How Quantitative Easing Affects Forex: A Decade of QE/QT

You must have seen Quantitative Easing and Quantitative Tightening on the news. Maybe you’ve thought that’s for the economists and not the traders. You’d be wrong. These policies affect Forex in multiple ways. These policies are as important for you to understand as for any economist.

What Forex Traders Need to Know about Quantitative Easing

Quantitative Easing Forex strategies stem from a central idea. Central banks will buy bonds and thus pump money into the economy. This is what QE is. The goal of QE is to reduce interest rates and mobilize funds across the economy.

If a central bank engages in QE, they increase the money supply by giving their currency to the market. This often decreases the currency in value. It is not too different from a concert that prints too many tickets. Too many tickets make each ticket worth less. The same logic applies to money. When the Fed prints more money, it usually loses value in the market.

A currency often weakens after QE announcements, though this is a tendency rather than a rule, and it can be outweighed by other forces. Traders are quick to sell off a currency to preempt the central bank’s purchases and the new money entering the system. You need to pay attention to the central bank announcements.

The most apparent market signals are linked to a Fed balance sheet Forex. As the Federal Reserve’s balance sheet grows, it’s buying more assets (bonds and mortgage-backed securities). The more assets the Fed has, the more dollars there are in the economy.

You can check this balance sheet on the Fed’s website (it gets updated weekly). A growing balance sheet tends to weigh on the dollar, while a shrinking one tends to support it,  though the effect depends heavily on what other central banks are doing at the same time. You can see Fed policy in a nutshell from this balance sheet.

You can’t put too much emphasis on interest rates. When new traders do this, they miss the big picture. The balance sheet tells a story that no single interest rate decision can tell. The balance sheet shows the inevitable monetary policy for many months, and even years.

How Quantitative Tightening Affects Currency Value

The opposite is true for Quantitative Tightening. Banks decide to sell their bonds and allow the rest to mature. Money is pulled from the economy, and the supply of currency reduces.

The market reaction during tightening is going to be the opposite of Quantitative Easing. A supply reduction of currency means that the value is going to increase, and traders react to this well.

Traders tend to buy the currency in expectation of strengthening the value, and this often is the trend that many traders love to capitalize on over several weeks or months.

QT is typically slower than QE. Central banks are usually conservative during QT to avoid any sudden impacts on the market. Therefore, tightening is usually gradual. This gives you the opportunity to strategize your trades for the tightening.

QT vs QE Currency Effects Summary

QE will typically weaken a currency, and QT will strengthen a currency. However, the magnitude and quickness of the effects vary.

Initially, consider the policy itself. Rapid bond purchases by a central bank will typically have a greater effect on currency compared to a slow process. Additionally, consider all central banks. If one country conducts QE and another QT, the currency difference will grow larger.

Lastly, consider how the market is thinking and feeling. It is very normal for a currency to move before policy is announced. Predicted movements often occur before the announcement rather than after it.

By the time a central bank conducts a policy and movement occurs, a majority, if not all, of the currency movement has already happened. This is the reason a lot of traders lose money trying to profit from announcements instead of the preliminary movements.

Effects of a Decade of QE on Currency

Observing the QE currency impact for the last decade yields some insights. Following the financial crisis in 2008, many central banks started expansive QE.

For many currencies, the aftermath of expansive QE was years of currency depreciation. Investors looked for opportunities in currencies of countries that had a more restrictive monetary policy.

Each progressive QE round caused huge depreciation of many currencies. Tightening monetary policy would counteract depreciation. Optimistic traders who took advantage of these currency fluctuations had many opportunities to profit.

This decade also brought along many lessons for traders.

• First and foremost, central bank monetary policy isn’t permanent.
• Changes that appear to be permanent have a tendency to be reversed, and will fluctuate based on the current economic climate.
• One of the most important lessons from this past decade is the importance of staying flexible and continuously monitoring the market for changes.

Trading During QE and QT

Do you want to trade under these policies? You really don’t need a degree in economics. To understand QE, you should start with the major central banks of the US, Europe, Japan, and the UK. Look for changes in the buying or selling of government bonds, or changes in the central bank’s balance sheet.

Be sure to note the dates for each central bank’s meetings, as these are often the sources for major fluctuations in the trading of currency pairs. It is important to set trading strategies for these dates. However, be careful immediately before the announcement, as these also tend to be volatile.

Start with a simple habit of checking balance sheets, either weekly or monthly, and combine that with tracking interest rate changes.

• The combination of Quantitative Easing (QE) and interest rates falling means you should expect a weaker currency.
• Conversely, Quantitative Tightening (QT) and interest rates increasing means you should expect a stronger currency.

Bottom Line

QE and QT influence currency values more than most new traders appreciate. When you understand the relationship of supply and price, your confidence in interpreting the market will be greater. Those who analyze balance sheets of central banks and watch for policy changes tend to be the first to spot market trends. Continue identifying these signals beyond special news days.