- Simplify your economic calendar by focusing on what the Central banks watch
- Central banks have shown to keep a close eye on the unemployment rate and inflation when setting their rates
- Changes in unemployment rate will usually be preceded by strong economic growth, something that the ISM indicator and Non-Farm Payrolls capture well
Looking at most economic calendars available online it’s easy to get overwhelmed. Should we focus on inflation, durable goods orders or maybe the ISM indicator? There are many different indicators and there are indicators from many different countries, this raises the question on what is relevant for us when trading Forex.
Focusing on what maters
If we trade Forex, the prominent driver of prices are short term interest rates and these rates are set by each country’s central bank. With this in mind, the market is interested to know if a central bank will increase or decrease their short term interest rate.
If the central bank is expected to increase their short term rate earlier or more than the rest of the major central banks, then the currency tends to gain. The opposite is true if they are expected to lower their rate.
For more on this specific topic please read: Interest Rates and the FX Market
With this in mind, when we look at the economic calendar, we should ask ourselves, is this data report important enough for the central bank to change their short term rate given the outcome?
Many indicators will not qualify with this criteria and will therefore be ignored as they will not change the major and longer term macro theme.
What will usually cause the central bank to change their interest rates?
The general focus of most central banks is to
- Keep inflation near or at a 2 per cent yearly growth
- Help the unemployment rate to reach its long term equilibrium
In general, for the Federal Reserve, the unemployment rate has lately been the more important variable as inflation has been low compared with the 70s. This means that they will allow inflation to be above its 2% target if the unemployment rate is higher than its longer term equilibrium.
With unemployment equilibrium I refer to the Non-accelerating inflation rate of unemployment (NAIRU), and refers to a level of unemployment which is simplified; said to expect to keep inflation stable. If the unemployment rate is above the NAIRU level, inflation tends to decline, if below, inflation tends to increase.
From this perspective the unemployment rate is linked to inflation, and it will sometimes allow a central bank to ignore high or low inflation readings, if the inflation is not consistent with the unemployment rate’s relation to the NAIRU level. Spikes in energy prices, which are not linked to strong economic growth is a prime example of when the CB might ignore inflation.
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The general model which central banks use
If we focus on the US central bank, they will usually increase their short term rate when the unemployment rate is about to reach its long term equilibrium. The reason for this is because if the unemployment rate is allowed to stay below its neutral level for too long, this will generally lead to higher inflation. The interest rate will usually be lifted higher and higher to limit gains of the labour market.
At one point when the interest rates have been increased enough; the demand for labour, consumption and investment will decline. This will cause the unemployment rate to become worse off. If the unemployment rate is expected to be higher than its longer term neutral level, the Federal Reserve will tend to lower its short term interest rate to boost demand for labour, as the labour market is getting too “weak”.
The figure below shows the key short term rate of the Federal Reserve in red and the difference between the current estimated NAIRU by the OECD and the current US Unemployment rate, in blue.
As we can see the correlation has been reasonably good in our sample, which spans from March 1994 to October 2014. With a current NAIRU of 6.08 and an US unemployment rate at 5.8, the blue line is positive and at 0.28, see left hand axis. The correlation between the blue and red line has lately broken down as the Federal Reserve wants to make sure that the labour market will be able to stand on its own feet.
Yet with the labour market being healthy, the markets are betting on the correlation between these two variables to link back. This is one of the reasons why markets are bullish on US interest rates, and while the FED’s fund rate is yet to change, traders are buying the US Dollar today, anticipating that rates will increase in the future. This is on the back of a strong labour market.
With this in mind, we can clearly see that the unemployment rate gives us an idea of how short term rates will move. Its however important to note during certain periods, inflation or other drivers have been the primary reason for changes in the US Feds fund rate. The central bank will usually communicate what they focus on via their interest meetings.
What leads the unemployment rate?
For the labour market to do well, the general growth of the economy needs to be good. If demand is high this will spur higher production by firms, which will hire more people to meet the increased demand.
Simplified this means that the unemployment rate will be determined by the economic growth. This is why indicators like the US ISM Manufacturing and ISM Services matter.
The ISM Manufacturing and Services reports are published each month and give us an indication of the state of the US economy. The report is quite extensive but any outcome above 50 means that the specific sector is growing, e.g. manufacturing or service sector, while an outcome below 50 means that the sector is contracting.
Months with above trend outcomes, e.g. when the indicator is persistently above 53, indicates a high economic growth, this will at one point lead to a lower unemployment rate, the opposite is true if the ISM remains below 51 for a long period of time.
Unemployment rate vs. ISM composite
As we can see below the inverse unemployment rate and the ISM composite is highly correlated. The ISM composite in our example below, is an economy weighed average of the ISM Manufacturing and ISM Services. When the ISM is above the 53 level the unemployment rate tends to decline. Please note that in our chart below, unemployment series has been inversed, see scale right hand. The blue line which is the ISM Composite, will clearly bottom out and stay at elevated levels many months before the unemployment rate declines (moves higher in the chart below).
Another key economic indicator to watch is the US Non-Farm payroll, in the chart below we can see how positive growth in the month over month change in US Non-Farm Payrolls, will eventually cause changes in the Unemployment rate. One or two months of strong NFP will usually not be enough, but many months of strong or weak US NFP will affect the unemployment rate. This is way the US NFP is closely watched and generates strong volatility if the numbers outperform or disappoints.
Suggested reading: Central Banks and monetary policy
With this in mind we can simplify our view of the economic calendar. Focus on what might cause the Central bank to change is short term interest rates. The unemployment rate is a key factor to focus on and the unemployment rate will usually change on the back of strong or very weak economic growth. The economic growth is something that the ISM and US NFP describes well. Inflation is important but can sometimes be ignored by the Central banks if the unemployment rate is below the neutral level of the central bank.
With this in mind, the US NFP, ISM, NFP and Federal Reserve meeting outcomes (FOMC), are what all traders should have a good grasp about if they want to trade and understand the long term trend.
- Trends in currency prices are mainly driven by relative interest rates and the rates are set by the central banks. It’s therefore interesting to watch what the CB is focusing on
- When central banks set their interest rates they will focus on inflation, the unemployment rate and the GDP growth
- When the unemployment rate is about to reach its longer term neutral level, the central bank will adjust their interest rate higher
- Changes in unemployment rate will usually be preceded by strong economic growth, something that the PMI (ISM) indicator and Non-Farm Payrolls capture well
- A strong decline in ISM and NFP will usually precede a weaker unemployment rate and a rate cut
A great trend as of lately has been the decline of the EURUSD. The ECB hints about lower rates in May 2014 while the US Unemployment rate improves, increasing the likelihood of higher US rates.
—Written by Alejandro Zambrano, FX Analyst.
Reach out to Alejandro on twitter @AlexFX00
Alejandro hosts our London session outlook webinar every day at 9:30 AM London time. He also hosts educational seminars in London each month and you could join him for an evening seminar or morning seminar, where he will show you how to setup trading ideas before the London session kicks off. Email at email@example.com for more info.