Events, dear boy, events
That’s a quote usually attributed to former UK Prime Minister Harold Macmillan when asked what he most feared. Forex traders should take note, because “events” offer an opportunity to make money and an easy way to lose it.
So, what is it? Well, the uncertainty surrounding anything from an important data release like the monthly US labor market report to a central bank decision on interest rates or a national election. The victory for Donald Trump in the 2016 US presidential election, the Brexit vote by the UK to leave the EU the same year and the inconclusive result of the 2017 German federal election all spring to mind as events that surprised many people.
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From a forex trading perspective, these events really matter. If the US employment report is stronger or weaker than predicted, the markets will move sharply. If a central bank makes an unexpected increase or decrease in interest rates, they will too, and if an election or referendum result defies the opinion polls, that might well move markets sharply as well.
Events really matter when trading forex
In a nutshell, events really matter because asset prices may react strongly. How they will react is a far more difficult question to answer. In some cases, the reaction will be predictable: think of the slump in the Pound when the British decided to leave the EU or the crash in the Euro against the Swiss Franc in 2015 when the Swiss National Bank abandoned the fixed exchange rate – or “peg” – between the two currencies.
As for the data, stronger than forecast economic data will generally lift the national currency on the argument that a buoyant economy will raise the specter of tighter monetary policy – higher interest rates or a cutback in stimulus – which will make the currency more attractive. A weaker than predicted number will have the reverse effect.
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However, the response will depend on which asset is being traded. There is, for example, an “inverse correlation” between the Pound and the London stock market at the time of writing, so a move higher or lower in the Pound is usually accompanied by a move in the opposite direction by the FTSE 100 index of leading London share prices.
Positioning matters too, because if most forex traders are “long” a currency – expecting its price to rise – and an economic release is weaker than expected, the resulting fall will be far larger than if traders were “short” – expecting the price to drop anyway. Risk may therefore be “asymmetrical”, meaning a surprise to the upside might bring a move of, say, twice the size of a surprise to the downside.
Trading the news to improve your forex strategy
Nonetheless, trading the news is a perfectly respectable strategy, as long as you know what news is important and what news is not. Central bank meetings to decide on monetary policy, for example, are always important – but sometimes more so than others. Central bankers have become increasingly adept at giving forward guidance so the markets may have been given a strong steer that policy will be left unchanged.
That does not mean there will be no reaction because the nuances of what central bankers say are important but it does mean that a sharp price move afterwards is less likely unless, of course, the guidance was misinterpreted or simply wrong. Still, a central bank policy meeting where we are almost certain that nothing will change and no press conference is scheduled is unlikely to prompt sharp price moves. In other words, as a forex trader, you need to know what is important and what is not.
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It is also crucial to understand that some “events” move just one market whereas others might move all of them. News of a surprisingly large rise in oil inventories, for example, will probably weaken the oil price but have little effect elsewhere. News of an unpredicted increase in interest rates, particularly in the US, will have an impact on every market everywhere.
A US interest rate rise that defied forecasts would not just send the Dollar soaring but would almost certainly weaken the prices of gold and other commodities, send stock prices tumbling and reduce the prices of US government bonds – “Treasuries” – as their yields moved higher. There would certainly be an international reaction too, with global stock prices following Wall Street downwards and global bond prices following Treasuries down too.
Why event risk matters
Put simply, global markets are all inter-related; if one moves others may too and there is no point in benefiting from a long position in the Dollar if you lose it from a long position in gold because you forgot that they often move in opposite directions. A sensible plan, therefore, is to decide whether an event is likely to matter, put it in context and decide on possible scenarios.
What will the impact be if this happens? What will it be if that happens? Am I bullish, expecting prices in a particular market to rise, or am I bearish, expecting them to fall? Which is greater, the risk to the upside or the risk to the downside. Which is the best market to be in, currencies, stocks, bonds or commodities?
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Note here the importance of the word “surprise”, used several times already. What matters is not so much what happened as what was expected to happen. If, for instance, the UK increases interest rates, that might be expected to strengthen the Pound and weaken London stocks. However, that will only happen if the decision was a surprise. If it was not and was “already in the price” there will be little response. Indeed, if a hike of half a percentage point was forecast and the actual increase was just a quarter of a percentage point then the Pound would almost certainly weaken, and stock prices rise.
Here’s what happened to the Pound when Mark Carney, the Governor of the Bank of England, said unexpectedly in February 2018 that UK monetary policy would probably need to be tightened somewhat earlier and somewhat more than the bank had expected in November 2017.
GBPUSD Price Chart, Five-Minute Timeframe (February 8, 2018)
It is important too to understand just what constitutes a surprise. Some figures, such as the US payrolls data, are hard to predict. So if a figure comes out that is 10,000 higher or lower than forecast, a strong market response is unlikely. If the number is 60,000 higher or lower, sharp price movements afterwards are far more likely.
There are other subtleties when trading forex too. The focus in the US employment report is principally on the “non-farm payrolls” number – the change in the number of people employed in the US outside the agricultural sector. The initial response, therefore, to the monthly labor market report is generally to that figure. However, a raft of other statistics is released at the same time and the initial reaction may be reversed very quickly when the data analysts find something pointing the other way, perhaps in the unemployment figures or in revisions to past releases.
Indeed, it is very common for the markets to move sharply one way after an economic data release, only to move even more sharply the other way when the statistics have been analyzed more carefully – all within minutes.
Fashions in event risk
There are fashions in economic releases too. Long ago, it was the international trade figures that moved financial markets. Later, it was money supply data. Today, it is all about the central banks and their likely future decisions on interest rates and monetary policy more generally. Today, trade figures will generally not inspire market volatility whereas inflation data are rather more likely to. Moreover, if a figure is notoriously unreliable, such as the monthly number for US durable goods orders, a surprising statistic is less likely to prompt a market response.
Even within a release, fashions can change. In the UK employment reports, the focus until recently was on the unemployment rate. Now, though, the focus has largely switched to the average earnings number because of its importance for inflation, consumption and therefore economic growth.
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It is also important to distinguish between “hard” and “soft” data. The former, generally official statistics, tend to be backward looking. Data for economic growth released in January, for instance, look back to the period from October to December. Soft data, typically released by private-sector companies, may be less reliable but are often forward looking, containing expectations components.
So, to summarize, event trading can be highly rewarding, as well as potentially loss-making, but preparation is the key. As always in the markets, work out what is important – likely to inspire volatility – and what is not. Decide whether the consensus, generally compiled from surveys of economists or from polls, is right.
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If not, in which direction is it wrong? Which asset is most likely to respond? What is the potential upside or downside and is the risk of a move in the opposite direction higher or lower? How is the market positioned?
In other words, expected events can provide opportunities and unexpected events can ruin even the best-planned strategies.
--- Written by Martin Essex, Analyst and Editor