Hello and Welcome to the ditto educational series that will provide you with the skills you need to become a forex trader!
Today we will be discussing Central banks and how they affect the forex markets, central banks main objective is to maintain inflation in the interest of sustainable economic growth and by doing so contribute to the overall stability of the financial system.
Central Banks are independent institutions utilized by nations around the world to assist in managing their commercial banking industry, set central bank interest rates promote financial stability throughout the country.
When central banks need to preserve order they will intervene in financial markets in line with the defined Monetary Policy Framework. The implementation of this policy is widely monitored and anticipated by forex traders seeking to take advantage of the volatility that will ensue because of it.
We will now look at the roles of the major central banks and how their policies affect the global forex market.
Open market operations
Open market operations or (OMO) describes the process whereby governments buy and sell government bonds in the open market, with the aim of expanding or contracting the amount of money in the banking system. The purpose of this would be to either stimulate or inhibit the growth of economy to maintain balance.
The central bank rate
The central bank rate, often referred to as the federal funds rate is set by the monetary policy committee with the intention of increasing or decreasing economic activity. A economy that grows to quickly can lead to inflation and a central banks aim is generally to preserve the economic equilibrium.
Central banks can also act as a lender of last resort. If a government has a modest debt to GDP ratio and can not raise money through a bond auction, the central bank can lend money to the government to meet its temporary liquidity shortage.
Having a central bank as the lender of last resort increases its investor confidence. Investors are more likely to believe that governments will meet their debt obligations and this heps to reduce government borrowing costs.
MAJOR CENTRAL BANKS
European Central Bank (European Union)
The European central bank or (ECB) is different from other banks in that it serves as the central bank for all member states in the European Union.
The ECB prioritises safeguarding the value of the Euro and maintaining price stability. The Euro is the second most circulated currency in the world and therefore is keenly observed by forex traders.
Federal Reserve Bank (United States)
The Federal Reserve Bank or “The Fed” has implications not just for the US dollar but for many other currencies as well, news and actions surrounding the bank are observed with great interest. The Fed specifically targets stable prices, maximum sustainable employment and moderate long-term interest rates.
Bank of Japan
The Bank of Japan is unique in that it has prioritized price stability and stable operations of payment and settlement systems.
The Bank of Japan has held interest rates below zero in a drastic attempt to give new life to the economy. Negative interest rates actually allow individuals to get paid to borrow money. On the flip side investors are disincentivised to deposit funds as they will incur a charge.
Bank of England
The Bank of England operates as the UK’s central bank and has two main priorities which are preserving monetary stability and financial stability. The UK operates using a Twin Peaks system when regulating the financial industry with the one peak being the Financial Conduct Authority (FCA) and the other the Prudential Regulating Authority (PRA).
The Bank of England regulates its financial services by requiring these firms to hold sufficient capital and have adequate risk controls in place.
CENTRAL BANK RESPONSIBILITIES
The purpose of Central banks is to fulfil a mandate in order to serve public interest. Their responsibilities vary however they all share a few common goals which include.
1. Supervising and regulating financial institutions.
2. Promoting the financial systems stability.
3. Fostering balanced and sustainable growth in an economy.
4. Achieving and maintain price stability.
5. Minimising unemployment.
CENTRAL BANKS AND INTEREST RATES
We discussed central bank interest rates in a previous video but to quickly recap as they tie into this branch of knowledge.
central banks set the central bank interest rate, and all other interest rates that individuals encounter such as loans, mortgages, credit cards and so on. The central bank interest rate is the interest rate that is charged to commercial banks looking to borrow money from the central bank on an overnight basis.
commercial banks charge a higher rate to individuals than the rate they can secure with the central bank.
Commercial banks need to borrow funds from the central bank in order to comply with a modern form of banking called Fractional Reserve Banking.
The bank generates revenue through this process by charging a higher interest rate on loans while paying lower rates to depositors.
Forex traders will monitor central bank rates closely as they can have a significant impact on the forex market. Institutions and investors tend to follow interest rates and therefore, changes to the rates will result in traders investing more toward countries with higher interest rates.
HOW CENTRAL BANKS IMPACT THE FOREX MARKET
We as traders often have to assess the language used by the chairman of the central bank to look for indications to whether the central bank is likely to increase or decrease interest rates.
The Language that is interpreted to suggest either an increase or decrease in rates is referred to as Hawkish or Dovish.
As if their wasn’t enough jargon to learn it is important to remember. The subtle clues that this language leaves behind are referred to as forward guidance and have the potential to move the forex market.
Traders that determine the central bank is about to hike a interest rate and perceive the outlook as hawkish will place a long trade in favour of that currency.
However traders anticipating a dovish outlook from the central bank will look to short the currency.
Central banks will not outright announce wether their outlook is hawkish or dovish so what are we looking for to determine this for ourselves?
A hawkish stance is guarding against inflation getting too high.
To curb inflation, a hawkish policy will increase interest rates or some other equivalent action.
An increase in interest rates can cause a strengthening in a countries currency.
Dovish is the opposite of hawkish. This is when an economy is not growing and the government wants to guard agains deflation which is a decrease in the cost of goods and services.
So basically we’re looking for signs they want to do something to stimulate the economy such as lowering interest rates to increase the rate of purchases on goods and services.
As we trade pairs in forex we are Looking for currency pairs with large directional potential. If one currency is strong and the other week the rate at which a pair can rise and fall may be substantial. Pairing this knowledge with your technical analysis can see you make superior trade choices and improve you trading all around.
hopefully you have enjoyed our discussion today ladies and gentleman and now have a greater understanding of fundamental analysis. please sit back and contemplate what you have learned today and remember Contemplation is the key to learning.