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We all know that central bank decisions are some of the most influential occurrences on the forex markets, but how do the actual mechanics work? When the Bank of Japan lowers interest rates, the SNB stops buying Euros, or the ECB starts buying bonds, what’s going on?
Here we’re going to have a look at the basic mechanics that cause central bank decisions to hit the forex markets. The important thing to remember is that old solid Supply and Demand. Currencies trade based on this in the same way as any other commodity. Central Banks have to affect on, the other or both in order to change exchange rates.

Interest rate changes
Back before 2008 central bank’s simply wouldn’t attempt to intervene overbearingly in markets and interest rate changes were the only likely outcome of a meeting of the Federal Reserve. When the Federal Reserve changes its interest rate, it changes the relative benefit of keeping money in one currency instead of another.

If the central bank increases the interest rate, bank rates and bond rates in the United States tend to go up. If everything else remains equal the US dollar is more attractive to hold that the euro or yen and money begins to flow into the country’s investments.

Basically the price of the currencies with higher interest rates will go up until no more money can be made through simple transfers. On the financial markets, as you can see after major interest rate decisions are made, this happens almost instantly.

Direct market intervention
This is the actual buying and selling of currencies by central banks designed to influence exchange rates. At its simplest level it involves affecting the demand for one currency in another by central bank intervention. It can take several different forms in specific cases, however.

The best example in recent years has been the intervention of the Swiss National Bank which set the maximum exchange rate at 1.2 Franc to the Euro in 2011. The central bank kept its currency low against the euro by printing francs and using them to buy euros, meaning there would always be infinite supply of Francs at that level and none above it. Nobody is going to sell 1.3 francs for a euro when the central bank is selling them at 1.2.

This, of course, was risky for the Swiss National Bank and was a last gasp policy designed to reduce the impact of serious deflation brought on by a flight to safety during the financial crisis.

The other, more common side of direct intervention is propping up a currency: a practice Russia attempted sporadically through 2014. This involves buying your own currency with the central bank’s foreign currency reserves. This is an unstable practice that can result in the bank running out of reserves, and the weakening of the currency accelerating as a result.

Quantitative easing and other innovations
Less understood than direct intervention because of its novelty, QE involves printing currency in order to buy securities, i.e. bonds and equities. The US began doing this several years ago and was followed by the ECB, the BoE and the BoJ. The way it affects currencies is still debatable, but the central theory references two factors: increase in currency supply and lower interest rates.

Buying US treasuries at such a level means that yields fall substantially, lowering demand for the dollar to buy them in and having a knock-on effect on interest rates across the economy, and having the same effect, at one level, as a change in interest rates.

Increasing the money supply by such a margin, 60 billion euro in the case of the ECB program, every month creates a downward pressure on the price of the currency compared to others.

This has been the basic effect of easing programs in the US, Japan and the UK, but the ultimate result of the European program remains to be seen. Further study as central bank innovations keep popping up will result in greater understanding of these mechanics.

Predicting movement

The above gives an outline of the mechanics that central bank decisions drive on the market, but there’s so many factors affecting the supply and demand for currencies that none is a guaranteed bet. Take any currency chart and look at it through the last seven or eight years to get an idea of the unpredictable volatility that drives forex at certain points in time.

Knowing is half the battle, however, so getting used to the way that central bank decisions are made, and learning about these mechanics and the decision making apparatuses behind them will put you ahead of the average market participant and give you insight into the more complicated derivative results of central bank intervention.

]]> https://mktplace.org/central-banks-affect-exchange-rates/feed/ 0 6 Central Banks That Rule Forex https://mktplace.org/6-central-banks-rule-forex/ https://mktplace.org/6-central-banks-rule-forex/#respond Mon, 02 Feb 2015 16:00:53 +0000 http://www.tradersdna.com/?p=32918

The role of central banks in deciding exchange rate levels cannot be overestimated. If you want to trade currencies you need to understand what a central bank is, and how it controls exchange rates.

The actions of these institutions drives the day to-day fluctuations in the forex markets, but who are they, and how do they work? Here’s  a look at the 6 most important central banks in the world, and the way they make their decisions.

1. The Federal Reserve
This is the big one. The Federal Reserve is the most talked about, and by far the most important, central bank on the planet. The Dollar is the currency of world trade.

How does it work? The seven governors, appointed by the president and confirmed by the senate, serve 14-year terms. The meet once every six weeks with 5 of the 12 presidents of the district reserve banks to form the Federal Open Market Committee. This committee decides interest rates, and more dramatic actions by the central bank.

What does it want? The Federal Reserve’s dual mandate is full employment and stable prices, meaning it wants to keep both inflation and unemployment low. This goal, which is wider than that of many other central banks, is what allowed actions like quantitative easing to take place based on unemployment figures rather than inflation numbers.

2. The European Central Bank
The guardian of the European common currency, the ECB was set up by a treaty between the member states of the Eurozone, which now number 19.

How does it work?  The decision making body of the bank is made up of the 19 heads of regional central banks and six executive board members nominated by the governments of the bloc in concord with each other. The bank’s governing council meets twice per month in Frankfurt, and announces its monetary policy decisions at the first of these.

What does it want? Enshrined in treaty, the objective of the ECB is clear: maintain price stability in the Eurozone. This is the reason that the ECB was not able to introduce QE-style program to allay the effects of unemployment. The bank was only allowed to interfere on the grounds of dangerous deflation.

3. The Bank of Japan
The keeper of the Yen since the nineteenth century Meiji Restoration, the BoJ is the monetary policy decision maker of Japan.

How does it work? The committee of the bank of Japan is made up of nine members, including a governor and two deputy governors. The committee meets once or twice per month in order to decide the country’s monetary policy.

What does it want? The bank of Japan doesn’t have the kind of clearly defined goals that the Fed or ECB have, making it a little less predictable. It’s mandate gives it reign to implement monetary policy and ensure the soundness of the financial system while maintaining price stability, though it doesn’t put any of these goals on a pedestal above the others.

4. The Bank of England
By far the oldest bank on this list, and the one that the rest have based themselves off of, the Bank of England has been around for more than three hundred years.

How does it work? Tricky because of its reliance on British traditional politics for guidance, the Bank of England’s monetary policy is decided by a committee which is made up of nine members and meets once every month.

What does it want? Price stability is currently the main goal of the BoE, but that can change as it’s the government that chooses the inflation target, and the overall objective can be amended by act of parliament. If the bank misses that target by a wide margin it has to explain its mistakes to the Chancellor of the Exchequer.

5. The Swiss National Bank
Established in 1907, the Swiss National Bank floats 45% of its shares on the stock market, and is the only central bank on this list that actually makes a profit.

How does it work? The SNB is supposed to conduct it monetary policy decisions as if it were an independent central bank. The governing board of the SNB has three members who are responsible for decisions on monetary policy. It decides interest rates quarterly.

What does it want? Price stability, including a definition thereof, is the central goal of the Swiss National Bank, though it has a secondary goal of accounting for economic developments in order to foster an atmosphere that supports economic growth.

6. The People’s Bank of China
Unusually opaque, the People’s Bank of China acts as the central bank for the yuan. It was the only bank in the communist country for decades, but the liberalization of the banking system left the PBC squarely with the duties of a central bank.

How does it work? China’s monetary policy is decided by  a committee which includes the governor and two deputy-governors of the PBC, along with representatives from government, regulators and an academic. The committee meets quarterly.

What does it want? The goals of the monetary policy committee are set to be prescribed by the State Council, meaning they’re unusually amendable.

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