What is Forward Guidance?
Since around a couple of years, central banks all over the world started to introduce to market participants the concept of “forward guidance“. The purpose of it was to bring more transparency regarding central banks actions and therefore to avoid huge price fluctuations.
However, is this concept working in reducing the volatility on the financial markets? Probably no and the purpose of this mini-educational article is to show to you that trading forex is mostly about fundamental and technical analysis and forward guidance is only part of the fundamental analysis.
According to the Federal Reserve in the United States, forward guidance is a policy tool that aims to steady expectations about the future interest rates by guaranteeing a level of interest rate untill a certain level of employment and inflation has been reached. This aims to assure markets that the central bank is confident and determined it can achieve their goals. Nonetheless, Fed’s projections have been all over the place, and so they did cause some volatility.
This is because Fed members normally can only base their decision on economic data and economic data can be traded by taking into account the economic calendar before deciding to buy or sell any given currency pair.
Like mentioned earlier, the very concept of forward guidance was introduced by the Federal Reserve but it has been adapted by other major central banks in the world. Original idea comes from academic economics and people like Michael Woodford.
Two classical examples are coming from Europe, where both ECB (European Central Bank) as well as Bank of England have made major changes when it comes to the way central banks are communicating their rate decisions and rate decisions expectations.
Since Mr. Carney was coming at the helm of Bank of England, the first thing to do was to change the way the bank functioned and by doing that basically he introduced the forward guidance.
It is a well-known fact that Bank of England is not having any press conference after the MPC (Monetary Policy Committee) is setting the rates unless the rates are being changed. However, after the 2008 financial crisis, rates are at the lower boundary and here we are now so many years later and rates are still low.
In order to communicate to market what the Committee is looking at, Bank of England moved the Inflation Report in the same day with the interest rate announcement and this allowed for a press conference to be held. And just like that, the press conference after the interest rate decision was invented, making room for forward guidance to take place.
ECB and Press Conferences
The ECB (European Central Bank) on the other hand always holds a press conference forty five minutes after the interest rate decision is being released but still they introduced something new to comply with the forward guidance principle: they made the minutes public and now the ECB is publishing its minutes showing what members of the Governing Council have discussed, just the same way like the Federal Reserve in the United States is publishing the minutes.
This way, central banks are aligning in order for market participants to have an educated guess regarding what is happening with interest rates and what to expect forward. After all, interest rate differential is all that matters when it comes to trading a currency pair or the stock market as well as they are going hand in hand.
There is a strong correlation between interest rates and the way markets are moving. For example, interest rates moving to the upside imply equities are moving to the downside, so what seems to be bullish for the currency, it is actually bearish for the equity markets.
However, equity markets have the tendency to recover when earnings season starts so it is not affected that much by rate hikes or cuts.
All in all, forward guidance is a new principle to stay with us from now and despite the fact that it is designed to bring less volatility to markets, it is in fact bringing more.
Federal Reserve Strategy
Federal Reserve of the United States it is having even economic projections made by central bank’s staff for the years to come and also some dots regarding where the Federal Reserve members are seeing the interest rate for the years to come. Of course that if those dotes are showing almost the same thing market will interpret it as a given and will act accordingly. On the other hand, if they are spread across different levels, it means uncertainty is reigning.
More details about the concept, when to expect it and what to look for when press conferences are starting, to be found in the two video analysis in this article as we’re going over the economic calendar trying to find out the most important releases for the forward guidance principle as well as tips and tricks regarding what to look for and what to consider when forward guidance is present.