Ultimate 2022 Forex Trading Guide

By | July 9, 2022

Ultimate 2022 Forex Trading Guide

There are 2 simple guidelines on how to trade Forex:

Then we apply the guidelines 1 & 2 learnt above with live examples:

1. But what causes higher inflows and outflows?

  • Similar to “Interest rate differentials”, if short term interest rates are expected to rise because the central bank announces their intention to raise it, the more inflows there is likely to be.
  • Link to detailed explanation below.
  • The higher the inflation, the more inflows there is likely to be, ONLY IF inflation is below the central bank’s target (usually 2%, this can be found on the central bank’s website). This is because it means the central bank is likely to raise short term interest rates to keep inflation in check.
  • However, the higher the inflation, but if inflation rates are already above the central bank’s target, then it is more likely to cause outflows, because when the central bank raises interest rates to combat high inflation (usually 5% or greater), the higher interest rates will weaken economic growth in order to bring inflation back under the central bank’s target. Hence bringing us back to Point #1 “Change in expected Economic Growth”.
  • Link to detailed explanation below.

Let's look at them one by one in detail

  • Change in expected Economic Growth (GDP)

Change in expected economic growth (GDP), which potentially leads to a stronger/weaker currency. Stronger economic growth also could lead to higher inflation especially when economy is nearing full employment and consequently higher interest rates (thus more inflows) as central banks raise rates to keep inflation in control. Likewise, weakening GDP growth could lead to central banks having to cut interest rates to stimulate economic growth and lower interest rates are likely to lead to outflows from the currency and therefore depreciation of the currency.
  • Interest rate differentials

For example, if EURO yields -0.5% and USD pays 2%, more money is likely to flow into USD and flow out of EURO, causing EURO to depreciate against the USD.

We confirm this correlation with the image below of the white line closely tracking the blue line (USDEUR).

The white line is the difference between USD and EURO interest rate. It is called “Forward Points”.

It is calculated as: (10000*spot rate* (1+USD interest rate*90/360)/(1+EUR interest rate*90/360))-spot rate.

The USDEUR sign is flipped to illustrate its positive relationship USD and EURO interest rate differential (i.e. if USD interest rate increases, USD strengthens against EURO).

Likewise, this relationship also holds for other currency pairs.

In the USDAUD chart below, the higher the AUDUSD forward points (white line), the more the USDAUD (blue line) chart rises.

Formula of AUDUSD forward points: (10000*(spot rate*(1+USD interest rate *90/360)/(1+AUD interest rate * 90/360)- spot rate). This is simply a measure of the difference between the two country’s interest rates.

The same goes for AUDCHF below.

  • Expected change in Interest rate differentials

Expected change in interest rate differentials happen when the central bank announces they are going to make a series of rate hikes or cuts:

  1. Such an expected increase or decrease in rates can cause the currency to appreciate or depreciate respectively as money flows in or out in response to the higher or lower yields.
  2. Usually this effect is observed more when short term interest rates changes (i.e less than 2 years) and not so much for long term interest rate changes (10 year) (see below, notice how the USDEUR doesn’t respond to the change in 10 year forward points, being the white line)
  • Change in expected inflation

Expected change in interest rate differentials happen when the central bank announces they are going to make a series of rate hikes or cuts:

  1. Such an expected increase or decrease in rates can cause the currency to appreciate or depreciate respectively as money flows in or out in response to the higher or lower yields.
  2. Usually this effect is observed more when short term interest rates changes (i.e less than 2 years) and not so much for long term interest rate changes (10 year) (see below, notice how the USDEUR doesn’t respond to the change in 10 year forward points, being the white line)

It is possible to pre-empt the central bank’s expected change in rates by observing inflation rates.

If inflation rates are too high (6-7%) while the central bank announces that they want to keep inflation around 2%, there is a good chance they will eventually raise rates to the “Neutral Rate” to first stop inflation from worsening, then to a higher than “Neutral Rate” to reduce inflation. Some central banks might share what they think is the neutral rate. You can google for this by searching “<Central Bank Name> Neutral Rate”

In theory, if all else is equal, bringing the interest rate to neutral only keeps inflation at its current level. However, if the population thinks that 6-7% inflation per year is too high, then the interest rate has to be more than neutral in order to reduce it. We’ve seen this in the late 1970s, where persistent inflation was finally killed when the US Fed raised interest rates to around 18%, while inflation peaked at around 14%. 

Hence you can buy the currency in advance in expectation the short term rates will rise beyond inflation levels.

There is a caveat though. Although we expect interest rates to rise, there will come a point where the news is fully priced into the markets. This means almost everyone is long USD in expectation of the rate rise and there is no one left to buy to push prices higher. So this doesn’t mean that we exit our position only when interest rates hit beyond inflation levels. Perhaps we can close 2/3 our position at various historical highs/lows, but leave the final 1/3 to run until interest rates hit beyond inflation levels.

This also brings us to our point later on positioning.

1a. Where do I get these economic data on inflation and the latest economic news?

Use trading view to figure out the current inflation numbers

  • United States Inflation – USIRYY
  • Australia Inflation – AUIRYY
  • German Inflation – DEIRYY (as a proxy for Europe)
  • 5 year breakeven inflation rate – T5YIE (market’s expectation of the inflation rate in 5 years).
    • Important as a forward looking indicator, because the current market prices reflect what is forward looking. The 3 indicators above are backward looking but depict the current inflation picture.

I find the Financial Times to be very helpful in keeping abreast with the latest central bank news, changes in their policy stance, the latest changes in economic news which are all important in understanding the above currency moves. Basically it is an all in one place for the market moving news, so you don’t have to look at each central bank’s website daily. If the bank of England publishes that it expects the UK’s economy to slow this year, it will be published on the Financial Times. (5 May 2022)

The subscription costs about SGD50 (USD40) per month, but I am of the view that it is a necessary cost to incur and it will help your Forex trading so much more because of the quality of its content, as well as save you time in searching for the latest news as it is all in one place.

You might ask, what about free news providers like Dailyfx and Forexlive. I used to use them but they don’t hold a candle to Financial Times. The news in Financial Times helps me grasp the picture and potential direction of currency pairs so much more easily because of the higher quality of content.

Read overview of central bank statement to figure out state of economy. For example, a tight labour market means further economic growth is likely to come at the expense of wage inflation and this is likely to drive inflation higher. Other major inputs of inflation include fuel prices, so if fuel prices start to decrease (which is unlikely due to supply shortages arising from the war in Ukraine), then we have a clue as to the direction of inflation and consequently the direction of interest rates.

But there will come a point where all the news of inflation and higher interest rates is fully priced into the market and high inflation currencies like the USD is less likely to rise further because the expectation is fully priced in and because the currency is so overbought it deviates from its fundamental value too much and because there is no one left to buy it. i.e the market is very long USD. This brings us to the next point on positioning.

Bank of Canada
US Federal Reserve

(Central banks may change links containing monetary policy from time to time, but it is easy to find the new link by doing a google search for “Central Bank name + statement” (i.e. Federal reserve statement))

2. Positioning (oversold/overbought) (Is the data priced in?)

The rationale for this is that you don’t want to be the last person buying, resulting in no one after you to buy to push the price higher. You need to check if the market’s positioning is near its previous extremes. (i.e. how long EUROs is the market)

View the market positioning and take a look at the “Large speculators/non commercials” position (orange line). If it is near its past extreme in the past 3 years it might not be such a good idea to enter the trade.

Applying what we learnt in #1

Let’s dive into detail to understand how the factors below drive each individual currency’s movement.
  • Change in expected Economic Growth (GDP)
  • Interest rate differentials
  • Expected change in interest rate differentials
  • Change in inflation (which potentially leads to higher interest rates to keep inflation under control)

 

Your next steps …

As explained above, the magnitude and the expected future direction of the difference in interest rate between currency pairs is an important factor that contributes to inflows into a currency, and consequently its appreciation and depreciation.

By listing G10 currency pairs with their respective central bank rates, together with their expected future direction, you are able to immediately see which has the largest difference, and consequently good pairs for going long or short.

You will be able to find the expected future direction by searching “<Central Bank Name> policy rate”. (e.g. RBA policy rate, ECB policy rate)

You will then have to click into the latest monetary policy statement and read it to understand the future direction.

For example, in the Reserve Bank of Australia’s latest statement on 6 July 2022, it states

The Board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead.

For example, in the European Central Bank’s latest statement in June 2022, it states

We intend to raise our interest rates by 0.25% in July. We expect to increase them again in September. How fast we raise rates after that will depend on how inflation develops.

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Any shortcuts?

  1. Subscribe to Financial Times. They will update in their news when central banks change the monetary policy stance.
  2. Take note of the gap of current interest rates to the current inflation rate. As a very rough estimate, if inflation is 8%, interest rates should be around 8% to bring inflation back below 8%. Hence if interest rates are much less than 8%, there is still room for it to rise.
  3. Take note of the central bank’s target inflation rate (usually 2%). If current inflation is 8% and interest rates are 2%, interest rates are likely to rise further until inflation is observed to start falling from 8%.
  4. Use Global-Rates.com. They list out all the central bank rates and their expected future direction (image below), doing all the hard work on our behalf. Just remember to ignore exotic currencies (explanation below).

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Exceptions

You should ignore emerging markets currencies (except China), because non G10 currencies are not driven by interest rate differentials as much as G10 currencies. They are instead driven by economic factors such as current account deficits, foreign debts that are in USD instead of their home currency. The factors that drive emerging market currencies are above.

Again because interest rates should roughly be equal to the inflation rate for inflation to be reduced, we can make an educated guess as to the future direction of interest rates if inflation is 8%, while interest rates are only at 2%. In such case, interest rates are more likely to rise until we start to observe inflation coming down.

All central banks will have a policy stance that is either hiking (raising rates) or easing (cutting rates or maintaining low rates/ quantitative easing program). Your job is to find central banks that have opposing stance. Then you would want to go long the currency that is hiking, while short the currency that is easing.

As of this time of writing, most central banks are hiking with the exception of the Bank of Japan being the only one keeping an easy monetary policy.

With that being said, at this point of writing (July 2022) among all the central banks that are hiking, you would want to be long Australian Dollars because it is economically strong, with low unemployment rate at 3.9% and China’s purchasing managers’ index (PMI) has started to rise in June 2022, meaning a rise in economic activity which benefits Australia.

You could be long US Dollars, but since the currency has appreciated significantly in the past 2 months, I believe there may not be much room left for the currency to appreciate further. Please see my guideline on positioning to understand why it may not be prudent to enter new US Dollar longs. 

Why not long GBP since BOE is hiking?

Because at this time of writing, UK’s economy is slowing and the Bank of England (BOE) forecasted that the UK could end up in a recession. The two reasons for this is inflation (driven by higher fuel and gas prices because of the Ukraine war causing a shortage), and the BOE hiking interest rates to bring inflation down while the economy is already not in a good shape. BOE doesn’t really have a choice.

Hence you don’t want to go long a currency pair that has deteriorating economic growth. See my explanation above.

At the time of this writing (June 2022), the United States’ Economy is doing well relative to Europe and United Kingdom. This is judged by United States’ Purchasing Manager’s Index being relatively stable and remaining above 50 while Europe and the United Kingdom are plagued by high inflation and slowing GDP growth (possibly leading to a recession). We would want to short Euros or the British Pound against the US Dollar on a pullback, because the price you enter directly affects how much profit you make in the end.

DateUS ISM PMI
May 31, 202256.10
April 30, 202255.40
March 31, 202257.10
February 28, 202258.60

We could also go long Australian Dollars (AUD) against Euros, although I would prefer going long AUD against US dollars because Euros has been already heavily sold in March – May 2022 and I am concerned how much downside there is left, whereas the US dollars has been appreciating during March – May 2022 and perhaps it may be due for a correction to the downside.

The reason for going long AUD would be if China starts to release economic stimulus. Lowering of banks reserve requirement ratio, the Chinese Government selling more bonds, etc.  

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