Using word clouds to predict forex moves

The search for an edge in currency trading often takes the trader through incessant back-testing of different indicators, strategies, set-ups and systems. Some work until they stop working. The markets seem to be irreducibly complex, making it likely that any set-up is, at best, a rough approximation of the variables that will make a difference. 

As a result of this complexity it is a very difficult challenge to predict future movements based on pure price action. Yet, there are sources that provide leading indications of likely direction in currencies. These sources are not hidden. They are the central bank statements.   

Central banks are the key catalysts for currency directions. By setting interest rates and monetary policy, central banks generate either bullish or bearish expectations about the currency direction. Central bank statements are carefully constructed, where each word is compared to the previous statements. Any differences between statements impact immediate market reactions. In short, words have become a key variable, and act like a Rosetta Stone providing semantic clues behind the decisions. 

Central bank statements can provide actionable knowledge beyond the data release dates. A comparison of key words used by the central banks in recent statements show a leaderboard of concerns and provide further clues to the coming shifts in currency valuations. For example, in trading currencies, expectations of inflation is a critical concern. Let’s compare the frequency of the word “inflation” used by different central banks in their latest statements. Word clouds are images composed of words used in a particular text or subject, in which the size of each word indicates its frequency or importance. 

A frequency analysis of the number of times a word is mentioned in central bank statements indicates that “inflation” is the major focus of the banks (see “Word counting,” right). The take-away for traders is to be vigilant on Consumer Price Index data, as it becomes important in confirming whether the central banks are getting closer to their near-universal 2% goal. But of significance is the divergence of the Bank of Canada and Reserve Bank of Australia’s focus from the rest. We see that the lack of a high score frequency mentioning of inflation indicates a bearish sentiment skew for that currency as their economies are not heating up to warrant expectations of a tightening of monetary policy.

The word cloud on the May 2 Australian interest rate statement shows visually the concern is on growth, not inflation. Compare it to the Bank of England statement on May 11 (see “Rating inflation, below”). 

It is no coincidence that rates for Canada and Australia have been on hold. For the trader who wants an edge, a close reading of central bank rate decision statements provides a different dimension of analysis and meaning compared to viewing the currency pair charts. It may very well be that the edge that is being sought after by forex traders on finding direction can be found in the word clouds.