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25 - Understanding Fundamental Trading Within The Economic Cycle
At the beginning of this section we looked at the concept of an economic cycle and the four different phases that make up that cycle. We also looked at how various factors influence these cycles and that we can use certain indicators to measure where we may be within a cycle. We also know that these cycles dictate how central banks act and react in order to move the economy from one cycle to another with the hopes of keeping growth stable and predictable.
In this final lesson on economic cycles we are going to spend a little more time looking deeper into the inner working of these cycles and how fundamental trading evolves within these cycles
In this Article:
- A Perfect Economic Scenario
- Fundamental Trades from the Perspective of Big Money
- Fundamental Trades from the Perspective of Speculators
- How Fundamental Trades Unfold
A Perfect Economic Scenario
A perfect economic scenario for a central bank is where the economy is growing while their currency stays relatively weak when compared to the other countries that they do a lot of trade with. This is exactly the kind of economic scenario an exporting economy wants to have. If you think about it this makes a lot of sense.
If a country exports more goods than it imports then this would mean they want their currency to be relatively low compared to the currencies of the countries they export their products to. Why? In this scenario, the country that is exporting will be paid in a currency that is worth more than their own currency. This means that the exporters will have the potential to make more money. If the exporters are making more money than they will pay more taxes and help contribute to a higher GDP within their country. That’s exactly what a central bank would love to have all the time.
However, this situation is very rare and almost never happens for any length sustained of time because of the impact of various economic cycles. But this doesn’t stop central banks from relentlessly pursuing this exact utopian economic situation. These days, economic developments are moving at a much faster rate than we have ever seen before and will probably continue in this direction of speed as technologies continue to expand.
It seems like “reactionary” central banking is taking the place of “predictive” central banking. These days, central banks have to react more and more to economic developments because economic trend switch so fast. Most economies have also become prone to abrupt crashes because of new complex financial products that are not fully understood.
This is very different from the old days when central banks could spend a year predicting how the economy will play out and then have the flexibility to do then implement ideas and policy changes over the next couple years. Different times we are in.
Fundamental Trades from the Perspective of Big Money
Now that we know what a perfect economic scenario looks like, let’s think about that scenario from the perspective of the big investment houses and asset management firms.
Let’s pretend for a minute that you are a wealthy investor (maybe you are 😉 whom is looking to not only protect your wealth but also to grow it at a decent rate of return. Given that you have plenty of money, what would you do and what would you invest in?
When you have lots of money your primary concern is to preserve that money rather than growing it at massive rates. Of course you want the best possible return on investment but the primary focus typically shifts to wealth preservation rather than aggressive growth.
When you have little money, such as most retail traders, your primary objective is to grow that cash as fast and as aggressive as possible. It’s just the nature of human beings that we will take huge risk with small amounts of money and smaller risk with large amounts of money. Most people would not take the same level of risks on a $5,000,000 account that they would with a $500 trading account.
Or imagine that you are responsible for allocating capital for a large pension fund with exactly the same goal in mind; to protect and grow the wealth of the portfolio in a stable manner. You would no doubt want to place your capital in a country that is politically stable, has good growth potential, and a high level of interest payout. This would be the perfect scenario with low risk and a slightly higher reward. It’s for reasons like this that interest rates are so important to the FX market.
There is literally trillions of dollars floating around in large funds, investment banks, asset management firms, and wealthy investor’s portfolios all looking to do the same thing; low risk and decent reward. So, it makes sense that we as speculative traders would want to know what these big money players are doing and why. This is only going to help us find and pick up some nice trading opportunities along the way.
Investors from all over the world are looking for places with political and economic stability but also offer higher rates of interest to help their money grow. This is why these investors watch the FX market very closely for any signs of politically stable countries that might start raising their interest rates soon. Big Daddy FX loves the higher interest rates!
When investors do find this combination economic stability, and potentially higher interest rates, there is a flood of excitement and a wave of demand rushes into the specific currency in question. This happens because these investors try to get their cash into these countries’ currencies early to take advantage of, not only the higher rate of interest, but also the increasing valuation of the currency due to more people buying the currency up. Simple supply and demand equation here; more people interested in buying rather than selling = price goes up.
For example, if a Japanese asset management firm wants to invest in the United Kingdom because they think higher interest rates are coming then they have to first purchase British Pounds. They will do this by buying the GBPJPY currency pair. This is the same thing as buying Pounds and selling Yen. This will have a direct effect on the value of the British Pounds because there is a lot of buying taking place.
In general, as more outside investors come in and buy a currency the value of that local currency can go up and up until the economy is no longer attractive and the cycle turns around the opposite way again.
Fundamental Trades from the Perspective of Speculators
For us retail traders and speculators that are clued up on the fundamentals and sentiment we know what the big players are thinking. This is because we now know when an economic cycle looks like it’s improving. Us traders will try and get in on the expected higher interest rates by buying the currency ahead of the larger investors. But we do this because we know what the larger investors are thinking. We’re inside your head bra!
Remember, it’s us speculators that provide the liquidity to the FX market that these large investors need. So it’s not like we are not getting a free ride here.
We are also lighter and more nimble when it comes to getting into and out of our currency trades quickly. This is one of our competitive advantages that large funds do not have. Think about that; if we buy a lot or two the market won’t even blink. And we can make a great living off buying a couple lots at a time. But when large funds are coming into a currency they are looking to buy tens of thousands of lots which are going to have a measurable impact on the particular currency in question.
It may take a large fund several weeks to make decisions and process their transactions before their huge capital is fully converted. By this time we are already in and riding that wave up, and sometimes several times. In certain situation we can use one trade idea for months to come. Thanks be to the big boys!
How Fundamental Trades Unfold
A fundamental trade and trend can unfold in several ways but there are 2 distinct waves that we need to look out for. We are going to keep with the theme of higher interest rates for this example.
- The first wave is the reaction wave and this is generally speculators trying to beat the larger players into the position. This happens because we have been given clues as to what the big money players are thinking. We are essentially anticipating how they are going to move their cash.
- Over time comes the larger secondary wave that is caused by the reallocation of large investment firms moving their money into the particular currency of interest. This can set up multiple trades for us as well because it takes a long time for these firms to get their massive capital reserves into the market.
Knowing this information is one of the main reasons that economic cycles are so important in predicting interest rates. It’s also why interest rates are so important to predicting the moves that the larger players in the markets will make and want to be a part of. This is the type of information and trading opportunity that speculators live to take advantage of.
Make sure to commit this to memory because potential higher interest rates in stable economies can reap a lot of very easy trading profits if you understand how this all works. By the time you have gone through this entire guide you will have all you need to go out and practice the same type of trading that the big players use.
It’s also worth pointing out that the exact opposite of higher interest rates is also true. We have focussed on higher interest rates being a positive thing but remember that central banks obviously cut rates too when they need to. In this case, we simply flip the equation. We would want to sell the currency belonging to a country that we think will cut interest rates soon. The big funds will look to exit their long positions and might even want to flip short in a falling interest rate currency.
This is also another good point to remind you that what the market expects will happen is hugely important to know. This is because the market bets its money based on what it expects to happen. It’s a discounting mechanism and we want to know when the discounting mechanism is moving in full force so that we can make some pips along the way to.
Next we are going to take a look at something called Sentiment. We are going to start putting some of this macro fundamental trading knowledge to use on a more micro time frame so that we know when we might potentially have some nice day trades.