Learn Forex Trading for Intermediate Traders

Intermediate
Trading101
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PMI's and Their Role in the Forex Market

Throughout the trading month, there’s a plethora of economic data that comes out and makes the currency pairs move. Suddenly, Forex trading isn’t lethargic anymore, as activity picks up.

Every country releases a different set of economic data, but some are common for every economy. An example of such a release is the PMI or the Purchasing Managers Index.

The PMI is a survey of companies in the private sector. Released monthly, it shows the economic health of a specific sector of the economy.

PMI’s belong to the first tier category economic data of any economy. In the financial calendar, it is marked with the color red, highlighting its importance.

Traders use the economic data to form an idea about what the central bank will do with the interest rate level. Positive economic data is typically associated with economic expansion, which leads to an optimistic central bank’s analysis. Hence, traders will buy the currency.

On the other hand, economic data that misses the target suggests economic contraction. Because central banks are the first to react due to their proactive nature, traders buy and sell in a frenzy during or right after critical economic data.

For any central bank, the following data matters the most:

  • Inflation or the CPI (Consumer Price Index). Released monthly, it shows the changes in the values of goods and services.
  • Jobs data
  • PMI’s
  • GDP – Gross Domestic Product
  • Consumer-related data

Anything else which would be part of the economic data, will influence the above releases. Hence, it belongs to second tier data.

Interpreting the PMIs

The PMI is an original economic release. As mentioned earlier, it is a survey conducted monthly in various economic sectors.

For some economies, the PMI is calculated only for two sectors: manufacturing and services. For some, the PMI refers to the construction sector as well.

In any case, the PMI can cause extreme volatility in Forex trading. When the PMI release misses the target or when it implies economic troubles, currencies plunge on expectations that a recession might come, and the central bank will react faster than initially thought.

Throughout the world, dedicated institutions calculate the PMIs. For example, the Markit Group is responsible for calculating the PMIs for over thirty countries in the world.

In the United States, the Institute for Supply Management (ISM) is responsible for calculating two releases for the manufacturing and non-manufacturing sectors. Or, for the manufacturing and the service sectors.

Another major supplier of economic data, this time from Asia, is the Singapore Institute of Purchasing and Materials Management (SIPMM). Together, the three institutions are responsible for “mapping” the PMI activity for the most important economies in the world.

Compiling all data gives one a general idea about the health of the global economy. Armed with such information, macroeconomic traders quickly spot differences between significant economies/regions in the world, and they adjust their portfolio accordingly.

Explaining the PMI Release and its Importance in Forex Trading

The PMI is a survey of about four hundred managers of companies from manufacturing, services and, in some cases, construction sectors. The managers answer questions relative to:

  • New orders
  • Inventories
  • Supply deliveries
  • Employment
  • Order Backlogs

Armed with the responses, the institutions compile the data from the five areas, and the weighed outcome revolves around the fifty level.

The standard interpretation of any PMI release is that values below the fifty level signal economic contraction for that specific level. As such, a release above fifty shows improving economic conditions.

Traders look beyond the numbers. Namely, savvy traders compile statistics and charts that go back in time, trying to make the most of an economic cycle by examining how the PMIs evolved for the last six or twelve months.

In the PMI’s case, the more, the better, doesn’t work. A PMI release of sixty, signals more troubles than economic success. Here’s why.

For an economy to grow at the desired rate, PMIs around 55 would be enough. The higher the value goes, the higher the risk that the economy overheats, and eventually, a “hard landing” comes. (it means the economy will contract as fast, if not faster, then it expanded, sending shockwaves throughout the region)

PMIs in Major Economies

Being the largest economy in the world, it is normal to start with the United States. As mentioned earlier, the ISM is responsible for the two releases: manufacturing and non-manufacturing.

While they have a different name than in other parts of the world, the releases are similar.

Because the United States economy is a service based one, the ISM non-manufacturing weighs more in the overall GDP number. Hence, what’s happening in the service sector will create more volatility in the Forex market.

The ISM has released such data since 1948, each month, helping traders and other parties interested in the economic evolution of the United States. If you go back and check the criteria for the survey again, you’ll understand why the PMIs are so important in Forex trading.

The Federal Reserve of the United States (Fed) has a dual mandate: to keep inflation below or close to two percent and to create jobs. But one of the criteria of the ISM survey refers to employment levels in the manufacturing and non-manufacturing sectors.

Hence, traders use the ISM releases to form a better idea about the next Non-Farm Payrolls (NFP) release and the unemployment rate. The aim is to interpret the ISM employment component (especially the one referring to the services sector) to forecast changes in the NFP.

Armed with that information, traders position for the next move in the federal funds rate by the Fed. After all, interpreting economic data is just a logical process part of the fundamental analysis in Forex trading.

The Chicago PMI release deserves a special mention here. Calculated by Deutsche Borse, it refers to the manufacturing and non-manufacturing activity in the Chicago area. The thing is that this area is considered representative for the entire United States, as the mix of services and manufacturing companies and their weight in the regional economy resembles that of the whole country.

As you can see, traders have plenty of clues regarding the way an economic sector evolves, way before the Fed meets every six weeks to decide on the federal funds rate. In other words, there’s no excuse not to be prepared for a shift in monetary policy, if you did the “fundamental homework” right in the first place.

For the rest of major economies like the United Kingdom, Eurozone, and Australia, the PMIs refer to the services and manufacturing sectors (Eurozone) but also the construction one (U.K. and Australia).

In Canada, there’s only one PMI release, called the Ivey PMI, that gathers all the info relevant to the economy, no matter the sector. The name comes from the institutions that make the poll.

In Japan, there’s the Tankan report. A comprehensive economic analysis, the Tankan report shows not only the info regularly seen in the PMI’s but also other relevant data to interpret the shape of the economic activity.

Conclusion

While not the primary driver of prices in Forex trading, the PMI releases are one of the first ones to spark a change in direction. In an expansionary economic cycle, if the PMIs keep confirming the expansion, no one will pay attention to the releases. After all, they’re expected.

However, when the economic cycle is at its peak, or shortly before that, the first data to stumble is the PMI data. Hence, the releases have a crucial role in Forex trading and positioning at the end of economic cycles.

For this reason, they offer a tremendous competitive advantage for traders that know how to interpret the data provided.