Last updated on November 15th, 2022 at 01:55 pm
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?
- An improving economic growth outlook brings more inflows.
- Link to detailed explanation below
- The higher the short term interest rate, the higher the inflow.
- Link to detailed explanation below.
- 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)
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.
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:
- 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.
- 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:
- 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.
- 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
- 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)
AUD & NZD do well when China’s economy does well and also at the start of an economic recovery (typically when central banks and governments flood the economy with money through quantitative easing and cash handouts, which are both stimulative monetary and fiscal policy).
This is related to Point 1. “Change in expected economic growth (GDP)” because China purchases a lot of Australia and New Zealand’s exports. Hence when China’s economy booms, there is a positive chance in expected economic growth (GDP) of Australia and New Zealand.
AUD & NZD correlation with China’s PMI data
To illustrate how China’s economic growth drives changes in the Australian Dollar, I’ve superimposed both of them in a single chart.
Year 2020 onwards
2007-2020
What is Purchasing Manager’s Index?
Why is it so important? It is a leading indicator of demand for goods in the economy. In short, purchasing managers in a specific country are surveyed on whether new orders have increased, decreased or remained the same from the previous month. All answers are compiled into an index showing increase or decrease in new orders which is the proxy for economic growth. Detailed explanation on PMI.
Why China’s PMI this related to AUD?
Because a lot of China’s manufacturing inputs such as steel and copper come from Australia’s exports, an increase in new orders /output from China’s factories means a lot more raw material has to be purchased from Australia, contributing to Australia’s economic growth.
Canadian Dollar strength is tied strongly to the price of crude oil. Again this is related to Point 1. “Change in expected economic growth (GDP)” because Canada is a net exporter of Crude Oil who will benefit from higher Crude Oil prices.
https://www.abundancetradinggroup.com/usdcad-correlation-crude-oil/
Gold is inversely related to real yield. This is because Gold is a store of wealth while inflation erodes wealth. Inflation erodes wealth when real interest rates become negative. This means that despite earning an interest on your savings, it is insufficient to keep up with inflation, so you gradually lose your purchasing power each year.
When real yields are falling, Gold prices tend to rise because investors buy them wanting to retain their purchasing power.
Likewise, when real yields are rising, Gold prices tend to fall because investors prefer to buy treasury bonds with higher real yields.
What drives higher Real Yields?
There are two components to real yields. Inflation and interest rates.
- If inflation remains stable while the Federal Reserve raises interest rates, real yields rise.
- Or if inflation is high (like in 2022), but the central bank raises interest rates, chances are, the rise in inflation will slow, because the central bank is doing something to slow its rise, and interest rates go up, therefore increasing real yields.
What drives lower Real Yields?
- If inflation is stable, but the central bank cuts rates to stimulate the economy, this will result in lower real yields.
- If the central bank cuts rates to zero (quantitative easing) during a recession, this will increase inflation and cause interest rates to remain at zero, causing lower/negative real yields.
How to calculate Real Yields?
- Real yield can be the US 5 year treasury yield minus 5 year breakeven rate.
- The 5 year breakeven rate is the market’s expectation of the inflation rate in 5 years.
- The 5 year breakeven rate is calculated as 5 year treasury bond yield minus 5 year inflation indexed treasury bond yield.
USD is somewhat inversely correlated related to growth. If the economy is at the early stages of recovery (typically when central banks perform quantitative easing and stimulative monetary and fiscal policy), AUD and NZD appreciate while USD depreciates.
Later on during the economic recovery, when unemployment is near its lows and inflation starts rising slowly, resulting in central banks starting to raise short term rates, USD starts to appreciate against currencies with low interest rates.
The 5 repeatable scenarios of the USD are listed below as the economic goes through one full cycle of boom and bust.
- USD weakens when interest rates are cut and in the early stages of the economic recovery. The stock market usually rallies at this stage.
- USD strengthens when the Fed announces “lift off”, meaning they will start to raise short term rates. The economy is usually doing well at this stage with low unemployment close to 5% and inflation beginning to rise as the economy nears its long term sustainable capacity.
- USD declines once interest rate hike expectations are fully priced in. The economy typically does well at this stage and the stock market continues to rally.
- Economic growth starts slowing, PMI numbers start decreasing towards 50 (below 50 means there is no growth in purchasing managers order from the previous period). The fed usually cuts rates to stimulate economic growth. Because interest rates are cut, USD usually depreciates at this stage. The stock market typically makes an initial rally as rates are cut, but then soon falls thereafter.
- As the stock market starts to drop rapidly, USD starts to appreciate as it becomes a safe haven asset in times of crisis and because margin calls rise or increased margin requirements by exchanges because of the rise in volatility of the stock market or even commodities. This results in investors requiring even more cash (typically USD) to meet increased margin requirements. This forces investors to sell their other currency holdings to buy USD, or liquidate even more stock to raise cash to meet margin requirements, further fuelling the already heightened volatility. This causes the USD to appreciate rapidly.
#5 Usually ends (And the USD peaks) when the Fed shows resolve to inject enormous amounts of liquidity into the economy by cutting rates to zero and quantitative easing to meet strong USD demand (arising from margin calls etc)
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In general, emerging market currencies depreciate when factors have a negative impact on their economy or fiscal balance (the difference between a government’s revenues and its expenditures).
These include:
- Rising USD short term interest rates because these countries have a high amount of USD denominated debt.
- Rising oil prices affecting net importers of oil (India)
- Falling oil prices affecting net exporters of oil, palm oil (Malaysia, Indonesia)
- Government policy to keep interest rates low despite rising inflation (Turkey)
Likewise, emerging market currencies appreciate when factors have a positive impact on their economy or fiscal balance (the difference between a government’s revenues and its expenditures).
These include:
- Falling USD short term interest rates because these countries have a high amount of USD denominated debt.
- Falling oil prices affecting net importers of oil (India)
- Rising oil prices affecting net exporters of oil, palm oil (Malaysia, Indonesia)
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.“
Any shortcuts?
- Subscribe to Financial Times. They will update in their news when central banks change the monetary policy stance.
- 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.
- 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%.
- 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).
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.
| Date | US ISM PMI |
| May 31, 2022 | 56.10 |
| April 30, 2022 | 55.40 |
| March 31, 2022 | 57.10 |
| February 28, 2022 | 58.60 |
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.