How to earn on PMI readings?

• What is PMI?

PMIs (Purchasing Managers’ Indexes) are economic indicators derived from monthly surveys of private sector companies and have been developed in many countries. The PMI surveys are among the first indicators of economic conditions published each month, shortly after the end of the reference period. The data are collected using identical methods in all countries so that international comparisons may be made. The release of PMI is always an important event for financial markets due to their high correlation with GDP growth.

The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. A reading of more than 50 represents expansion of the sector compared to the previous month (seasonally adjusted). A reading under 50 represents a contraction, while a reading at 50 indicates no change.

• How can we use PMI to predict changes of the EUR-USD rate?

In this article we concentrate on Eurozone PMI and the EUR-USD rate and build an econometric model that will show us what position we should take after PMI release at the beginning of the month to take profit at the end of the month.

We use PMI series for manufacturing sector, because they are released earlier than for services sector.  Our sample period runs from January 2001 to December 2013. We define four phases of economic activity: a boom, a downturn, a recession and an upturn.

A boom is when the economy is expanding at an accelerating pace, then PMI reading is above 50 and it is higher than in the previous month.

We can express it this way: PMI(t)>50 and PMI(t)-PMI(t-1)>0  - PMI in period t is above 50 and higher than in the previous month.

A downturn phase is when economy is expanding at a decelerating pace. PMI in period t is then still above 50 but lower than in the previous month: PMI(t)>50 and PMI(t)-PMI(t-1)<0.

A recession phase is when economy is contracting at an accelerating pace. PMI in period t is then below 50 and lower than in the previous month: PMI(t)>50 and PMI(t)-PMI(t-1)<0.

An upturn phase is when economy is contracting at a decelerating pace. PMI in period t is then below 50 but higher than in the previous month: PMI(t)<50 and PMI(t)-PMI(t-1)>0.

We have four phases of economic activity defined using PMI readings. We need to create four explanatory variables:

Boom(t) =1 if PMI(t)>50 and PMI(t)-PMI(t-1)>0 and Boom(t)=0 otherwise.

Downturn(t) =1 if PMI(t)>50 and PMI(t)-PMI(t-1)>0 and Downturn(t)=0 otherwise.

Recession(t) =1 if PMI(t)>50 and PMI(t)-PMI(t-1)>0 and Recession(t)=0 otherwise.

Upturn(t) =1 if PMI(t)>50 and PMI(t)-PMI(t-1)>0 and Upturn(t)=0 otherwise.

• Let us build an econometric model that will help you to earn on PMI readings

The regression will be following:

Return(t)= A * Boom(t) + B * Downturn(t) + C * Recession(t) + D * Upturn(t) + e(t),

Where Return(t) is a change between the EURUSD rate at the end of the period t and at the beginning of the period t in pips, Boom(t), Downturn(t), Recession(t) and Upturn (t) are dummy variables as defined above and e(t) is an error term.

• What are regression results?

Boom, downturn and upturn phases are characterized by positive returns but in case of upturn estimated monthly return is lower than standard error. Boom, downturn and upturn phases did not survive the test of statistical significance (too low values of t-statistic at the 5% level of significance)

Our calculations suggest that the EUR-USD falls during the recession phase and average return from short position on this pair is statistically significant and much higher than standard error.

• Is there any trading rule?

The results of our calculations show that we should initiate short position during recession phase, take long positions on the EUR-USD during boom and downturn (however it is risky due to low significance level) and we should rather do nothing in case of upturn.

We back tested the above strategy from January 2001 to December 2013 and the results are reported in the table and the chart below:

All returns are spot returns. Compound annual growth rate is 9.3% and the annual return pattern is attractive - there were only two cases of negative returns in 13-years history. This rule is strongly successful in recession phase. You can take some diversification benefits if you combined the strategy with the other one.

• What should be the strategy for today?

Recent PMI readings show that the economy is in boom phase (PMI>50 and rising). According to our strategy we should have long exposure in EUR-USD.

We are going to expand our analysis to more countries and currency pairs in the near future. To get an immediate access to our research, including information not available publicly, we urge you to sign up for free on www.growthaces.com

Thank you for reading.

Growth Aces