Forex Trading and CPI - Part 1
07/16/2008 12:00 am EST
Forex trading is often a mix of technical and fundamental analysis. In the case of currencies, these fundamentals are usually economic fundamentals. This lesson is the first in a series on the most important regular fundamental releases. In this lesson I will be discussing the meaning, problems and opportunities of the CPI release.
In part one I will walk through what CPI is and why traders think that it will affect yields and therefore currency values. In a normal (non-
crisis) market this relationship is very clear and relatively easy to understand. However, there are some big problems inherent in the measure that helps lead to its breakdown when the market is in crisis- mode.
1. CPI is subjective: The CPI measure looks at a number of different consumer items and calculates their price changes within a basket with different weightings attached to each item. That sounds simple but it is completely subjective and therefore it is usually very misleading.
2. Price shocks are confusing: CPI is usually divided into two components. The first component includes the entire basket of "stuff" which includes food and energy prices. Core CPI, the second component, excludes food and energy from the same basket and for very debatable reasons is often emphasized as more important than the total basket. Clearly the issue with this is that price shocks in the food or energy market will break the normal inflation cycle and the division in the measure makes it very confusing for traders to understand what is going on.
3. Comparison is difficult: CPI in the US is not the same as CPI in the Euro-zone or China or any other economy. This makes comparison very difficult which is problematic for forex traders who obviously trade currency pairs.
In the next part we begin discussing how forex traders can use CPI in forecasting risk as well as timing a trading strategy. Although CPI has problems, simplifying the analysis and looking at trends, can help understand what is going on in the market and what a trader can do about it.