How to Identify the Line of Least Resistance with Fundamentals

In a previous blog post we have discussed why fundamentals matter & how to get in sync with market sentiment.  I have since received various emails from readers that detail their frustration when following fundamentals. Here are the main points touched in most emails:

  • “So many times data is better than expectations but the market sells off. I just don’t believe fundamentals are useful for trading”
  • “The RBA held rates steady but price rallied, and I don’t understand why, it’s confusing”
  • “The FED is raising rates but the USD is pulling back so why not just follow charts?”

Let me say right here & now that if this is the kind of issue you are facing,  it will be relatively simple to take your trading to the next level. The simple fact is that a keen understanding of fundamental data output allows you to identify the line of least resistance (whether short-term or long-term) and will give you a level of confidence you likely never experienced in your trading.

Give Colour to Your Charts

“For myself, any trade idea must be well thought out and grounded in reason before I take the position” – Bill Lipschutz, Market Wizard

A thought-stimulating example I like to use, in order to illustrate the importance of reasoning through fundamentals first, and charts only in a second moment, was something a former trader from Caxton Associates (founded by Market Wizard Bruce Kovner) asked me back in the day:

“If I were to give you $5 Mln to deploy on a trading idea, which explanation would sound more convincing to me?

  • I’d like to buy AudUsd  because it crossed over it’s 20 Day moving average and the RSI is above 50
  • I’d like to buy the Aussie because the RBA’s most recent assessment of the economy was surprisingly upbeat despite leaving rates on hold. RBA’s Lowe was also surprisingly sanguine about the exchange rate.

The above examples are not the original questions I was asked, but they convey the same meaning and are relevant examples which are currently playing out in the markets. The key point being that pure technical analysis is fairly useless for justifying sizeable trades. I’m not saying it’s impossible to trade by using technical analysis alone; I’m saying that having a good understanding of what’s driving price can offer a tremendous amount of confidence when shifting to charts.

Your trades should always find a justification within the fundamental realm first, and the technical realm second. When the two align, it makes for tremendous confidence.

One positive side-effect of following the fundamental stories behind price moves is that time-frames become largely irrelevant. Many traders get confused because one time frame is bearish or lateral (like the weekly chart above) and another time frame is bullish (like the chart below).

But this apparent conundrum can be easily solved with an understanding of sentiment. As illustrated in our previous article  Central Banks are the main protagonists within FX markets. So the first thing to keep in mind is that:

the longer-term bias (or line of least resistance) for any currency is given by it’s Central Bank policy. Central banks, with their recurring analysis of fundamental data output (CPI, GDP, Employment first & foremost), will be very vocal about their intentions via forward guidance.

Secondly, remember to factor in sentiment influences:

  • how has the data output been since the last central bank meeting?
  • what are market participants expecting (which is the same as saying “what is discounted in the current market price”)?
  • Is there an overriding geopolitical factor driving markets (which in central bank jargon is called “external event”)?

Focus on the Matters that Matter

“What is important is to assess what the market is focussing on at the given moment” – Bill Lipschutz, Market Wizard

Let’s make things very explicit by using a real-life, current example. We are going to explore the current monetary policy divergence between two very close Central Banks: the Reserve Bank of Australia (RBA) and the Reserve Bank of New Zealand (RBNZ).

Going back to the December meeting of the RBA there was no change in rates (as expected) and Governor Lowe gave the following assessment of the economy:

  • global inflation outlook is balanced
  • Australian Inflation was quite low
  • Growth is in a temporary slowdown
  • Housing is stronger
  • Terms of trade improved
  • Appreciating AUD a concern

Whereas Governor Wheeler of the RBNZ in November had cut interest rates by 0.25% and said:

  • this third cut in 2016 was largely motivated by a need to depreciate the kiwi, which has become “higher than is sustainable for  balanced economic growth”
  • excessive house price inflation
  • numerous sources of uncertainty in the international scene, so monetary policy needs to be accommodative
  • inflation hasn’t risen to the 3% target yet

So there was already a certain degree of divergence between the two central banks…so why did the cross currency, AUDNZD, not trend upwards right from December 2016?  The answer is that the market’s focus was all on President Elect Trump and his potential first policy moves into the new year. It was hence all about the USD because most central banks of the world were discussing “external risks” all tied to the uncertain US political scene.

However, the lofty expectations that pushed the USD up since early November have exhausted their effect and now the USD is in need of a new catalyst. Hence, other dynamics are back in play.

The most recent RBA meeting conveyed a certain amount of hawkishness, as Governor Lowe stated in particular:

  • the recent rebound in the AUD was not a cause for concern
  • the movement in our terms of trade is boosting our national income at the moment which is good news
  • [regarding key commodity prices such as Iron Ore and Coal] It’s a much better situation than it has been in the last four years when in each year it has been down.

Now compare that with the most recent RBNZ assessment:

  • the exchange rate remains higher than is sustainable for balanced growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed
  • what we have adopted is very much a neutral bias [compared to] an easing bias in November, because we had a 20% probability of a cut in the OCR built in, now we have removed that.

There appears to be a growing divergence between the central banks’ policies and this is what has boosted AudNzd above the highs from back in November when the RBNZ cut rates.

Divergence or Convergence?

The AudNzd trade has just started and can potentially run much longer, since the policy divergence between the two central banks has just become apparent. The convergence/divergence trade is one of the most powerful long-term drivers in the FX space. It’s the reason why EurUsd & GbpUsd have been dropping for so long (ECB & BOE maintaining an easing bias vs. FED’s hiking bias). It’s the reason UsdJpy has recently risen so much (BOJ’s easing bias vs. FED’s hiking bias).

By keeping this background divergence/convergence in mind amongst currencies, it becomes easier to spot value amongst currencies. Let fundamental influences guide you towards the best currency pairs to play, and only then bring on board your technical analysis (for entry & risk management).

Short-Term Influences &  Long-Term direction

There is one last point to cover: the role of short-term influences. Just because there may be monetary policy divergence between central banks, it doesn’t mean prices will move in  a straight line. Instead, the markets wiggle, will take two steps forward and then retrace. There may be periods of consolidation or retracement.

All this can be very confusing for traders that rely only on technicals.

In reality, short-term influences need to be followed because they change the fundamental landscape. If fundamental data were to radically improve in New Zealand during the next month, do you think the RBNZ will continue with it’s neutral/dovish bias? Not likely. At the same time, if housing or employment were to worsen in Australia, would the RBA continue to sound so hawkish? Not likely.

Markets are driven by the ever-evolving flow of fundamental output, which is directly related to market participant’s view of the future prospects for the various regional economies. Central banks watch the same information – they don’t invent their policy stance out of thin air.

Sometimes market participants discount conditions correctly, ahead of the central bank’s decisions. In these cases, traders will likely “sell the fact” when the central bank confirms market expectations.

Other times (such as with the RBA last week) the central bank will “surprise” the market in one way or another, and market participants will need to adjust their expectations (and thus their positions in the markets) to account for the unexpected information.

Just like changes in price trends start on the small time frames and only after a certain amount of time become evident on the daily & weekly time frames, changes in fundamentals start with the short-term data releases (& accompanying expectations which are missed/met/exceeded) and the short-term picture gradually forms the longer-term picture central banks acknowledge.

Over To You

Understanding fundamental data & how the data shapes central bank views is possibly the best starting point for serious traders. And yet so many aspiring traders simply cannot be bothered to do a minimum amount of research.

So I invite you to do the bit of extra work that is necessary to become skilful at following market sentiment & fundamental data output.  Play this game just like institutional traders do, and it becomes very clear what category of traders will be on the other side of your trades.

Good Luck!

The post How to Identify the Line of Least Resistance with Fundamentals appeared first on www.forextell.com.

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