The largest central bank defines the currents of money, stocks and commodities with just a few words
The FOMC is announcing its last rate decision for 2014 today and as usual it will be accompanied by a statement and press conference. Traders around the world will be focused on two parts – the interest rate number itself, as well as the two most important words in the statement – how long the rate decision is planned to hold.
But why are stock markets, forex pairs and even commodities so heavily influenced by this largely planned announcement that many try to predict?
The reasons are many and overlap with each other, but the single most crucial one is that by controlling and changing interest rates and providing future guidance, the Federal Reserve exerts pressure and/or control over an extremely large amount of money and other financial resources. If the not the largest.
The FOMC (short for Federal Open Market Committee) is a committee within the Federal Reserve System (often referred to as the Fed) that has two major mandates – maintaining control over inflation and keeping employment on healthy levels. This is done by the levers they control.
The future guidance for the U.S. economy is the first one. Whether there is an imminent downturn or happy days ahead, this concerns traders, as the indexes and stocks they are buying or selling operate in this environment. All this on the other hand changes the amount of dollars in actual circulation and might make the Fed intervene on the forex markets.
The second is the interest rate, which falls under Fed jurisdiction and dictates the rates for transactions between private banks. If the rate is high, the overall cost of doing business is also higher and this cools down the economy and lowers inflation. If the rate is low then businesses can take credits with low interest, fuelling activity and job creation. If no actual changes are announced, then traders try to decipher the intentions of the central bankers in the statement and press conference.
There is no better source for basing your decisions on. The FOMC is built up of some of the smartest and most informed people around – the twelve voting members in the committee, containing the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents. They are the decision-makers.
Trading the announcement is preferred by traders who prefer more volatility, as its aftermath offers sharper moves. Two general approaches can be discerned. The first one proposes that a position is taken up before the actual announcement and is effectively a prediction in a certain direction – traders select it based on their analysis and place stop losses on the other end. Some might also place a take profit level, but many prefer to monitor the market itself and exit with their profits when they see fit.
The second approach is to wait for the announcement to start pushing the market and trade right after it starts moving. Which is usually quite rapidly, occasionally even reversing its initial direction. This trading type is risky but offers the greatest possible returns, because the largest volume occurs at these times.
The latter approach can also be subdivided, depending on the specific tactic you are employing. You can enter right after the interest rate announcement or you might wait for the press conference of the chairman, who now is a lady named Janet Yellen. This press conference is closely scrutinized by market participants as it can give additional information or context for the announcement that came just before it. It has two parts, a scripted text that is delivered at the beginning and a Q&A session where journalists ask their own questions. This part can sometimes generate surprises, as answers coming from the chairman, despite the obligatory preparations, are sometimes made-up on the spot and can give too much information, or a different twist to the scripted and carefully worded statement.
This evening’s announcement will be quite interesting, as we’ve seen a strong drop in oil prices in the last months, which also has a heavy influence on the overall economy. Coupled with the free-fall of the Russian rouble that might be commented on by Janet Yellen, this will see traders looking for hints on how the Fed will (or won’t) react to the turbulence.