Resources to Help You Know About Central Banks and their Role in Moving Currency Markets ?

Having covered the key fundamental areas of market forces and conditions, the next step in trading fundamentals is gaining an understanding of the key role that central banks have on currency markets.

The elephant in the forex trading room is the central bank of a country. What central banks do is design and implement monetary policy. Their instruments of monetary policy are mainly expanding or contracting the supply of money, and varying the level of interest rates. There is controversy as to whether the central banks should have explicit rules for shifting monetary and interest rate policies, or whether policy should be situational. Whether one agrees with this mode of policy making is irrelevant, at least from the perspective of the trader. Whether one believes that the central banks are politically motivated or manipulated is also irrelevant. 

What is more important is to understand that every moment in time, expectations about changes in central bank intentions for stimulus, or contraction will impact price direction. The market, in a real sense, is a crowd of traders always sensing a potential shift in expectations about the central banks’ near-term actions. Therefore, forex traders who want an edge in identifying currency direction are advised to gain a better understanding of central bank policies and behaviors. Ironically, even though central bank decisions are so important, few traders actually bother to read central bank statements. This is unfortunate as the central bank statements, and changes in those statements, are our modern versions of “tea leaves,” and provide powerful leading indicators for predicting the direction of a currency pair. 

Stimulate or Tighten : The Policy Choices of Central Banks

Let us begin by asking when and why would a currency strengthen ? The direction of currencies does not occur by accident. It has a lot to do with central bank actions and policies. There are two major causes of an increase in the attractiveness of a currency. First, a currency will strengthen when there are expectations that the demand for that currency will increase. For example, if the global economy is growing and needs more crude oil, exporters of crude oil, such as Canada, will experience a greater demand for Canadian dollars. 

If there are expectations that China will increase in growth, it will need more copper and therefore there will be a greater demand for Australian dollars, as Australia is a big exporter of copper. If there is a trade war between the USA and the rest of the world, though protectionist tariff policies are expected, some currencies will be weakened as their country’s export potential is perceived to be weakened. Others may strengthen. For example, a tariff war between the USA and China will likely impact soybean prices and Brazil may benefit as a substitute exporter of soybeans to China, thus strengthening the Brazilian Real. In the longer term, the country that has stronger interest rates will have an edge in the competition for capital in-flows. This is also known as “the Carry Trade,” which virtually disappeared after the 2008 financial collapse . But as global recovery occurs, this may very well be a major recurring phenomenon. From a general point of view, any projections or forecasts about economic growth in a country are actionable knowledge about the probable strengthening or weakening of a currency.

Global growth and estimates of global growth are taken into account by central banks. The reason is that central banks look to stimulate growth when needed, and to restrict growth when it threatens to exceed inflationary targets. Increasing the money supply and decreasing interest rates are the main tools used. This does not mean that they work directly. The transmission mechanism within an economy to affect central bank intentions is not direct and may often not work out as expected. The recent era of low interest rates and in fact negative rates (in Europe and Japan) have had a less than immediate stimulus effect . Even though the Federal Reserve, in response to the 08 collapse, significantly increased its balance sheet, by trillions of dollars, the real impact of printing money is less impactful until banks expand their loaning.

It is estimated that of the total money supply, State money (money printed by the Feds) accounts for only 20% of the supply. Bank money (private money being lent out) accounts for 80%. The economist Steve Hanke, of Johns Hopkins University has underscored the critical role that Bank money has on stimulating economic activity or reducing it, when regulations restrict bank lending.

It is quite possible that the money supply does not reach as expected by a central bank, consumers, or corporations, through the credit market due to restrictions on lending and increased standards of risk control. This is known as a transmission problem and is an unsolved challenge of the central banks. In fact, the leading authority on measuring money supply, Professor Barnett, has argued that the Federal Reserve incorrectly measures the money supply (Getting it Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System and the Economy). The key point the forex trader needs to understand is that central bank policies are prone to error and even failure. It is important to watch whether the private money supply is actually reaching companies.

The End of the Era of QE

In any case, central bank stimulation known as quantitative easing (QE), with low to near zero interest rates dominated central banks from the 2008 Financial collapse to 2017 when interest rates started increasing again. The weakening of interest rates was so low, “that the yield on the worlds principal sovereign benchmark security made an 800 century low of 1.318% in July 2016” (Grant interest rate observer, December 1, 2017.) As of the beginning of 2018, the shift to increasing interest rates by the central banks is likely to continue. Which central bank will lead the way for ward into 2018 and 2019 in this tightening? Which central banks will lag behind? The answers to these questions will help to shape prediction of the direction in currency pairs.

Inflation Targeting

Few traders who are alive today remember the time when inflation was soaring and a threat to the economy of the USA. We have to go back to the 1970s. But the era of increasing inflation may in fact be coming. Traders will need to update their knowledge base about economies and inflation. Basically, when economies are growing, the threat of an increasing rate of inflation becomes a front-burner issue for the markets. Central banks look to tighten monetary policy and increase interest rates to avoid overheating. 

It is a balancing act. Central banks have implemented a macro economic model where a 2% inflation target is accepted as the point at which an economy has a balance between growth, full employment without overheating into unacceptable inflation. That, at least, is the desire of the central banks.When inflation data demonstrate low inflation pressures (keeping an economy below the 2% rate), central banks look to stimulate that economy by increasing the money supply (through asset purchases such as bonds), and by reducing interest rates. 

From a trader’s perspective, if the market expects that the central bank will act to stimulate an economy, the currency will weaken because the expectation of stimulus goes in hand with an expectation of no increase in rates. In contrast, if the totality of data coming to the central bank indicates that an economy is growing, employment is strong, and wage growth is increasing, the central bank is generally going to seriously look at contracting policy mechanisms, reducing their bond purchases, and increasing interest rates. All of this is done to head off the overheating of that economy.It is, however, often not a stimulus versus contraction choice. 

There is a third middle choice: tapering. Tapering is reducing stimulus by reducing the bond or asset purchases of the central bank. A central bank is not likely to go cold turkey from stimulus therapy. Instead, it chooses tapering. This is what the European Central Bank chose in the latter part of 2017 by reducing its bond purchases, but not yet increasing interest rates. In fact the ECB did announce in June of 2018 that they would end stimulus in December of 2018. But they did not forecast or project an increase in rates. The result has been greater volatility in the Euro currency.

Inflation Projections and Expectations are Key

Certainly inflation data and expectations about inflation are becoming more important and at the center of whether a currency will increase in value. Keep in mind that inflation forecasts are prone to error. It is not an exact science. In fact, the state of low inflation, even in the contexts of full employment in the USA, is an example of a disconnect between forecasts and what the models are predicting. Economic data is now more prone to error because of massive shifts in the global economy where technological innovation is suppressing prices.

It’s important to note that deflation is often part of the scope of concern of the central banks. Deflation, which is the falling of prices, discourages consumers to save and avoid spending and therefore slows the economy even further. In particular, the Bank of Japan has been especially vigilant in fighting deflation. In response to deflation fears, the Bank of Japan has been aggressive in trying to stimulate the economy of Japan, to the extent of introducing negative interest rates. Here is what their monetary statement said on December 21, 2017:At the Monetary Policy Meeting held , the Policy Board of the Bank of Japan decided upon the following. (1) Yield curve control The Bank decided, by an 8-1 majority vote, to set the following guideline for market operations for the intermeeting period. 

[Note 1] The short-term policy interest rate: 

The Bank will apply a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank. The long-term interest rate: The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain at around zero percent. With regard to the amount of JGBs to be purchased, the Bank will conduct purchases at more or less the current pace – an annual pace of increase in the amount outstanding of its JGB holdings of about 80 trillion yen – aiming to achieve the target level of the long-term interest rate specified by the guideline.

Brexit and Inflation

The reaction of the Sterling to the Brexit vote demonstrates a classic relationship between currency values and inflation. The shock wave of the Brexit vote caused an initial significant decline in the currency. After Brexit, the GBPUSD declined by nearly 11% causing an increase in inflation as imports became more expensive. 

There are estimates that a decline of 10% in Sterling versus the euro increases UK prices by 3.8%.

A major reason that a trader should not ignore central bank statements is because the central bank does not want to surprise and disrupt markets. They need stability in markets and transparency in policy to enable the effective transmission of policy through the markets. A central bank shock is at all counts to be avoided. This makes central bank statements one of the most salient leading fundamental forces.This does not mean that markets are not surprised when a central bank decision occurs. An excellent example is the Bank of England decision (November 2) to raise rates for the first time in ten years. Conventional wisdom would expect the currency to rise, since greater rates are attractive and should strengthen a currency. But in this case the Sterling fell. 

The reason was that the central bank gave the market no expectations of any near term further increase in rates. This is similar to when in the equity markets, a stock issues a strong earnings report, but the markets expect that it cannot continue to be that strong.The point to keep in mind is that central bank statements, and often the news conferences that follow, unleash the important force of expectations. Expectation uncertainty about what the central banks will do at their next scheduled rate deliberations causes the prices to move and change direction. Once again, exclusive focus on technical analysis will fail to provide the trader the edge in trading central bank decisions.