Ever wondered how to identify the moment markets turn? Most traders have – because it’s a skill which can unlock profitability. These moments are called fundamental turning points. It’s simply where the long-term trend of a currency changes. This article explores how to work out fundamental turning points.
Central banks hold the key
Identifying these moments depends on your understanding of your currency pair’s respective central banks.
Moreover, this skill requires more than just your interpretation of a central bank’s monetary policy. It actually requires you to recognise the interpretation of the market as a whole. This is absolutely vital. Your task is to determine whether market sentiment matches the long-term policy programme of a central bank or not.
Getting a feel for market sentiment is actually quite straightforward. You just need to read and watch as much financial news as possible. In particular, pay attention to what analysts are saying about central bank action. It’s usually quite obvious if the market has turned – or whether it’s a temporary volatile reaction.
Once you have identified a turning point – you need to act. You should aim to match your turning currency with one that has an opposite monetary policy extreme.
A recent example of this comes from the Canadian dollar (CAD). The Bank of Canada has just hiked their key interest rate from 0.5% to 0.75% (July 2017). Fundamentally, an increase in interest rates represents a stronger Canadian economy. It also means we can expect CAD to enjoy a period of strength over the long-term.
The Japanese yen (JPY) is a good candidate (at the time of writing) to pair with CAD. The Bank of Japan’s monetary policy divergence is strong compared with the Bank of Canada. They are currently pursuing an aggressive quantitative easing programme. Such action typically weakens a currency.
Patience can be rewarded
Needless to say, fundamental turning points can be very profitable if executed correctly. In fact, they have the potential to make hundreds of pips.
While it can be difficult to identify an exact entry point for such moments, your goal should be to enter the trade as close as possible to a central bank’s change in direction. This will ensure you maximise the amount of pips that you make.
Many traders make the mistake of obsessing over the perfect entry point. My advice is to keep things simple. Use the principles of support and resistance to enter your trade accordingly.
Plus, we really want to trade turning points that will the play out for a significant period of time.
But how do we know if a turning point is indicative of a longer-term trend? Again, keeping up with the most recent financial news is important. We can usually determine from the news whether a central bank is entering a new cycle of action.
An example: USD interest rate hike
Back in December 2016, the Federal Reserve increased its interest rates for only the second time in 10 years.
But this news was widely expected by the markets. The news that strengthened the US dollar related to the increase in hikes anticipated by the Federal Reserve for 2017. It was clear that the Federal Reserve was entering a new hiking cycle. A clear fundamental turning point with long-term prospects.
It is possible for false fundamental turning points to lead to a ‘one-off’ turn of events, rather than a long-term trend.
As a trader, you need to be aware of events that have the potential to be volatile and unpredictable. Once such example that springs to mind is Brexit. Following the unexpected referendum result in 2016, the market saw a significant selloff of the pound (GBP). The market was clearly nervous here – and anticipated a prolonged period of economic weakness for the UK.
However, just over a year later, we can see that the UK economy has proved resilient. The Bank of England also became more hawkish as UK inflation crept up. Clearly, the Brexit vote was a false turning point.
How to work out fundamental turning points
The above example illustrates the importance of trading in line with a central bank’s current monetary policy – not market sentiment.
This is a difficult skill because market sentiment actually drives price over the short-term. It’s what generates moves for intraday traders.
But as Brexit demonstrates, market sentiment can be inaccurate over longer periods. Think of market sentiment as gauge for short-term price movements (but nothing more).
This is why it’s important to make your trading decisions based on the monetary policy programmes of central banks. Trades taken on this basis have a much higher chance of being profitable over the long-term.
Removing market sentiment from your long-term trading decisions is simple – but it can take a little practice. The process is complicated by financial news coverage on television. With 24/7 news cycles, the media can tend to focus on market sentiment shifts. But once you’re aware of this fact, it’s much easier to filter that information out of your decision-making process.
I hope you’ve found this article useful. If you have any questions, please leave them in the comments below. I’ll do my best to reply to as many as I can.