Whether you’re trading stocks, forex, commodities, indices or something else entirely, it’s likely that the prices of your chosen markets will be affected by the actions of central banks.
What are central banks?
Central banks are institutions that are responsible for managing the monetary system of a nation (or a group of nations). They have a range of responsibilities, including overseeing monetary policy, keeping inflation in check, ensuring high employment levels and maintaining currency stability.
In addition, central banks will:
- Issue currency to control the money supply
- Function as the bank of the government
- Regulate the credit system
- Oversee commercial banks
- Manage exchange reserves
- Act as a lender of last resort
However, to traders, the most important action from central banks is changing interest rates as part of their monetary policy.
Major central banks
Almost every economy has its central bank, but traders pay most attention to the ones attached to the most-traded currencies:
- US Federal Reserve Bank (USD)
- European Central Bank (EUR)
- Bank of England (GBP)
- Bank of Japan (JPY)
- Swiss National Bank (CHF)
- Bank of Canada (CAD)
- Reserve Bank of Australia (AUD)
- Reserve Bank of New Zealand (NZD)
Central banks and interest rates
Central banks must maintain a tricky balancing act. If the economy grows too quickly, then rapid inflation will make prices too high for consumers. On the other hand, if it grows too slowly, then unemployment will soon follow.
The main mechanism they have to keep this balance in check is the base interest rate.
How do interest rates work?
Interest rates work by either encouraging saving or spending – with a trickle-down effect for the rest of the economy.
Businesses borrowing money to grow their bottom line, and individuals buying houses, are vital to a growing economy. Lowering interest rates encourages both, resulting in growth.
But when growth gets out of hand, it can lead to excessive inflation. It can even cause reckless spending that risks an economic crash. By raising interest rates, central banks can slow things down.
Examples of interest rates
Say, for example, that the US economy is struggling. Banks are concerned about the situation and reluctant to loan out capital. They are scared they might not get it back.
High-interest rates
In this environment, high-interest rates will encourage banks to hold onto their money. Why? Because they can earn a good return by keeping it with the central bank, where they know it is safe. So, they will in turn charge higher interest on loans – as they present a relatively higher risk.
This makes it more difficult and expensive to borrow money. Small businesses may keep their purse strings tight, and prospective homebuyers may be priced out of mortgages. Spending remains low overall and the economy continues to struggle.
Low-interest rates
However, if the Federal Reserve (the Fed) reduces interest rates, holding on to capital looks a lot less compelling. Banks can no longer make much return from keeping money with the Fed, but they can borrow it at a low cost.
That means they can offer low-interest rates on loans to businesses and individuals. These loans are now worth the risk because there isn't a safer option readily available.
With more access to cash and lower rates on their savings accounts, those businesses and individuals are encouraged to spend and invest. The higher spending kickstarts the economy into growth.
How interest rates affect the markets
All of this doesn't just affect businesses and homebuyers, though. It also has a significant impact on forex and other financial markets.
Like any asset, currency prices are set by supply and demand.
Investors will flock to economies with comparatively high-interest rates because they can get a larger return. But to invest in foreign economies, you usually buy currency.
This will increase demand for a currency with high-interest rates, causing its price to rise.
Some investors take advantage of this relationship using a carry trade. In this strategy, you buy a currency with a high-interest rate while selling one with a low rate. If you can earn enough interest to cover any fluctuations in the exchange rate between the two currencies, then you could make a profit.
Central bank meetings
But how do central banks announce changes to interest rates? Usually, it takes a central bank meeting.
Each central bank will have its regular meetings. For example, the Federal Open Market Committee (FOMC), which sets monetary policy for the Federal Reserve, usually meets eight times a year.
Traders will watch for any announcements from each meeting, such as rate hikes or cuts, forward guidance on future policy, or any other new monetary measures (such as quantitative easing).
However, traders and investors usually won’t just wait until an official rate announcement before taking a position. Instead, they will scour multiple sources for any clues as to what a central bank might do.
Central banks pay a lot of attention to various economic indicators when deciding their next course of action. Traders will also pore over these releases and attempt to anticipate what is about to happen. We’ll cover these indicators in more depth in the next few lessons.
They'll also pay attention to the key staff at a central bank, to ascertain whether important decision-makers are hawks or doves:
- Hawks are proponents of higher interest rates to fight inflation
- Doves want lower interest rates to promote economic growth
You may also hear central banks overall described as hawkish or dovish, depending on their policy at any given time.
Because the markets pay such close attention to central banks, an anticipated interest rate move will usually be priced in long before it arrives. Major moves, then, often arise when a central bank confounds the market's expectations.
What is quantitative easing?
You might have heard of central banks using quantitative easing (QE) when the economy is struggling. This is a method of cutting interest rates where a central bank will cash in some of its holdings and buy bonds (usually long-term bonds).
By entering into the long-term bond market, the central bank increases demand those bonds, therefore driving down the interest earned on them. The goal of such a measure is to keep interest rates low to encourage more borrowing. QE is often used when interest rates are already at rock bottom.
Central bank interventions
Sometimes the value of a currency can inflict harm on an economy, which can lead to its central bank stepping in.
Japan’s economy is dependent on exports, for example. Countries with high exports tend not to want their currency to gain too much value.
If the yen is too strong against the dollar, then Japanese exporters make much less money. They might have to increase their prices, which could see overall sales fall. In this instance, the Bank of Japan might flood the market with JPY by releasing reserve cash. This supply glut should cause the yen to depreciate, meaning the USD/JPY rises.
Taking advantage of intervention is particularly challenging because unlike interest rate changes, it isn’t usually communicated to the masses until after it has occurred.
However, there may be clues that intervention is about to be implemented, particularly if a central bank repeatedly states that its currency is overvalued. Though the timing of it is difficult to gauge and is usually a surprise.
Central banks must maintain a tricky balancing act
