ECONOMIC DATA, FOREIGN EXCHANGE TRADING, CENTRAL BANKS – TALKING POINTS

• All fundamental trading strategies are rooted in economic data
• But reactions to that data can be puzzling, and complex
• The likely effect of any number on monetary policy is often most important

The foreign exchange market’s reaction to economic data is one of the most important subjects for traders to consider, but also one of the most vexed.

The monthly round of official and private releases from around the world covers everything from inflation and employment to the forward-looking views of corporate purchasing managers. Together with central bank pronouncements, it forms what we might call the framework of foreign exchange trading.

MAJOR ECONOMIC RELEASES CAN DOMINATE TRADE

Markets may well hunker down, losing both volume and volatility, in the run-up to an eagerly anticipated number. Official US labor market statistics are perhaps the most obvious example here. When the trading community expects serious gains or crushing losses the session can be subdued from Asia’s open and right across Europe as participants nurse suspicions or hopes. Even when the market expects neither many traders will – in financial journalism’s enervating cliché – “wait and see.”

This makes sense of course, enervating or not. Obviously, there’s a link between the economic performance of a country with a freely floating currency and the performance of that currency against its peers. At the most basic level a strong piece of economic data will boost a currency, a weaker one will tend to see it fall.

However, to take the matter no further would be a grave error. For one thing, individual pieces economic data tend to influence currencies in a very fleeting way. The gains provided by even a blockbuster, expectation-shattering number can be undone by the end of a day’s session, and well before that in some cases. It may even mean no more than a few minutes’ spike one way or another.

So, there’s clearly more to know about data and its effects.

The first and perhaps most important thing is that, while data provide the rhythm, the world moves to a monetarist cadence and central banks will always play lead. So, ultimately, the longer-term effects any piece of economic news must be considered with a view to how it might change monetary policy. No single data release is ever likely to do that, and markets would have caused to worry if it did. Central banks like to be ahead of the numbers, ready to tighten or loosen policy as needed before trends turn.

Therefore, we might see the markets only very briefly cheer strong retail sales, say, or powerful job creation. They might be great for the politicians, but, if inflation remains docile, they might not mean anything at all in terms of central bank policy changes. And if rates aren’t going up or coming down, then the longer-term effect of the data on the currency won’t amount to much.

Of course, these days docile inflation is little more than a happy memory across much of the world as war in Ukraine boosts both food and fuel prices at a time when post-Covid supply chain storms are still raging.

CURRENCIES CAN FALL EVEN WHEN INTEREST RATES RISE

In July of this year, the United States Federal Reserve delivered a three-quarter point interest rate rise, something which would have been considered extraordinary monetary action for most of the past thirty years. And yet the US Dollar actually lost ground by the end of the session for, in its post-rate-hike remarks, the Fed left markets reasonably sure that future actions were going to be a lot more measured.

So, we can on occasion see the phenomena of a ‘dovish’ rate hike, or even a ‘hawkish’ rate cut. That’s when a central bank takes action but strongly implies that it has finished doing so, or that the barrier to more is extremely high. Higher interest rates have not been terribly helpful to rare-breed Sterling bulls this year either. The United Kingdom’s political and economic turmoil has left the market wondering if its economy can bare higher borrowing costs. The US certainly looks much better placed to do so.

With all this in mind, merely watching and reacting to pieces of economic news is unlikely to make for a satisfactory trading strategy. Indeed, the Dollar’s broad gains this year have rendered data watching all-but meaningless in many countries. Their currencies have fallen against the Greenback regardless of the numbers as the US currency reveals itself as the ultimate safe-haven play.

Competent traders know where the market is focused and where in the business cycle we are. What that tends to mean in practice is which specific data releases are most likely to trigger changes in the monetary mood music.

These can change dramatically over time. Older readers may well recall the days when western industrial production figures were the ones to watch for the best central bank steer. In more recent times unemployment figures took over. Policymakers were leery of wage inflation and, poised to “withdraw the punchbowl” if the labor market party showed any sign of getting out of hand.

Now of course inflation figures themselves are perhaps the ones which traders look at most obsessively, with prices’ stubborn elevation. One day, the focus will move on again. It always does. But a nuanced approach to trading economic data should remain a constant.

Written by David Cottle for DailyFX