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Thursday, 20 February 2014

Putting Market Information In to Perspective: Focusing on Themes

At any given moment in the forex market, several themes dominate the market’s attention. Market themes are the essence of the real-world driving forces currently holding sway in the market. Themes are what market commentators and analysts are talking about when they explain what's happening in the market. But most important, themes are the filters through which new information and data are absorbed by the market. Or to put it another way, they’re the lenses through which the market sees events and data.

Market themes come in all shapes and sizes, and have differing impacts on the market over time. Some are long-term themes that can color the market’s direction for months and years; others may hold sway for only a few hours, days, or weeks.

Market themes come in two main forms that coexist in parallel universes but that also frequently overlap. The two types of themes that I like to focus on are fundamental themes and technical themes.

Driving fundamental themes

Each currency has its own set of fundamental circumstances in which it's being evaluated by the market. The basic fundamental environment is ever-present, but it’s also subject to change over time, just as economic conditions will change in the course of business cycles. Fundamental themes will also shift in relative importance to one another, with certain themes being pushed to the side for a period when news or events focuses the market’s attention on other, more pressing themes. Keep in mind that each theme applies to each and every currency but in varying degrees at any given moment.

Rising or falling interest rates

Interest rates are usually the single most important determinant of a currency’s value. (We go into greater detail on the significance of monetary policy and interest rates in “Currencies and Interest Rates”).  But it’s not just about where interest rate levels are now, though that’s still important (higher interest rate currencies tend to do better against lower-yielding Currencies). What matters most is their overall direction (whether they're going up or down), their future level (how high or low they’re likely to go), and the timing of any changes (how fast rates are likely to change).

Markets are constantly speculating about the direction of interest rates, even though interest rate changes are relatively infrequent. Speculation over the direction and timing of interest rate changes is one of the primary drivers of a currency’s value on a daily basis as well as over longer time frames.

The information inputs that drive the interest rate outlook are centered on economic growth data and inflation reports. The stronger the growth picture is, or the higher inflation pressures are, the more likely interest rates are to move higher, normally improving a currency’s outlook. The weaker the growth outlook or the lower the inflation readings, the more likely interest rates are to remain steady or move lower, typically hurting a currency in the process.

Bond markets also have a lot to say about the direction of interest rates and are probably the best real-time barometer of the markets interest rate expectations. Central banks can really influence only short-term interest rates, which are essentially based on the central bank’s official rate. But longer-term bond yields, with the ten-year maturity as the benchmark, reflect the market’s long-term view of an economy’s outlook and the direction of future interest rate moves. Falling bond yields (lower interest rates) point to a weaker economic outlook and the probability of lower interest rates ahead, typically denting that currency, while higher bond yields point to economic optimism and likely higher rates, usually supporting that currency.

The effect of interest rate themes is most powerful when the interest rates of two currencies are seen to be diverging when one currency’s interest rate is expected to move higher and the other lower.

When you’re looking at economic data or monetary policy rhetoric, always assess the incoming information first in terms of what it means for the interest rates of the nation’s currency - the interest rate theme. A currency that is expected to see lower rates in the near future, for example, is likely to stop declining and may even rebound if an economic growth report or an inflation reading comes in higher than expected. The market will pause to consider whether its outlook for lower rates is correct. By the same token, a currency facing the prospect of lower interest rates ahead, when hit with weaker economic data or lower inflation readings, is likely to weaken further. I say “weaken further” because it was probably already under pressure and moving lower before the latest batch of data hit the market.

Looking for growth

Economic growth prospects are the linchpin to _a host of currency value determinants, from the interest rate outlook to the attractiveness of a nation‘s investment climate (stocks and bonds). Not surprisingly, the stronger the outlook for growth, the better a particular currency is likely to perform relative to currencies of countries with lower growth outlooks. Strong economic growth increases the likelihood of higher interest rates down the road, as central bank officials typically seek to restrain too rapid growth to head off inflationary pressures. Weaker growth data increases the prospect of potentially lower interest rates, as well as dampening the outlook for the investment environment.

Many growth data reports reflect only a particular sector of a nation's larger economy, such as the manufacturing sector or the housing market. Depending on how significant that sector is to the larger national economy, those reports will tend to be interpreted as correspondingly more or less significant. Industrial production data in Japan, for example, is more significant to the Japanese outlook than it is to the U.S. outlook because of the more prominent role manufacturing plays in Japan.

There’s no set recipe for how growth data will impact a currency’s value, but when the interest rate outlook is generally neutral, as in no solid conviction on the direction of two countries’ rates, the growth theme becomes more important.

Fighting inflation

Inflation is the bogeyman that all central bankers have nightmares about. Even when inflation is low, they still worry about it - it’s just part of the job. When inflation is running too high for their comfort, fuhgeddaboutit. As a currency trader attuned to monetary policy developments, you need to monitor inflation readings as well.

The inflation theme is far more nuanced than the growth theme in what it implies for a currency’s value. Depending on the bigger picture, it can produce starkly different outcomes for a currency. In general, if growth is good, and inflation is too high, it's a currency plus. If growth is low or weakening, and inflation is too high, it’s a currency negative. Come again? Both scenarios point to steady-to-higher interest rates, which should typically be a currency plus, right? The rub is that the low-/slow-growth scenario coupled with high/higher interest rates increases the risks of an economy dropping into recession, which would ultimately result in interest rate cuts farther down the road. In this sense, currencies are a bit fickle in that they like higher interest rate some of the time, but not all the time.

The same phenomenon can happen when a central bank holds rates too high for too long, usually based on fighting inflation, and the market begins to sense that an economic downturn is ahead. The response is actually not that bizarre if you consider that the forex market is, first and foremost, always anticipating future interest rates.

When factoring inflation data into the interest rate theme, be aware of how the overall growth theme is holding up. If growth is good, and inflation is high because of economic strength, higher inflation readings will be currency supportive. If growth is slowing, and inflation is still too high, the currency impact will be decidedly less positive and very likely downright negative.

Gauging the strength of structural themes

Beyond interest rates, growth, and inflation, several other prominent themes regularly assert themselves, mostly in the structural sphere (the big-picture elements of how an economy is performing or national events are playing out).

Structural themes are the most fleeting - they can be in full force one day or for several weeks or months and then drop from the radar screen altogether. These themes are also usually secondary to the three we above (interest rates, growth, and inflation), but structural themes can still exert significant influence on a currency on their own. Most important, they can amplify the impact of the primary themes, like throwing salt in a wound. Following are frequently recurring structural themes: 

  • Employment: Employment is the key to an economy’s long-run expansion and a primary driver of interest rates. As long as employment is rising, the longer-term economic outlook is supported. But if job growth begins to falter, as reflected in incoming labor market reports, economic prospects will tend to be marked down. Sharp increases in unemployment are among the fastest triggers to interest rate cuts by central bankers, going back to the primary interest rate theme.
  • Deficits: Both fiscal and trade deficits are typically currency negatives. The USD has been especially prone to weakness based on recent increases in both the federal deficit and the ballooning trade and current account deficit. During times of low/slow growth, the impact of deficits can be magnified, as the very credibility of a currency can be questioned. During times of steady/high growth, their impacts tend to be more muted but are still a negative hanging over the outlook.
  • Geopolitical issues: It seems like a fact of life now, but geopolitical tensions weren’t always ever-present, as they seem to be today, from North Korean nuclear tests to conflicts in the Middle East or trade disputes with China. Geopolitical issues typically used to develop in relatively short order and tended to influence currency values on the margins, limiting gains in a currency's appreciation or increasing losses during a weakening phase. The USD is the most vulnerable to geopolitical issues, given the size of it economy, reliance on world trade, and potential military involvement. After geopolitical tensions subside, the market is quick to revert to pre-existing themes.
  • Political elections or uncertainty: Changes of government and political uncertainty in the major-currency countries can certainly dent the market’s sentiment toward the affected currency. The impact on the currency will usually be felt on the margins, hurting a softening currency and restraining an appreciating one. But shortly after the political situation is resolved, political issues tend to fade quickly into the background. 

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