Shares digital

Traders need to watch the effect of economic data. Nick Sudbury keeps his ear to the ground, his eye on the ball and his finger on the button

Important announcements that shed light on the state of the economy can have a potentially dramatic impact on the markets. On 5 February for example, weak service sector figures pointing to a possible recession in the US were enough to knock 300 points off the Dow. By contrast, the decision by the Fed to cut rates by 75 basis points on 18 March saw the index close up over 400 points on the day.

‘We are starting to see economic data having a big impact on share prices,’ says Christian Svendsen, equities strategist at Saxo Bank. ‘Anything that affects the global growth outlook can result in earnings revisions and this will have an immediate effect on the markets.’

Scheduled announcements

In view of the heightened event risk it is crucial that CFD traders look ahead at how the scheduled announcements could affect their positions. Information on what’s coming up is readily available in the forward diaries that CFD providers put together for their clients. There is also a calendar for the week ahead in Shares magazine, with details for the next month on its sister website MoneyAM.com.

David Jones, chief market strategist at IG Index, says that the most important scheduled announcements vary according to what the market is focusing on. ‘At the moment the key question is whether the US is going into recession. This means that housing data and indicators of consumer sentiment can have a big impact on share prices.’

Most online CFD providers include complimentary news feeds in their platforms and these allow clients to monitor the data as soon as it is released. The streaming real-time connections are particularly powerful, but the announcements attract such interest that the markets seem to respond almost instantaneously. This means that the onus is on taking suitable steps before the data actually comes out.

‘Someone who is really concerned about an open position ahead of an important announcement should simply close it,’ says Jones. ‘All the news has extra significance at the moment, so anyone who is looking to run a trade needs to use a wider stop and a smaller position size.’

The size of the trade and position of the stop are inextricably linked as the two together determine the maximum possible loss. At times of heightened volatility it is important to widen the stop to avoid being prematurely stopped out. In order to control the risk it is therefore vital to reduce the size of the trade. For those who get it right the bigger price movements ensure that it is still possible to make a decent profit.

‘Most CFD traders would tend to use technical analysis to determine their positions and this means that they would want to avoid the event risk associated with major scheduled announcements,’ says Svendsen. ‘The trouble is that this is becoming more and more difficult at the moment because sentiment is being driven by news and rumours as nobody really knows what the longer-term picture is.’

In this sort of environment it makes sense to have a diversified equity portfolio of longs and shorts. The risk can then be further reduced by including other asset classes such as currency and commodity CFDs.

‘The portfolio approach can work well,’ says Svendsen. ‘Another option is to use a pairs trade which targets the relative performance of two stocks in the same sector. This would help to limit the impact of any big fluctuations in the market.’

A pairs trade involves identifying two highly correlated stocks and going long in one and short in the other. If the monetary exposure of each trade is the same the combined position would be market-neutral. This will generate a profit whenever the long stock outperforms the short, but it is not the same as a hedge and will lose money if the relative performance goes the other way.

US interest rate decisions

The most influential source of economic news is the Federal Reserve, which is responsible for setting monetary policy in the US. Usually the most significant announcements are those made by the Fed’s Open Market Committee (FOMC) and these represent key points in the trading calendar.

The FOMC has eight scheduled meetings a year and releases the details of any changes to monetary policy straight afterwards at 6.15pm GMT. There are six remaining in 2008 with the next planned for 29/30 April followed by 24/25 June.

There are various steps that the FOMC can take to tighten or ease monetary policy but most attention is focused on changes to the federal funds rate. This is the overnight rate at which depository institutions will lend to each other and acts as a yardstick for all US interest rates.

‘Normally the market is very good at predicting the result of the FOMC’s scheduled announcements so that any change tends to be priced in before the news actually breaks,’ says John Pinkney, head of trading at Galvan. ‘We generally look at the way the market is trading and the analyst forecasts, as these tend to give a pretty accurate picture of the way it’s going to go.’

The Fed has been aggressively cutting rates in an effort to stave off the impact of the credit crunch and avoid an economic recession. It has even held a couple of unscheduled meetings so as to be able to intervene earlier than would otherwise have been possible. This was the case on 22 January when it announced a surprise cut in the federal funds rate of 75 basis points. The following day the Dow rose almost 300 points, with other world markets showing similarly strong gains. This same news also brought about a sharp fall in the dollar on the foreign exchanges.

‘It is the unscheduled announcements that can catch people out,’ says Pinkney. ‘The key is to have a balanced portfolio of longs and shorts. It is also important to have stops in place to cut any losers.’

UK interest rate announcements

Interest rates in the UK are set by the Monetary Policy Committee (MPC) of the Bank of England. This usually sits on the first Wednesday and Thursday of the month, with the announcement released at mid-day on the Thursday. The next decision is not, however, scheduled until 10 April, with the minutes coming out on the 23 April.

The Bank of England has an inflation objective and will set interest rates at such a level as to try and keep the Consumer Price Index at 2%. When rates are cut unexpectedly it tends to have a positive impact on UK equities.

Martin Slaney, head of derivatives at GFT Global Markets, says the sectors that are most sensitive to interest rate announcements are property, retail and manufacturing. ‘Someone with CFD positions in companies in these sectors can expect heightened volatility on the back of any interest rate surprises.’

The MPC’s decisions are not as significant in a global context as those made by the FOMC, but where they are out of line with expectations they will still have a major effect on the UK stock market. This was the case at the February meeting, when the quarter-point cut was less than investors had been hoping for and contributed to a 150-point fall in the FTSE.

Slaney says that those with CFD positions ahead of an interest rate decision need to trade within their means to accommodate the volatile moves that often go hand-in-hand with the MPC’s announcements.

‘Moving the stops further away is sensible if they wish to avoid what may turn out to be a short-term spike over the announcement, but only if they are able to accommodate the extra losses that would be incurred. Conversely, some traders judge that the MPC announcement is actually a trading opportunity and will attempt to profit from market spikes that turn out to be nothing more than short-lived panic moves.’

US non-farm payroll data

The US non-farm payroll (NFP) figures provide a good indicator of the general strength of the American labour market. This data is contained within the monthly Employment Situation report, which is released at 1.30pm GMT on the first Friday of each month, the next being scheduled for 4 April.

The NFP data measures the number of new jobs created in the previous month, excluding the highly seasonal farming industry. This is one of the most important barometers of the health of the US economy, as the strength of the labour market is highly correlated with the level of consumer spending, which makes up a large proportion of GDP. As it’s the first source of jobs data in the month it is highly susceptible to big surprises.

‘The NFP data causes a lot of volatility, with the main markets affected being US/EUR, US/GBP and the Dow,’ says James Hughes, market analyst at CMC Markets. ‘When the numbers are in line with expectations we tend to see an initial move followed by a reversal, and it is the reversal that clients tend to trade.’

Strong employment figures are usually bullish for the stock market and dollar, whereas weaker than expected numbers can signal a poor economic outlook. In March for instance the report revealed the biggest drop in the number of new jobs for five years and this prompted an immediate 36-point fall in the Dow.

‘A risk-averse client with an open position ahead of the announcement will either tend to close it or put in place a guaranteed stop,’ says Hughes. ‘The latter provides complete protection against an adverse reaction even if the market gaps, whereas a normal stop would run the risk of slippage.’