I wait it out.
Instead my trading strategy for NFPs is more long term. I do two things immediately
after the NFP release:
1. Digest what the data is showing; and
2. Decide if that is good or bad for the future trajectory of EURUSD.
On this occasion the data miss was extremely significant as it rounded off a week of
bad economic data from the US. This data added to the body of evidence that the US
economy was slowing down and would need some help from the US central bank to
get going again (see the interest rate section for more).
Since central bank stimulus in the past has been dollar negative, I decided to put on a
long EURUSD trade at 1.2650. Some may argue that I bought at the high of the day –
how can that be a good trade!? – but in Figure 1.2 you will see that EURUSD rallied
a staggering 400 points in the week after the NFP data was released. The circled area
shows where I entered the trade, on 6 September 2012.

Trading using economic data

The way to get the information needed for fundamental analysis is to look at the

official economic data releases. For most of the world’s major economies, economic

data is released regularly and it gives a glimpse of the overall economy and how fast

it is growing. The key thing for me is that economic growth means future prosperity,

which should then equate to a strengthening currency. Traders seek out growth

because that is usually where the best opportunities lie to jump on an uptrend.

Alternatively, economic data showing weakness in a country’s economy has the

effect of weakening the currency.

The markets have a tendency to price in future growth and prosperity. The forex

market, like the stock market, is thought to price in future growth expectations up to

six months in advance. Hence markets don’t wait for the GDP release that comes out

every three months before deciding on the direction of a currency; they react to the

incremental flow of data from economic indicators throughout the month in

anticipation of what that means for GDP and the overall health of the economy.

In addition to GDP the other indicators include inflation data, retail sales, industrial

and manufacturing data, and data on consumer confidence. These are a timely update

on the state of the economy and the occasions of their release can be major marketmoving

events.

In fact, there are thousands of economic indicators and it could make you dizzy if

you tried to analyse them all and determine what they mean for growth. As an

example of some of the kookier ways of measuring economic growth, some people

may look at the hog market to try and detect Chinese consumption of pork and use

that to deduce the strength of the Chinese economy. Others have been known to

search out demand for a certain chemical found in paint and then try to apply that to

demand for housing in the US.

Thankfully there are more accessible ways to understand what is going on from an

economic perspective and for some people it is most effective to narrow the list

down to a few key indicators. It is also possible to prioritise the indicators so that

you can organise your analysis and know which to pay most attention to. I will now

move on to introduce the economic indicators that I have found to be of most use in

my own fundamental analysis. Before I do, a couple of words on finding economic

data.

Use of an economic calendar

It is important to know when economic data is released and the easiest way to get

this information is by using a calendar. You can get reliable up-to-date calendars on

economic news websites like Bloomberg (www.bloomberg.com/markets/economiccalendar),

some blogs have them – like Forex Factory (www.forexfactory.com), and

the financial press often prints economic calendars at the start of each week. Also,

ask your FX broker as they may provide you with a free calendar. Some even contain

widgets that let you place orders or trade directly from the calendar.

Consensus

The key thing for traders to remember is that the actual data that comes out is only

relevant based on whether it hits, misses or exceeds consensus. Consensus is an

important word for the markets. Usually economic data calendars include the

market’s expectation of the data release. The expected number is the mean of

estimates from a number of economists who have been polled prior to the event and

asked to give their views on what the number will be. Reuters and Bloomberg are

some of the most popular data providers that measure the street’s expectations prior

to major data releases.

As a general rule, a data miss (the figures released are worse than the forecasts) can

be currency negative, a number around expectations usually has a negligible effect,

and if the reading exceeds expectations this tends to be currency positive.