Learn Forex Trading for Intermediate Traders

Intermediate
Trading101
20 Lessons
20 Hours

Explaining the Forward Guidance Principle

The ability to understand the actions of a central bank and their implications in Forex trading is essential for trading success. Everyone knows the central banks set the monetary policy for an economy and the currency will appreciate or depreciate as a result.

But few know why the central banks bother so much in communicating their intentions to the market participants. The answer comes from the automated trading that takes place in the twenty-first century, and the communicating tool is called forward guidance.

Automated trading makes it more and more difficult for retail traders to keep up with the market. Of course, retail traders can build their Expert Advisors (trading robots) too.

The MT4 platform, for example, offers a great tool to build and test indicators and robots. Plus, to run them both in demo and live conditions.

But the real challenge comes from the quant industry. Or, the high-frequency trading.

These trading algorithms or super-computers are so fast and powerful that they can bring the entire financial system to its brinks. For that reason, central banks take extreme cautionary measures when addressing the monetary policy or answering questions from financial media representatives.

If you’ve noticed, the most important things that happen in the world today take place over the weekend. Wars start over the weekend, referendums, elections, etc. so that until the Monday’s opening the eventual market contagion can be contained.

When the Swiss National Bank (SNB) dropped the EURCHF peg rate from 1.20, it did so during the trading week. What followed was real mayhem, with the Forex trading industry suffering the biggest blow since retail trading became available to masses.

The main reason for the failure was the lack of communication. The markets were taken by surprise, and when the announcement came, there was no market anymore.

In other words, even if traders had stop-loss orders for the long trades on the EURCHF pair, brokers/robots could not execute them, because it was no market. It was, probably, the most significant communication failure in the history of modern banking.

Forward Guidance as a Monetary Policy Tool

Believe it or not, forward guidance is a monetary policy tool. Just like a central bank decision, the way to communicate to markets creates significant volatility.

Under the forward guidance principle, central banks not only explain to market participants their plan but also offer clues about the conditions needed for their decisions. A great example comes from the United States.

When the U.S. economy slowed down, the Fed lowered the rates to almost zero. It was the logical thing as the housing bubble created one of the significant financial crisis in recent history.

However, as it proved, lowering rates to zero wasn’t enough. It was not only that the economy didn’t improve, but the danger of deflation (inflation falling below the zero level) started to show its teeth.

Hence, more needed to be done. And, the Fed delivered.

It started to buy bonds directly from the U.S. government, in a process called Quantitative Easing (QE). That was the announcement, but it also came with the conditions needed for the process to stop.

The last version of it, the QE4 came with a threshold based on a specific unemployment rate level. In other words, the Fed told markets that it'd keep the QE program alive until unemployment reaches the desired target.

Suddenly, that was the news to watch. When the jobs data came out during the months that followed, the dollar moved higher or lower depending on how much the unemployment rate got closer to the targeted rate, or not.

Press Conferences as a Tool to Guide Markets

The more interconnected financial markets became, the bigger the need for clear communication from central banks. For example, the Fed in the United States cannot just raise the federal funds rate without the implications to be felt on every single market and country in the world.

Hence, communicating and telling financial markets what the plan is, what’s the policy, what are the expectations and what conditions need to happen for a change in monetary policy, is part of the day to day activities of a central bank.

All central banks in the world hold press conferences. The idea of a press conference is to explain why the central bank made the decisions and to answer questions from press representatives.

Perhaps the best place to exemplify the importance of the forward guidance principle is the United States. Until a few years ago, the Fed held no press conference after its interest rate decisions.

The bank just issued the Federal Open Market Committee (FOMC) Statement every six weeks, and the statement was the entire forward guidance. However, it wasn’t enough.

As markets and market participants changed, conditions changed too. Hence, the Fed upped its game and introduced one quarterly press conference.

It still issues the FOMC Statement, only that half an hour later a press conference starts. The Chair reads the statement, together with the staff projections for the years ahead, and then takes questions from financial media representatives.

Not once has the price action in Forex trading been more volatile during the press conference than during the FOMC Statement. In other words, the principal decision is already old news by the time the press conference starts, but the market participants choose to focus on expectations in Forex trading.

Since it introduced the press conferences, not once has the Fed changed the federal funds rate without a press conference to follow. Hence, it became a rule of thumb that if/when the Fed changes the rates, it’ll do it after a meeting followed by a press conference. This way, it makes sure financial markets correctly understand the message.

If not, the forward guidance principle is reinforced via member’s speeches. Throughout the trading month or in between two central banks meetings, members have regular public appearances.

A TV interview, a newspaper article, a keynote speech at a particular event, they are all part of the forward guidance principle. When the market participants misinterpret a message, central bankers come out via a spokesperson and deny or confirm the news.

By market participants, don’t think of retail traders, as they are responsible for only about six percent of the entire Forex trading market. Instead, think of commercial banks, hedge funds and other big investors, Forex brokers, and even central banks as entities that move the market.

As an example, recently there was news stating that the European Central Bank (ECB) was preparing to hike the rates sooner than the markets believed. One of its members, the Austrian governor, claimed in an interview that the ECB would increase the rates sooner and there was no problem in doing so.

Consequently, the EURUSD and other Euro pairs jumped higher, as higher interest rates are attractive for a currency. However, a few hours later, the ECB stated that that’s not the ECB view, but only the view of one single member. Hence, the Euro reverted to the original breaking point.

Conclusion

The forward guidance principle plays a critical role in Forex trading. Not only so that the market participants know what the central bank does, but also why it is engaging in such policies.

As the markets and market participants change, look for the forward guidance principle to change too. Monetary policy today and the tools used are very different than the ones used a few decades ago.

What central banks try to do is to offer a clear perspective on the future interest rate levels. Using the forward guidance principle gives them the power of avoiding unpleasant market reactions.