Decoding FX CFD 2.0 February 20, 2024

This article is aimed at availing information and knowledge essential to intermediate forex traders. It will cover advance details not covered in our previous article “Decoding FX CFD”. It is highly recommended that readers check out the previous article first before reading this one.

The forex market boasts a vast and diverse range of participants, from individual traders and companies to central banks and government, making it the most liquid market in the world. This liquidity far surpasses that of the futures market, equities market and other exchanges, as shown in the picture below:

Source: Yahoo! Finance

Thanks to this high liquidity, participants in the forex market can establish substantial positions without significantly affecting prices. The forex market is not merely a collection of buyers and sellers, but also includes market makers, namely brokers, FX dealers, banks and more. The overarching forex market consolidates all bid and ask quotes to offer the best quotes for trading. The pricing of forex quotes is influenced by numerous factors, including the actions of buyers and sellers, and market makers. All three groups play a crucial role in shaping prices.

In contrast to equity markets, where the exchanges serve as a medium for buyers and sellers to execute trades, these platforms have minimal impact on determining the execution prices of equity trades, which are primarily influenced by the buyers and sellers.

Another advantage of high liquidity levels is the prevention of market manipulation by any single party. Not even central banks can exert full control over forex rates; and must maintain high levels of foreign reserve to maintain influence. A prime example is an event that occurred in September 1992 when George Soros and other hedge funds significantly challenged the Bank of England by selling vast amounts of British Pound. This forced the British government to withdraw the British Pound from the European Exchange Rate Mechanism (ERM) and led to the devaluation of the Pound Sterling [2].

Source: GFF Brokers

Traders should analyse how each component influences the forex market to gain a deeper understanding of how macroeconomic news releases affect FX rates.

Major Factors Determining FX rates

FX rates are influenced by a myriad of factors. Given that FX rates are always expressed in pairs (e.g., USD/JPY), they are impacted by the news related to both currencies involved. In this article, I will explore three key macroeconomic news factors that are crucial for FX traders.

Interest rate & Inflation

Interest rates and inflation are intricately linked, with the central bank controlling the former. Inflation measures the increase in prices of a basket of goods and services over a period and is often viewed as the destroyer of wealth, eroding the purchasing power of money. However, central banks worldwide, including the US Federal Reserve (Fed), target a long-term inflation rate of 2%. The Fed posits that a 2% inflation rate over the long term will facilitate maximum employment and price stability. Moreover, a low and stable inflation rate encourages household consumption and contributes to a robust economy. Therefore, when US inflation significantly exceeded 2% in 2022, the Fed raised interest rates 11 times from March 2022 to July 2023 to cool down the economy and combat inflation. The graph below illustrates the inflation rate (blue line) and the Fed funds rate (white line).

It can be observed that when inflation rises above 2%, the Fed typically increases interest rates.

The interest rate represents both the cost of borrowing money and the return on holding the currency. Consequently, currencies with higher interest rates tend to be more sought after than those with lower interest rates. For example, the US Fed has been progressively raising interest rates since March 2022 (from 0.25% to 5.5%). In response, central banks in other countries have also increased their interest rates, while the Bank of Japan has maintained its target rate at -0.1%. This policy stance has led to the depreciation of the Japanese Yen against all major currencies. The graph below illustrates the US Dollar appreciating by approximately 30% against the Japanese Yen.

The graph below illustrates the SGD/JPY exchange rate from February 2021 to February 2024, showing the Singapore Dollar appreciating by approximately 40% against the Japanese Yen.

Market participants often capitalise on the low interest rate of the Japanese Yen by borrowing in Japanese Yen and investing in currencies with higher interest rates, such as the US Dollar and Singapore Dollar, to earn positive swap points. As the interest rate of a currency increases, that currency tends to appreciate against currencies with stable interest rates.

Balance of Trade

The Balance of trade (BOT) represents the difference between the monetary value of a country’s imports and exports over a period of time [5]. This macro-economic data is essential for forex traders as it indicates whether a country is a net exporter or a net importer, —signifying either a net inflow of domestic currency (for net exporters) or a net outflow (for net importers). For instance, the US is a net importer, with exports amounting to US$261.1 billion and imports to US$322.7 billion, resulting in a trade balance of -US$61.5 billion. [6]

Analysts often predict upcoming balance of trade data releases. If the actual figures are higher than expected (indicating more exports), it’s a bullish signal to traders. Conversely, if the actual figures are lower than expected (indicating more imports than anticipated), it is considered a bearish signal for traders [7].

Employment Data

Employment data is scrutinised by most central banks, as many have mandates to maximise employment, either directly or indirectly. For example, the US Fed has a dual mandate to maximise employment and maintain price stability [8]. It uses interest rate adjustments as a tool of monetary policy to meet these objectives. Thus, if US employment data is weaker than anticipated, it provides the Fed with more justification for monetary expansion to boost aggregate demand and stimulate the economy, thereby increasing employment. This becomes particularly significant when market participants are trying to predict changes in interest rates.

Upcoming Macro Data Releases

For forex traders, upcoming macro data releases are pivotal as they have the potential to significantly move markets and present trading opportunities. Platforms like the POEMS 3 App and the POEMS web platform feature an Economic Calendar, as illustrated below. Users can customise this tool to suit their needs with filters for countries, volatility, and categories.

Source: Poems

Source: Poems

In conclusion, the forex market stands as the pinnacle of liquidity, boasting a trading volume of approximately US$7.5 trillion per day. This vast liquidity allows market participants to establish significant positions in the forex market without causing huge market movements, a stark contrast to the equity market. While players in the forex market can influence prices, it is the collective market dynamics that ultimately determine these prices. Furthermore, the forex market is significantly affected by macroeconomic news, including interest rates, inflation, the balance of trade, employment data, and more. For those keen to stay abreast of macro data releases, the POEMS 3 App and the POEMS web platform offer comprehensive economic data covering most major markets.

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References:

• ¹ https://finance.yahoo.com/news/forex-market-size-traders-advantage-044400707.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAK824Fc_2MKg2c-tplYMFQBfEf7BInPdC0TX4EyLzYaeVdUgEyXGf13IfsKCpKr7YnHrb31eQZadlA1fWcltx1gvaaOmn0KdPo8yYB5twWBFv5_VEi-mc-nC7L9aQi4BPLx_yEoJd68tddD3-kuQ_xZuJfXpUy1zuBy1EGIo8y-g
• ² https://www.gffbrokers.com/black-wednesday)/
• ³ https://www.investopedia.com/ask/answers/08/george-soros-bank-of-england.asp
• ⁴ https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Inflation
• ⁵ https://www.federalreserve.gov/faqs/economy_14400.htm/
• ⁶ https://corporatefinanceinstitute.com/resources/economics/balance-of-trade-bot/
• ⁷ https://www.bea.gov/news/2023/us-international-trade-goods-and-services-september-2023
• ⁸ https://www.investopedia.com/ask/answers/041515/how-does-balance-trade-impact-currency-exchange-rates.asp#:~:text=The%20balance%20of%20trade%20(which,less%20demand%20for%20its%20currency/
• ⁹ https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm