Central banks control their country’s economy and also play a vital role in the outside markets. Their importance is especially relevant while trading the Forex, as they usually set the reference for funds and traders activity. If you are still unsure why interest rate releases can throw the markets in a maelstrom, then here is a little guide to help you understand better.
What are central banks?
Central banks are institutions responsible for producing and managing the money used by their respective countries. Most major central banks are independent, meaning that they are free from the influence of the government. Some of their functions include lending money to other banks, lending money to governments, printing physical money, and ensuring monetary stability through monetary policies.
Each central bank has a monetary policy. Monetary policy is a process by which banks achieve their objectives. Nowadays, a common objective is to maintain inflation at a certain level (usually 2%), but other objectives exist. To achieve their goals, central banks have different tools, two of which are controlling interest rates and open market operation.
The interest rate is the rate at which the central bank lends money to other banks. By changing the interest rate, it can influence both the country’s inflation and currency. For instance, if prices increase too fast the bank will want to reduce inflation by increasing the interest rate. If the economy is in a slowdown and there is not enough spending, then the bank can lower the rate to increase inflation.
Controlling inflation through interest rates also affect currencies. Higher inflation reduces the purchasing power of a currency, and it loses value concerning other currencies. On the other hand, lower inflation increases a currency value.
However, timing is an important issue when studying the effect of interest rates on currencies. Increasing or decreasing rates can be an indication of a country’s economical state. For instance, if the ECB (European Central Bank) decides to increase the interest rate after an economic downturn, traders can see this as a sign of recovery in Europe and drive the Euro up. The inverse is can happen as well. This is why it is important to analyze the context for each monetary policy release before any trading decision.
Open market requirements
Central banks can also intervene by executing operations on the market. They buy or sell currencies, bonds, or even securities to control the amount of money in circulation to achieve specific goals. Take for example Canada’s economy, which relies massively on US exports. Canada’s exports could suffer from a powerful Canadian dollar because the Americans will have to pay more to purchase its goods. Hence, the Bank of Canada can decide to sell large amounts of its own currency to lower its value and bring back exports to satisfying levels.
How can traders profit from central banks?
Unless your name is George Soros, you can’t afford to fight against central banks. So the best thing for traders is to trade in the same direction as them. The beautiful thing is that they won’t try to hide their intentions – in fact, it is quite the opposite. They want to divulge their intentions so that they can receive help from traders in moving the market. Remember that the Forex is the largest market in the world, and influencing the value of currency requires very large forces. That’s where traders can join in to help a bank move a currency to a certain level.
Now, this is more relevant for long-term trading strategies, but even for those trading shorter time frames, it can help to know which way the market is heading and develop a long or short bias. So it’s a good idea to keep a close eye on central banks’ conferences, news releases, and interviews to determine their point of view and trade accordingly.
Which central banks should you track?
You should track any bank which has an interest in the currency you are trading. The Federal Reserve which controls the U.S. dollar is a must watch for any Forex trader since its action influence the entire market.
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