Using The ISM Manufacturing Index To Find Forex Trends

By Richard Lee AAA

The foundation of any economy is its manufacturing sector. That's why the market is always aware and focused on the Institute of Supply Management's (ISM) manufacturing surveys. This is particularly true in the case of the United States - where the sector contributes roughly 12% of U.S. overall economic growth. Although the survey's impact on the market is a bit less than some other reports - such as the non-farm payrolls and consumer price index - it still offers some support for an overall FX trend. Let's look at the basics of the ISM manufacturing survey and how the data can be interpreted to make trades on the forex market. (For more, see Using Coincident And Lagging Indicators.)

TUTORIAL: Economic Indicators: Non-Manufacturing Report

What is the ISM Manufacturing Survey?
The Institute for Supply Management's manufacturing report is a diffusion index conducted by the institute on a monthly basis. Put simply, this means that the survey itself has different components, and the headline or total number follows the consensus results of all the components. It is created by the ISM - a Tempe, Arizona-based, nonprofit association geared towards the supply management profession. (For more, see Leading Economic Indicators Predict Market Trends.)

Before compiling and totaling results, the institute surveys executives and supply managers on their expectations of several different components, specifically, future production, employment, inventories and new orders. The headline number is then computed with a value of 50 being the benchmark. Figures that are higher than 50 signal expansion, while any release below 50 signals contraction in the sector. Given the timeliness of the survey and the nature of its responses, the report is widely referenced as a leading indicator to the U.S. economy. For example, a pickup in the ISM manufacturing survey can hint at a pickup in business spending and investment, which supports economic growth.

Using ISM Manufacturing Data to Find Trends
While the ISM manufacturing index doesn't set an intraday tone like the U.S. employment numbers or gross domestic product figure, the survey does help to either support or deny the strength of a current trend or sentiment. (For more, see Investors Intelligence Sentiment Index.)

There are three ways to look at it:

1. A lower ISM reading will usually decrease the attractiveness of a certain currency. This can either be a below-50 release or a lower than expected release. Why? If the sector shows weakness in the month, it may be a signal that the economy is slowing down, decreasing economic growth potential.

2. An equal or same print of the ISM manufacturing figure will lead foreign exchange investors and traders to dive deeper into the report, looking to the individual components and how they fared during the month. These usually include new orders, prices paid and the employment subcomponents, which sometimes show an even better picture than the headline figure.

3. A higher ISM reading will increase a currency's attractiveness. Just like a higher employment or growth figure, a positive survey result supports speculation of a growing economy, supporting currency appreciation.

Now, let's put everything together and take a look at how to apply this to an actual currency trade.

In figure 1, we see an opportunity in the U.S. dollar/Canadian dollar exchange rate. Since hitting a top of 0.9720 on April 18, 2011, the USD lost some strength and declined to test support just above 0.9450 (right-hand side of the chart). The test of support comes right before the U.S. Institute for Supply Management's report for the month of April. (For more, see 6 Factors That Influence Exchange Rates.)

USD/CAD Tests Support Ahead of ISM
Figure 1: USD/CAD Tests Support Ahead of ISM
Source: FX Trek Intellicharts

Now, the trade is first and foremost based on technical analysis.

So, using the stochastic oscillator, we see a golden cross forming in conjunction with our support barrier (indicating a buy signal). As a result, the long entry would be placed at or near the support level - in this case at 0.9475. An accompanying stop will be placed below the support barrier. This gives the trade not only room to move, but to avoid any potential whipsaws through the level. As a result, the stop order will be placed 50 pips below, giving us a position stop at 0.9425. (For related reading, see An Introduction To Oscillators.)

Fundamentally, in this situation, a foreign exchange trader or investor should be looking for a U.S. ISM figure that benefits the USD. In this case, it will be either a higher headline figure or a positive subcomponent number.

And, that is just what the market gets.

On May 2, 2011, the Institute for Supply Management reported a headline figure of 60.4, both above the 50 benchmark and the forecasted 59.9 reading. Adding to the positive release is a higher prices paid subcomponent reading. The higher prices paid reading suggested higher U.S. interest rates to come in the near future, boosting the greenback's attractiveness.

So, the positive April 2011 ISM report helps to support our long trade in USD/CAD. Now, remember it doesn't act as a catalyst, but it helps to keep our medium-term sentiment supported towards greenback strength. (For more about indicators, see The Most Reliable Indicator You've Never Heard Of.)

In figure 2, we can see that the trade worked in our favor. The USD/CAD exchange rate tops out at 0.9680, approximately 255 pips higher than our entry. Not only was the trade profitable, our risk to reward ratio was also maintained at a healthy five to one.

USD/CAD finally tops out well above our entry
Figure 2: USD/CAD finally tops out well above our entry.
Source: FX Trek Intellicharts

The Bottom Line
Manufacturing surveys will always be around, and traders and investors will always be interested in the survey's results. So, being able to interpret and understand the survey will give the FX trader a leg up in capturing portfolio returns for years to come. (For more, see Vital Link: Manufacturing And Economic Recovery.)

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