Every country has got a central bank, and its purpose is to regulate a country’s economy and ensure it is growing at a desirable rate according to the goals of the country. The central bank acts as an independent institution from the government, although politics often affect its actions. Nevertheless, a central bank is pretty much the main determinant of a country’s economic direction, and any information about a central bank’s decisions will have an effect on the Forex market.
Although nearly every country has a central bank, not all reports have as much of an impact as the reports from these major central banks:
- FED – Federal Reserve (United States)
- BoE – Bank of England (United Kingdom)
- ECB – European Central Bank (European Union)
- BOJ – Bank of Japan (Japan)
- People’s Bank of China (China
- SNB – Swiss National Bank (Switzerland)
A central bank alters its country’s economy through several actions, the most important of which is monetary policy. There are other uncommon measures, but those are only taken in the worst case scenario, which every central bank tries to avoid. For now, these are all the measures you need to know about.
Monetary policy
All measures taken by a central bank to regulate a country’s economy can be summarized as monetary policies, of which there are 3 main types:
Quantitative easing
The process whereby a central bank trades securities in the open market in order to increase or decrease money supply in the economy. These open market operations usually involve the trade of government bonds, although other securities can sometimes be used. During quantitative easing, the central bank acts as an independent institution either selling or buying the bonds. Since these transactions are done on the open market, anyone can get in on it, including individual citizens and even non-citizens, although commercial banks play the biggest role because they have the most money.
A central bank could buy bonds from the open market, thereby increasing the money in the hands of banks and individuals and lowering interest rates. When the big banks and other financial institutions have a lot of money, simple price action determines that interest rates would fall to increase the demand. This action is taken when the economy is slowing down as it boosts spending by people who now have more money in hand than before. When the economy is growing too fast, however, the central bank will sell government bonds in order to take money off the market and decrease spending.
QE has both detractors and supporters – the supporters claim it is an innovative solution to solving a country’s economic problems while the detractors see it as a desperate measure that is only a temporary solution. Indeed, the problem with QE is not that it doesn’t work, but it can be risky – too much QE can lead to hyperinflation as has happened in several countries, and it can depreciate a country’s currency value. Not to mention that QE measures do not dictate that the banks have to lend the additional money to individuals, they could just use it for their own investment plans.
Reserve requirements
Banks operate by lending money to borrowers that has been deposited by other customers, sort of like taking money with the left hand and giving it away with the right. But just how much is left in the bank if they can give it away? To ensure commercial banks cannot facilitate withdrawals made by savers, the central bank implements a reserve requirement, which is the amount of money the bank has to have in its reserves compared to the money borrowed. This requirement is expressed in a percentage, and the premise being that it’s unlikely everyone will want to withdraw their money all at once. In addition, this requirement is checked daily to ensure it is upheld.
Discount rates
It is impossible for a bank to predict how much deposits against withdrawals will be made in a given day, yet bank operations must continue and the reserve requirement observed at the end of the day. If at the close of business, a bank notices that they haven’t met the reserve requirement, they have to borrow money from either the central bank itself or other commercial banks. The interest rate at which this money is borrowed is determined by the central bank, and can be used to ensure that banks give out less loans for fear of higher discount rates and vice versa.
How these actions are used
Imagine a country like the United States which relies on its exportation of automobiles, consumer goods like smartphones and even materials. In case the US dollar became stronger, more countries would look elsewhere for these goods, and could turn to, say, China, thereby increasing the balance of trade in the US. The US government obviously does not want that, and this is where the FED comes in.
For example, the past FOMC (federal open market committee) press release that was on the 2nd of November 2016 chose to leave the interest rates unchanged. The press release justified this lack of change to the fact that the US economy was growing steadily in terms of household spending and inflation rates which were below 2%. This decision by the FED caused the value of the US dollar to fall sharply, although it quickly recovered because a lack of a change was not sufficient to change the overall strength of the US dollar.
Contrary to this action, the FED had lowered interest rates in the months after the global recession of 2007 – 2008 in order to stimulate the economy. At that time, the value of the US dollar decreased, but the action was necessary in order to revive the economy. You see, the central bank does not always do what’s best for the currency. Being put in place to regulate the country’s economy means that the foremost priority is to ensure the country’s residents are happy with the economic climate.
How a central bank’s actions affect the Forex market
It’s not enough to just state how central banks operate, after all, you’re not here for an economics lesson. Everything the central bank does to affect a country’s economy will have an impact on that country’s currency, and this is where the Forex market comes in.
When monetary policies are implemented that stimulate a country’s economy, more often than not, this also decreases the value of that country’s currency. A good example is the action by the Swiss National Bank to peg the Swiss Franc against the Euro by devaluing the Franc. The value of the Franc was soaring, and as it would have affected the country’s exports, the SNB chose to reduce the value of their currency. Similar actions have been taken by the ECB and BOJ for the same reasons.
Therefore, depending on the central bank’s decision, it is possible to determine the strength of a currency, whether positive or negative. If one of the major central banks were to release a report that stated they were going to raise interest rates, that currency would grow stronger and the trader should buy that currency. The opposite is also true.
The changes in the Forex market after a central bank report are instantaneous, and you will immediately notice spikes or dips in the Forex charts. Traders can take advantage of these sharp moves to make several pips in minutes and you can too. You should also be aware that Forex trading companies tend to widen their spreads during these periods, so you should not be alarmed by this. It might not be the best time to get into a trade, especially if you are a scalper, but the big profits can make up for it. The best STP Forex brokers can still maintain relatively tight spreads, although there will still be some changes which you should be notified about by email or right there on the Forex trading platforms.
Besides the Forex market, central banks’ reports also affect CFD trading Forex brokers, so if you trade futures and options, you should be on the lookout for these reports as well.
Where do you get this information?
To make use of central banks’ reports, you first have to find them, right? The Forex calendar is the first place you should look, as it provides information on critical news announcements. Reports by the central banks of countries like the FED, ECB, BoE, BOJ and other major economies like China are what you should be keenest on. These countries have a huge impact on the Forex market, and knowing where their central banks are leaning will be a great resource.
Other sources of this information are the central banks’ websites, which provide a lot of details about the monetary policy decisions. In case you run into such a lengthy report, scroll down to the final page for the headlines, it’s all most traders read anyway, you can always browse the rest of the report on the weekend.
While checking out these reports, you might come across terms like ‘dovish’ and ‘hawkish’; these are used to indicate how the policy makers are leaning. The common perception of a hawk is that of aggression, while that of a dove is humility, and the same attributes are applied to market sentiment. A hawkish sentiment represents a keen interest in tightening monetary policy through the raising of interest rates to keep inflation down. A dovish sentiment, on the other hand, represents more concern about stimulating the economy regardless of the rising inflation rates.
A good example of such statements can be seen on most forums and financial blogs which see claim that the upcoming FOMC report is going to be hawkish. The FED has kept the interest rates unchanged for most of the year, and given the consistent growth and changes in the country like the presidential election, most pundits believe the FED is finally going to raise interest rates. If this outlook proves to be true, the value of the US dollar is going to increase in the short term until the next release, which happens after about a month.
Why now?
This article is just in time for this week’s FOMC report which will be released at 7pm (GMT) on Wednesday, the 14th of December 2016. All indications point to a hawkish sentiment, which could result in a rise in value for the US dollar, which would reverse the current increase the value of the dollar even further, extending the uptrend. Other important reports this upcoming week will involve a report by the SNB and BoE, all of which will rock the Forex market.
All the information above can also be summarized in the short video below:
