Lessons

Lesson 4: What really determines the FX rates?

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.

Inflation:

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.

10 Comments

  1. Hi Mo,

    Another very good read! Thank you so much for your time and step by step explanation. I really have the feeling I am learning and given the time can do my own trades with good solid explantion on the ‘why’.

  2. Mo,

    Reading your recent posts and the response to the central banks meetings last week, I have a question in regard to what will drive the Fed’s decision to increase or not interest rates in December. Some people are starting to argue that interest rates are actually of less concern and that liquidity is the key concern as already being addressed by the ECB. Given that billions or trillions (sorry can’t keep up with these large numbers) of treasury bonds in the US are maturing next year, this will also potentially have a big impact on the US economy and Fed decisions. Have you given any thoughts on this, or still to early to be relevant? Also, I’m not entirely clear how related the two are?

    Regards,
    Anja

    1. Liquidity is not an issue in the US at the moment, they have no desire to start easing but rather the opposite and to tighten. You can not begin to compare the situation in Europe with the US, completely opposite sides, with one bank (ECB) needing to lessen monetary policy while the other (FED) seeks to tighten.

      Furthermore, treasury bonds maturing next year are not an issue. Every year, a titanic amount of fixed incomes mature and more are issued. This is the same in EVERY government, even in the middle east. Whatever gave you an idea that this is a concern for the FOMC when it is an issue they never mention? To be blunt, it is not relevant at all.

      You ask questions which show that you are thinking about the situation, which is an excellent sign, but I worry that you might be wasting your time worrying about the wrong issues. Issues which are not relevant. Try to understand all the basics first, that is the best investment of your time at the moment.

    2. Ouch, sorry reading over my answer it sounds harsh or condescending slightly. It wasn’t meant this way. I typed it while multi tasking. Please know I only want the best for all of you and didn’t mean it to come off sounding so firm.

      1. Mo,
        I’d appreciate the bluntness and the time you’ve taken to answer the post. I’m an open and direct person and keen to learn so no offence taken. Point taken – makes sense.
        Regards,
        Anja

  3. Dear Mohammed,

    Another concise info which made me think.

    Is there a website or are you maintaining on an excel /spreadsheet showing all this information having the previous month/year data for each currency so as you can be able to make a sound decision using these fundamentals? I also noticed that there was a trade that you had the fundamentals but looking for an entry using technical analysis (probably this is for another lesson).

    1. Sound decisions are hard to make, but a “roughly accurate” figure is good enough for me in most cases. And yes, I maintain excel workbooks for modeling purposes.
      I am not the biggest fan of technicals but I sometimes use them to make sure im not opening a sell before a massive support or a buy before a massive resistance etc.

  4. Hi Mo

    I would like to say that i am really appreciating all you doing for everyone, there aren’t many people like you out there. I am really enjoying the forex lessons, can’t wait for lesson number five as I am keen on learning more from you.

    Oh and one other thing may you please add me to you valued copier list as would like to make trades based on your strategies as it is the best way to learn.

    Thank you very much once again.

    Uzile8

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