If you've read my previous post, you've probably gotten the impression that determining monetary
policy is mostly an exercise in shades of gray rather than a simple
black-and-white equation-and you’d be exactly right. But given the significance
of monetary policy to currencies, currency traders devote a great deal of
attention trying to divine the intentions of central bankers. This has not always
been an easy task, but recent trends among central banks to improve the
openness of communications with markets, frequently referred to as
transparency, have made the process less of a guessing game.
Central bankers communicate with
the markets in a number of ways, and their comments can provoke market
reactions similar to major economic data releases - by that, I mean sharp
initial price movements followed by continued volatility or a potential change
in direction.
- Rate decisions: Interest rate setting committees of central banks meet at regularly scheduled times. At the conclusion of a meeting, they issue a formal announcement of the policy decisions made at the meeting. They can raise, lower or hold interest rates steady. They can also make changes to reserve requirements or liquidity operations.
- Policy statements or guidance: Along with the interest rate decision, central banks frequently issue an accompanying statement that explains the basis for their policy action. These statements are also used to provide guidance to markets on the future course of monetary policy. The statements are carefully parsed by markets intent on discovering what the central bank is thinking, which way it's leaning, and what the timing may be for future changes. Rate announcements and accompanying policy statements are included on economic data/event calendars.
- Public speeches: Central bankers frequently appear before community and business groups, and address subjects ranging from trends in the financial industry (such as the rise of hedge funds or the use of derivatives) to relatively mundane governance issues (such as financial reporting requirements). But when a central banker gives a speech that assesses the economic outlook or the future course of monetary policy, forex markets are all ears.
Appearances by central bank
officials typically are included on most economic event/data calendars, and you
need to be aware of them to avoid being taken by surprise. Sometimes, the topic
of the speech is given in advance; other times, it’s not. The most important
speeches are those that focus on the economic outlook or the current monetary
policy assessment.
In most cases, a prepared text is
released by financial newswires at the scheduled start time of the speech.
Accredited news agencies receive copies of speeches in advance to allow their
reporters to prepare stories and headlines, but the release of the information
is embargoed until the designated time. The remarks are then encapsulated into
a series of headlines that capture the main points of the speech; this is the
news that markets receive at the appointed time. When these headlines hit traders’
screens, market prices start to react. If a question and answer session
follows, the central banker’s comments will be posted by the newswires as
they’re delivered live. This setup can make for some exciting headline-driven
trading.
In following monetary policy
developments, market participants essentially operate under a fluid, constantly
evolving model of expectations of where monetary policy and interest rates are
heading. The biggest market or price responses come in reaction to unexpected
changes to or shifts away from the prevailing expectation. For example, a
central bank may be in the process of progressively tightening monetary policy
in response to stronger growth or rising inflationary pressures, and traders
will take market positions based on this outlook for higher interest rates.
When these central bank officials make comments in line with the prevailing
view, there is little reaction to market prices. But when these central bankers
signal a shift in thinking, the reaction can be fast and furious. Continuing
with the preceding example, if a central bank official signals in a speech that
he thinks inflationary pressures are beginning to recede, the prevailing market
wisdom is turned upside-down. Suddenly, higher interest rates are no longer
assured - positions are reduced or exited entirely, and new positions betting
on steady to lower interest rates may be opened.
Usually, it’s not too difficult
to tell the overall direction of monetary policy, whether interest rates are
going up or down. This is especially true in recent years, as central banks try
to communicate their views more openly to markets in the name of transparency.
So the question usually boils down to the timing or size of changes to interest
rates. Will the Fed tighten at the next meeting or wait to gather more
information? If inflation is seen to be accelerating, will the Fed feel
compelled to hike by more than 25 bps? So traders clue in to every piece of
data and every comment by Fed officials to gauge the size and timing of the
next move. Subtle shifts in language or turns of phrase by a Fed speaker can
generate sharp price moves as market participants interpret their comments and
react in the market.
Currency traders need to be aware
of and constantly follow the current market thinking on the direction of
interest rates because of the strong relationship between interest rates and
currency values. The best way to do this is to follow market commentaries in
print and online news media, always keeping in mind that such outlets
(especially print) are usually one step behind the current market. This makes
online news commentaries that much more relevant. Some of the best sites for
timely insights and market reporting are Bloomberg.com,
Reuters.com, and MarketWatch.com. Best of all, these sites are free. Look
for currency brokers that offer real-time market analysis and news updates.
