Understanding Central Banks

Understanding Central Banks

Central banks are at the heart of their country’s economy and play a key role in the global markets. Their importance is particularly relevant when trading the Forex, as they often 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 to produce and manage 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. A monetary policy is the 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. In order to achieve their goals, central banks have different tools, two of which are controlling interest rates and open market operation.

Interest rates
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. A higher inflation reduces the purchasing power of a currency and it loses value with respect to 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 economical 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 analyse 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 in order to achieve specific goals. Take for instance Canada’s economy, which relies heavily on US exports. Canada’s exports could suffer from a strong Canadian dollar, since the Americans would 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 satisfyingly 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 a 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.