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Central Banks 101: Everything A Forex Trader Needs To Know
Posted On 04 Apr 2017
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To be a successful Forex trader, you must understand the role of central banks. I can’t overstate the importance of this. So I’ve written a post entitled: Central Banks 101: Everything A Forex Trader Needs To Know.
If you follow me on social media, you should know that I trade the ‘fundamentals’. It’s sometimes referred to as ‘fundamental analysis’. It’s a means of predicting price movements based on market sentiment. In other words, I look at global news events (which I call risk events) that affect the confidence of traders.
Trust me when I say this is how institutional traders navigate the markets. They don’t rely only on technical analysis. Instead, they interpret real-time events and predict price movements. The overall mood of the market influences price. Therefore, your job as a Forex trader is to gauge that mood and act accordingly.
Recent history has many examples of significant risk events. Look at what happened to the pound after the EU referendum result. In addition, look at the US dollar after President Trump’s travel ban.
If you’re in any doubt about the effectiveness of fundamental analysis, these two events alone should encourage you to stop relying solely on technical strategies.
What Are Central Banks?
So how does a trader analyse all global news? Isn’t there too much to analyse? Well, the answer to that question is yes. The secret is to focus on the news that matters. The majority of the time, this news comes from major central banks.
Most modern economies have a central bank. They are independent institutions which look after the price stability of their currency. This is achieved by controlling the rate of inflation through something called monetary policy. They are also responsible for printing a nation’s currency.
It’s important to emphasise that central banks are not controlled by their governments. For example, the Bank of England is not under the control of the UK Treasury. This is important, as it removes political bias from the decision making process.
Monetary Policy
In simple terms, the role of a central bank is to control the supply of capital to its economy.
Monetary policy describes how aggressively a central bank does this. Recently we’ve seen major central banks use monetary policy to balance two opposing economic forces called ‘inflation’ and ‘unemployment’. Inflation is the rate at which the costs of goods and services increase, while unemployment is the number of people not in full-time or part-time work.
Central banks exert control through two primary monetary tools: interest rates and quantitative easing. Let’s explore them below.
Interest Rates
The first tool is a central bank’s interest rate, which they can increase or cut at any time. What is an interest rate? It’s the cost of borrowing money from a central bank, displayed as a yearly percentage rate.
Now here’s the important bit for Forex traders. A higher interest rate strengthens the native currency. Why does this happen? Because a higher rate encourages inward foreign investment. Remember, interest rates apply to commercial banks too. It means businesses and people have more incentive to save money.
This higher demand for a currency increases its value. Furthermore, lower interest rates have the opposite effect on currency price, as investors will move their money to countries with higher interest rates.
Quantitative Easing
Quantitative easing is the second monetary policy tool available to central banks. It’s often referred as ‘printing money’. The purpose of quantitative easing is to spark economic growth by pumping money into an economy. Consequently, the population borrows more money (with low-interest rates) to create employment. During a quantitative easing programme, the value of a currency weakens, since supply is high. In my video below, I explain how quantitative easing works.
What Problem Is Being Addressed?
Now that we have an understanding of central banks, we need to look at how we interpret their actions.
My trading strategy identifies the problem each major central bank is trying to solve. With that in mind, we know what monetary policy tools they are likely to use, therefore giving us the ability to predict future price movements.
In the video below I explain this concept in more detail.
We’re living in a time of historically low-interest rates. However, the major central banks are dealing with very different problems. To help you understand, I’ve summarised the priorities of four major central banks.
The Federal Reserve
The Federal Reserve is the central bank for the United States of America. December 2016 saw the Fed raise interest rates from 0.5% to 0.75%. Since 2008, it was only the second rate hike. Three more interest rate hikes are forecast for 2017.
The immediate problem facing the Federal Reserve is the rising rate of inflation. The new Trump administration has promised a large pro-growth stimulus package to create jobs. Further interest rate hikes will help taper growth, slowing inflation in the process.
The Bank of England
The Bank of England is the central bank for the United Kingdom. It’s currently trying to anticipate the impact of Britain leaving the European Union. As such, the central bank is open to both increasing or cutting rates in 2017.
Once the triggering of Article 50 has happened, we could start to see an impact on UK economic growth. For this reason, I’m not backing an interest rate rise from the Bank of England during 2017.
The European Central Bank
The European Central Bank controls monetary policy for the entire eurozone. In recent years the central bank has embarked on a programme of quantitative easing to boost economic growth. Despite this, countries including Greece, Spain and Italy are still struggling with unemployment. In fact, Greece has an unemployment rate of 23%.
There is now speculation that the ECB could start to roll back its quantitative easing programme, despite its mixed success. Should this happen we can expect the euro to strengthen slightly.
However, the ECB’s interest rate is currently 0% to encourage lending. It’s a clear indicator that the central bank’s primary concern is stimulating economic growth for the eurozone. Therefore, I don’t expect any interest rate changes from the ECB in 2017.
The Bank of Japan
The Bank of Japan controls monetary policy for Japan. It’s another major central bank that has undertaken a quantitative easing programme to tackle sluggish growth. At its January 2017 meeting, the central bank left interest rates at 0.1%. It also opted to continue its ‘quantitative and qualitative easing programme’.
The priority for the BOJ is to reach its inflation target of 2% (it was 0.3% in December 2016). Therefore, I don’t expect an increase in interest rates from the BOJ. Traders should anticipate continued weakness in the Japanese yen as quantitative easing continues, combined with a historically low-interest rate.
Central Banks 101: Everything A Forex Trader Needs To Know
I hope you now understand why major central banks are so important. Remember, your task is to identify the problem each central bank is trying to solve. Once you’ve done this, it’s then easy to predict long-term currency price movements.
Your next step is to ensure that you have everything in place to monitor news from the central banks. If you don’t have a system in place already, follow these four steps:
1. Join my Facebook Group
The first thing you need to do is join my Facebook Group. At the start of every week, I share a video listing up and coming risk events traders should watch. It’s free to join this community, so please do so by clicking here > https://goo.gl/X7f7Ea
2. Bookmark An Economic Calendar
It’s important to keep track of central bank forecasts and data releases. You can do so by using a free economic calendar. This one from Forex Factory is one of my favourites.
3. Follow Three Reliable News Sources
Finally, you need to monitor any statements from central banks closely. To do this, I suggest you follow three reliable press outlets that will be quick to report statements. Bloomberg, MarketWatch and The Financial Times are three I follow.
I hope you’ve enjoyed reading this article and found it useful. Please leave any questions you might have in the comments below. I’ll do my best to answer as many as I can.
The post Central Banks 101: Everything A Forex Trader Needs To Know appeared first on Jarratt Davis.
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