The Impact of the Inflation Forecast Indicator on the Currency and Stock Markets

Today, we will talk about the impact of such an indicator as the 5-year forward inflation expectation rate on the US currency and stock markets.

Inflation implies an increase in the overall level of the cost of goods and services within the country's economy. It is one of the main fundamental factors of the economy.

Therefore, the heads of states and governments take into account its forecast value when drawing up both long-term and medium-term plans.

How does inflation within a country affect the rate of its currency?

The connection is this. If the inflation rate within a country rises, then its currency weakens. On the contrary, if the inflation rate inside the country decreases, its currency strengthens.

Sometimes inflation can have a positive effect. For example, for exporting countries.

In this case, the depreciation of the national currency becomes a positive fact, since the competitiveness of goods supplied to other countries grows. As a result, the country's economy grows, and its currency strengthens.

The 5-year forward inflation expectation rate is calculated by the Federal Reserve Bank of St. Louis and updated daily.

This indicator reflects the average expected inflation rate calculated over the 5-year period from the current day:

( [ { [ 1 + ( BC_10 YEAR - TC_10 YEAR) / 100 ] ^ 10 / [ 1 + ( BC_5 YEAR - TC_5 YEAR ) / 100 ] ^ 5 } ^ 0.2 ] – 1 ) * 100

where BC 10_YEAR, TC_10 YEAR, BC_5 YEAR и TC_5 YEAR are the 10-year and 5-year nominal and inflation adjusted Treasury securities.

Analysis of the obtained results

The presence or absence of a relationship between changes in the forecast inflation level and quotations of financial instruments will be determined using the day-to-day correlation coefficient and with shifts of 1, 2, 3, 4 and 5 days forward and backward. When determining the strength of the relationship, we will focus on the Chaddock scale:

The results are presented in the diagrams:

So, there is a weak day-to-day direct link between changes in the forecast inflation and the S&P 500 index rate.

There is a weak day-to-day reverse connection between changes in the forecast inflation and the USDCAD currency pair.

There is no connection between changes in the forecast inflation, gold and the following currency pairs rates: AUDUSD, EURUSD, GBPUSD, NZDUSD, USDCHF, USDJPY, USDRUB.

The forecast inflation and the considered financial instruments do not follow each other, since the correlation coefficient at shifts does not reach the value of 0.1 modulo.

Now let's evaluate the rate of return of the trade opening strategy based on the forecast inflation:

• When the inflation forecast rises, we buy gold, the S&P 500 index and currency pairs with the quoted currency USD; we sell pairs with the base currency USD;
• When the inflation forecast decreases, we sell gold, the S&P 500 index and currency pairs with the quoted currency USD; we buy pairs with the base currency USD.

Market entry strategy

1. at the opening of the data update hour;

Exiting the market:

• at the close of the European session;
• at the close of the North American session;
• at the close of the hour before updating the inflation forecast;
• at the opening of the hour when the opposite signal appears.

2. at the opening of the European trading session;

Exiting the market:

• at the close of the European session.

3. at the opening of the North American trading session;

Exiting the market:

• at the close of the North American session.

4. at the opening of the data update hour, if the percentage change in the forecast value of inflation modulo is greater than the established threshold (p);

Exiting the market:

• at the close of the European session;
• at the close of the North American session;
• at the close of the hour before updating the inflation forecast;
• at the opening of the hour when the opposite signal appears.

Under the exit on the opposite signal, in this case, we mean the exit from the market when the direction of change in the inflation forecast changes. That is, if the previous inflation forecast was for an increase, then the current one is for a decrease, and vice versa.

Values of the p parameter >= 1, 3, 5. Theoretically, the greater the change in the inflation forecast compared to the previous period, the stronger the expected reaction of financial instruments.

We will evaluate the trading strategy according to the following criteria:

• The average rate of return reflects the relative change in quotes of financial instruments in percentage. A positive value of the average return indicates the profitability of the strategy, a negative one indicates a loss.

The average rate of return (R) of a financial instrument is given by the formula:

where:

n - the number of transactions;

P (%) – the percentage of change in the quotation of the financial instrument at the time of fixing the position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• The total rate of return (TR) is the sum of the returns from all trades. The greater the value of the total return, the greater the profit brought by the signal during its testing period.

• Max drawdown (MaxDD) is the maximum loss in percentage terms from fixing losing trades for the entire testing period. The smaller the value of the maximum drawdown, the better the trading signal works.

where:

n - the number of trades;

R - rate of return;

TR_n - total return of n trades;

DD_n – drawdown at the time of closing the nth trade;

MaxDD – max drawdown.

The results with a significant average rate of return (it is 0.15% for intraday trading and 0.3% for day trading) are presented in the diagrams below. See the appendix for detailed results.

So, a strategy based on changing the inflation forecast for 5 years forward, without filtering and with filtering from 1%, is ineffective.

Filtering entries with changes in the inflation forecast from 3% has led to an increase in the average rate of return of the strategy for the S&P 500 index:

• up to 0.14% during the position holding period from the date of publication of the updated value of the inflation forecast until the end of the European session.
• up to 0.29% when entering at the time of updating the inflation forecast and exiting at the opposite signal

In intraday trading of the S&P 500 index, the strategy has shown a total rate of return of 46% with a maximum drawdown of 24%.

In day trading of the S&P 500 index (exit on the opposite signal), the strategy has shown a total rate of return of 95% with a maximum drawdown of 49%.

At the same time, the number of entries into the market amounted to 333.

Filtering entries with the inflation forecast changes from 5%.

1. Intraday trading:

• S&P 500 Index: the average rate of return of the strategy has grown to 0.18% during the position holding period from the publication of the inflation forecast update until the end of the European session;
• Gold: the average rate of return of the strategy has declined to -0.14% during the position holding period from the release of the updated inflation forecast until its next update.

In intraday trading, the strategy has shown the total rate of return of 18% with the maximum drawdown of 20% for the S&P 500 index, for gold: -15% with the maximum drawdown of 28%.

2. Day trading (opposite signal):

• Currency pairs: the average rate of return of the strategy has increased to 0.27%;
• S&P 500 Index: the average rate of return of the strategy has increased to 0.66%;
• Gold: the average rate of return of the strategy has decreased to -0.52%. 

In day trading (exit on the opposite signal), the strategy has shown the total rate of return of 67% with the maximum drawdown of 40% for the S&P 500 index, for gold: -55% with the maximum drawdown of 108%.

Among the currency pairs, the following have turned out to be the best:

• USDJPY with the average rate of return of 0.64%, the total rate of return of 69% with the maximum drawdown of 7%;
• USDCAD with the average rate of return of 0.38%, the total rate of return of 41% with the maximum drawdown of 19%;
• USDCHF with the average rate of return of 0.34%, the total rate of return of 37% with the maximum drawdown of 9%;
• GBPUSD with the average rate of return of 0.32%, the total rate of return of 34% with the maximum drawdown of 22%.

The number of market entries ranges from 101 to 109.

It should be noted that with an increase in the threshold value for changing the inflation forecast, the rate of return of the strategy increases to a significant value for currency pairs and the S&P 500 index and decreases to a significant value for gold.

That is, the “stronger” the inflation forecast changes, the more noticeable financial instruments react, especially the S&P 500 index.

At the same time, the number of market entries declines. On average, the inflation forecast change by more than 5% occurs once every two or three months.

It is also noteworthy that with an increase in the threshold for changing the inflation forecast, the total rate of return and maximum drawdown on instruments mainly decrease.

As for gold, it is worth making deals with it on the condition of entering the “vice versa”.

Then the average rate of return of the strategy will be 0.52%, the total rate of return will be 55% with the maximum drawdown of 41%.

Detailed results are shown in the Appendix:

XLSX (0.16 MB)The impact of the inflation forecast indicator on the currency and stock markets.xlsx