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We have a quick question here from a new subscriber asking, “How we can predict “longer term currency trends, “especially from a swing trading perspective?”
Now, the biggest and most influential way to predict track as well as trade longer term currency trends is definitely through something called Central Bank Policy Divergence.
Now, this might sound like a lot of big words if you’re new to this, but put in simple terms, it just simply means that you’re looking for two central banks that are basically on different interest rate paths. So, on the one end we have a central bank that is expected to hike interest rates. And on the other hand we have a central bank that is expected to cut rates.
So one bank’s rates are expected to go higher while another one’s rates are expected to go lower.
Now, a word of caution here is that longer term fundamentals are simple to grasp, but of course, like most things in trading, it’s not always easy and will require a lot of analysis on your part to make sure that you are staying on top of the possible changes in any of the currencies fundamental factors that might change the overall buyers.
So for example, imagine that the market expects central bank A to keep rates unchanged for a long time, let’s say the next 18 months. So in other words, the bank is more neutral and then imagine on the other end we have a central bank, central bank B, which is expected to move interest rates in terms of hiking rates.
So in anticipation of this the market will start to buy central bank B’s currency against central bank A’s currency. Now the trade runs great for a couple of weeks or months. And then imagine that suddenly central bank B, that is the one that’s supposed to go into a hiking cycle.
Imagine that their central banker comes out, or governor comes out and saying that the bank might wait until inflation overshoots the inflation target, and allow inflation to run a little bit hotter than previously expected before they tighten monetary policy.
Now, when that happens, the underlying reason for the trade that is the Central Bank Policy Divergence, it’s no longer valid from an immediate term point of view, because the hiking might start later, and that doesn’t take away the expectations for hiking of course.
But the question will then become, “Okay, by how much will the bank allow the inflation “to overshoot?” And that will be the next key driver then, or focus for that potential currency. And not really then the overall possible divergence between the two currencies or between the two central banks. Now also keep in mind that Central Bank Policy Divergence works best when it’s fresh, right?
So, just think of it like short-term sentiment. What we mean by this is if Central Bank A has been hiking for 12 months, and Central Bank B has been neutral for 12 months, it’s not really a new theme in terms of a new Central Bank Divergence, right? It’s been going on for a very long time, so keep that in mind. So, the very best trading opportunities for this type of trade is when the shift in policy shifts expectations when it’s very recent.
So something that you can use as a possible barometer of possible divergences is using something or tracking the central banks by reading through their statements, making sure that you’re doing research on where the market expects their rates to go next, so what is the rate path. And as another quick measure you can also consider using something like the bond spreads between two currencies. So the bond market like most markets are very sensitive to changes in overall interest rates, and more specifically to changes in interest rate expectations.
So using your bond yield spread between two currencies can be a very good barometer to see what the bond market expects of rates. And of course, as a general rule, usually your currency pair should follow the direction of the overall bond spread or the bond yield spread. But there are obviously circumstances when that won’t necessarily be the case.
As with all correlations they don’t work perfectly all the time, but it is useful as a general rule to keep in mind. So I hope that helps any other questions with regard to this. Please don’t hesitate to let us know.