Consensus Forecasts and Herd Mentality

This is the third and final note about a post by the FX guru of Nova Scotia, Tom Yeomans, entitled “Is news trading dead?”

Tom talks about how FX trading around economic announcements has changed over the last few years. He then outlines a view of the future of FX news trading that involves forecasting the announcement.

Since it is news (that is difference between the actual release and the market’s expectation just before the release) that moves the market you need not just a forecast but also a read on what the market thinks.

Tom discusses the use of consensus forecasts. He notes that “Usually they had 18-21 people making guesses. That always seemed a little suspect to me …”.

I have noted in another post about the problems with consensus forecasts.

However consensus forecasts can be made useful. In a paper on how forecasts can be used by financial institutions for risk management purposes I noted that surveys of forecasts can be used to develop scenarios for risk management and how …

“This allows risk managers to understand their potential losses conditional on a range of forecasts. The average forecast and the dispersion in forecasts can be used to build a model of the distribution of market participants' expectations. The fitted model can then be used to extrapolate to large moves and thereby address the problems of sparse and clustered data. Finally, conditional scenarios can be used to mitigate the lack of coverage in forecast surveys.”

Note that scenarios, based on forecasts, can also be used for speculating as well as risk management since the focus is on the entire set of possible outcomes and so scenarios paint a picture of the return and the associated risk.

Of course, for certain announcements getting a read on the market is easy since a full distribution of expectations can be had from auctions of economic derivatives.