Trading the FOMC Meetings
There are several fundamental
news and economic events that can have a huge impact on the forex market, and
the FOMC meeting is one of them. The anticipation and speculations in the days
leading up to the meeting and the fallout thereafter cause so much volatility
in the market, as traders and analysts react to decisions made in the meeting.
It is such an important event
that even pure technical traders look forward to it and adjust their trading
plan accordingly — temporarily stay off the market during the press conference where
the key decisions in the meeting are announced or formulate strategies to
benefit from the increased volatility during the period.
Before looking at how to trade
the FOMC meeting, let’s find out what the meeting is all about.
Table of Contents
FOMC is the acronym for the Federal Open Market Committee, which is the branch of the U.S. Federal Reserve Bank that supervises the direction of the monetary policy of the United States. Members of the FOMC include seven governors of the board and five presidents of the Federal Reserve Bank.
Eight meetings are scheduled for the FOMC each year. The purpose of each meeting is of twofold:
1) Previewing existing economic data
2) Deciding the necessary intervention based on the economic data.
What Happens During the Meetings?
During the meeting, the committee deliberates on several issues about the U.S. economy and the global economy. The committee considers a lot of economic data, including the growth of household spending, job gains, unemployment rate, wage increase, inflation, and business fixed investments.
After carefully considering all these data, the committee decides on the Federal Fund Rate and money supply. Fund Rate is the short-term overnight interest rate that banks charge each other for loans and deposits with the Fed, and this rate dictates the medium-term and long-term interest rates. The Fed’s decision on money supply affects the sale of U.S. Treasury Bills and bonds.
Meetings are closed to outsiders, and only the seven governors of the board and the five Federal Reserve Bank Presidents are in attendance. Shortly after the meeting is concluded, a press conference is held, and the general outcome and the key decisions are announced. However, the minutes of the meeting are not published until three weeks after the conclusion of the meeting.
How do the Markets React?
Market reaction to the decisions reached during the FOMC meeting can vary dramatically, but it is generally based on the prospects of changes in the interest rates. The FOMC’s position on whether or not to intervene in the U.S. economy has far-reaching effects even outside of the US. Being the largest economy in the world, whatever affects the U.S. market also affects the rest of the world. Moreover, other central banks take a cue from their U.S. counterparts.
The Fed usually targets an annual inflation rate of 2%. So, depending on whether it wants to slow inflation or drive it up to balance out the money supply and ensure price stability, the FOMC may introduce policies to raise interest rates or lower them. In essence, the outcome of the FOMC meeting gives traders an idea of the official view of the U.S. economy.
Probably the most important indicator of the U.S. economic health, alongside the Nonfarm Payroll report, the FOMC meeting is keenly followed by traders all over the world. Many traders, especially the fundamental traders, make use of the FOMC decision to design a framework for their trading strategies.
Technical traders also pay great attention to the decisions of the committee because of the volatility it generates in the markets. Some technical traders tend to stay away from the market during the post-meeting press conference and when the minutes are published. However, others love the increased volatility and formulate strategies to trade the event.
Decisions from the FOMC can have a direct impact on several aspects of the U.S. economy and the markets that rely on the economy. So, the effects can be felt in different markets or asset classes, including:
1) Forex markets
2) Bond markets
3) Equity markets
4) Commodity markets
Forex Markets
Decisions of the FOMC have a serious impact on the forex market because most of the major currency pairs have the USD as either the base or the quote currency. When the FOMC increases interest rates, the value of the USD increases because more foreign investors will be attracted to the U.S. economy. Conversely, when the interest rates are lowered, the value of the USD is likely to decrease.
Bond Markets
Bond markets are highly dependent on the prevailing federal rates. Bond prices and yields have some inverse relationship with each other and the interest rates. When the interest rates increase, bond prices fall, and yields increase. On the other hand, when interest rates fall, bond prices rise, and yields decrease.
Equity Markets
Interest rates affect the way businesses and consumers can borrow money. When interest rates are increased, people tend to have less disposable incomes to buy shares, leading to declines in prices. This is due to less demand for certain shares. When the interest rates are low, people can easily borrow money to invest in stocks, so stock prices often rise.
Commodity Markets
Commodities (such as gold, silver, and other precious metals), tend to have an inverse relationship with the USD. So, when the interest rates are low and USD is weak, those commodities tend to rise in value. Conversely, when interest rates are high and the USD is rising in value, the value of those commodities often decreases. Also, investors see those precious metals as safe-haven assets to buy when the economic outlook is looking gloomy.
Increases in volatility occurs during the FOMC meeting press conference, and when the minutes are released, may present some trading opportunities. Scalpers and day traders may formulate some strategies to benefit from the increased volatility that occurs around the time of this economic event.
However, trading during a period of increased volatility can also be very risky. If the price goes against your position, you can lose a lot of money. Even if you’re using a stop loss or a trailing stop, the price movement can be very dramatic that the slippage may be more than you can handle.
Speculation Prior to Meetings
In the weeks leading up to an FOMC meeting, speculation as to what the Fed’s decision will be is common, so more often than not, the market may have already priced in the interest rate adjustments expected from the meeting, by the time the outcome of the meeting is announced.
Unexpected Decisions - Implications
Implications of an unexpected FOMC decision is that the market reaction can be very swift and severe as volatility may increase significantly. It is often difficult to take advantage of the confusion, but if you have a good understanding of the dominating market sentiment and you are quick enough, you may be able to capture the quick price spikes that come with such surprises from the Fed.
While long-term traders may not be concerned with the price spikes that occur during this kind of economic events, they should also be aware of the fact that the FOMC decision can affect the long-term direction of the market. However, the actual effect of any adjustments in the interest rates may take time to manifest in both the economy and the financial markets. This is sometimes more than 12 months.
So, it is very necessary to take the time lag into consideration when analyzing any potential trading opportunity or making any investment decisions. Another thing to consider is the possibility of formulating a specific trading strategy for each FOMC meeting which can benefit from the price movements, irrespective of the outcome from the meeting.
You can combine the outcome of the FOMC meeting and a simple technical strategy to scalp the market in the minutes following the announcement of the FOMC decisions.
Use the 5-minute and 1-minute timeframes for this strategy and only for currency pairs with USD as the base currency. Here is what you do:
1) Put a 21-period EMA and a 100-period EMA on your chart and watch the direction of the indicators before the news release.
2) If interest rates are raised and the 21-EMA is above the 100-EMA, enter in favor of the USD and put a stop loss below the nearest support level. Then trail your profit very fast.
3) If interest rates are lowered and the 21-EMA is below the 100-EMA, enter against the USD and put a stop loss above the nearest resistance level. Then trail your profit very fast.
For currency pairs with USD as the quote currency, the opposite may work.
Final Words
FOMC meetings are among some of the most important events on any traders’ economic calendar. It is scheduled eight times in a year, and it’s where interest rate decisions are made. Its reports have some significant effects on the forex market, and the increased volatility that occurs during the event may present some trading opportunities.
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This does not constitute investment advice or personal recommendations as your specific financial circumstances have not been considered. No warranty is given in regards to the accuracy and completeness of information. Past performance is not an indicator of future results.