Well, finally we can begin with a lesson that is genuinely practical. Enough of the rubbish psychology and lectures on staying disciplined and maintaining focus. I apologise for those but you needed to read them to decide if you wanted to continue or not. I guess since you are still reading that you are finally ready. Now you are going to learn the most vital and important fact about what determines the FX rates.
I am sure that all of you have seen the notifications when economic data is due for release and you have experienced how deviations of the actual data from expectations and previous data have influenced the exchange rates. However, a good question for you would be do you know why? What does all of this matter? Does it just cause a temporary fluctuation in the markets or is there something more long term to it?
Well the fact of the matter is that individually none of these pieces of really data matter. At least not alone. They matter only collectively with other economic data since such data combines together to form an overall picture of the economy. This picture then helps the respective nation’s central bank determine monetary policy and most importantly interest rates.
And that is the basic truth about all of this data and why it matters. It only matters because it is a piece of the puzzle that helps determine a nation’s interest rates which directly affects the value of that countries currency. The higher the interest rate, the stronger the currency will be relative to its counterparts and vice versa. (For example if 2000 units of currency A are usually equal to 1 unit of currency B and the Central bank of currency B’s nation increases its interest rates, then B will buy more units of currency A). Therefore when data continues to support the idea that a nations central bank is on course to tighten monetary policy and raise interest rates, that currency becomes stronger.
But what is the fundamental key data that matters and affects monetary policy? This is the important part and luckily I have broken these down into the various factors that I believe the central banks look at closely. At least if I was the governor of a central bank (stranger things have happened), I would pay attention to a few key economic released. I have broken these up into three categories to make it easier to understand. Please realise that keeping successful track of these is vital in understanding the long-term direction of a nations economy and consequently the long-term trend and direction of its currency. It really is that simple my friends.
Growth and Productivity:
A.) The key indicator I would look at it this would be gross domestic product (GDP).
B.) I would look at changes in industrial production both compared to previous year and compared to previous months.
C.) I would look at the participation rate of the workforce and the unemployment rate as two key indicators of productivity and if possible, if there was data on the change in jobs then this would also be a useful indicator.
A.) I would look at the consumer price index ( CPI) and how that has changed over time, in this respect while all data is helpful, the core inflation figure is more useful in the long run.
B.) I would look at the producer price index ( PPI) and see how that has changed over time.
C.) I would look at the cost of wages and how it has changed over time.
Household wealth and savings:
A.) I would look at growth in the stock market (or contraction).
B.) I would look at the average prices of homes and how they have grown or declined over time.
C.) I would look at the risk-free rate ( Treasury bills) and how yields have changed for the various maturities (for example two years, five years, 10 years).
Now you have learnt the most important lesson that will help you become successful at determining the long term direction of currency pairs. It is genuinely this simple and it took me a long long time to understand this because I had nobody who made it so clear in such a short lesson. I have to read many books and undergo a lot of trial and error and frustration. All the while not understanding why things were going the way they were going until I finally learned, accepted and understood how all of these things came together to make one clear path.
However there is more to this than that. It is all very well knowing where the road goes, but for maximum profitability you need to understand where to get on and off the road with buys and sells at the right time. Just because the economic data suggests that in the long term an FX pair is on the way up, it doesn’t mean that it’s going to go up in a straight line. As convenient as as this would be, the markets don’t make it that easy.
So how do we do this? Well it’s quite simple. We understand the core data that can move the market and we decide when we believe the analysts are right and when we believe that they are wrong. I haven’t been successful trading solely because I randomly guess right each time I believe the analysts to be wrong or right, I’ve been successful because I have been doing my own forecasting with my own models and discovering relationships between pieces of data (you’ve probably seen me talk a lot about this in previous trade ideas and posts when they used to be public) and my forecasts are correct more times than they are wrong (70%+ of the time).
This is what I want to teach you all over the next few months, how to forecast data and implement it with historical economic data and market expectations to determine direction. I know it might sound hard and overwhelming, but please don’t worry. We will get there. If I can do it, then all of you can as well. Please do not think that I am better or more capable than any of you in any respect whatsoever. I am not.