Central bankscan affect market prices on a massive scale. So, you need to closely monitor the policy paths ofcentral bankswith many traders basing their positions on their announcements. How frequently they are likely to change and the potential direction they will go in are crucial in trading decisions.
What is a Central Bank？
A central bank is a financial institution that sets the monetary system for a nation. Central banks are given privileged authority to issue currency, function as the bank of the government, manage exchange reserves, regulate the credit system, oversee commercial banks and act as a lender of last resort. Central banks have a defined range of responsibilities that includes overseeing monetary policy and implementing specific tools to achieve main mandates such as currency stability, steady inflation and full employment.
Some central banks have a single mandate which is price stability, such as the European Central Bank. Others have dual policy mandates; price stability and employment, like the Federal Reserve and Reserve Bank of New Zealand.
Which Central Banks Affect the Forex Market？
Top Central Banks that affect forex prices are the banks of the most traded currencies. The eight major central banks are:
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The Federal Reserve – FED
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The European Central Bank – ECB,
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Bank of England – BoE
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Bank of Japan – BoJ
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Reserve Bank of Australia – RBA
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Reserve Bank of New Zealand – RBNZ
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Bank of Canada – BoC
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Swiss National Bank -SNB.
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Hawkish Tone:It is seen as a positive tone, where a central bank starts to consider tightening policy and hike interest rates in wake of a better economic outlook.
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Dovish Tone:It is seen as a negative tone, as the central bank considers taking expansionary measures and cutting interest rates to fight economic downturns.
Altogether, these eight banks control the currencies of themajor forex pairs.The Federal Reserve Bank is the top influential bank asapproximately 90% of all currency transactions include the US Dollar, which is also the top reserve currency in the world.
Policies of Central Banks
Monetary policies are divided into two main categories; expansionary monetary policies and contractionarymonetary policies. Both involve controlling the level of themoney supplyin a country to maintain steady and sustainable economic growth.
Expansionary monetary policy is simply aimed to increase the supply of money, while contractionary monetary policy works on decreasing currency supply to curb demand. Aneutral monetary policyintends to neither create growth nor fight inflation.
To achieve their policy mandates, central banks use monetary tools mainly to controlthe interest rates, inflation levels, money supply, lending to commercial banks, and reserve requirements.
Central Banks and Interest Rates
Interest ratesare the primary influencer of investment flows. Central banks set interest rates applied to businesses and individuals.
Central Banks tend to raise interest rates to curb high inflation and an overheating economy. This is because high-interest rates mean people and businesses will borrow and spend less. These policies aim to prevent the economy from growing too fastwhich can create economic bubbles.
However, after expansionary cycles, hiking interest rates can be a good sign that the economy is growing.
On thecontrary, when an economy is shrinking, interest rates are lowered as thecentral bankwants people to borrow and spend more. Lower interest rates encourage more people to borrow and spend, therefore stimulating the economy. When the central bank considers lowering interest rates, it means that the economy is not doing well which leads traders to sell that currency. And when lowering the interest rate isnt efficient enough to revive the economy, thecentral bankmay startquantitative easing.
Trading Central Banks Decisions
Forex traders tend to interpret announcements bycentral banksbased on their tone, language, and forward guidance to forecast future steps. Policy announcements usually hint whether they will cut, hike or hold interest rates.
Typically, intending to hike interest rates or maintain neutral levels is good for the currency. In contrast to when a central bank intends to cut interest rates or maintain high levels.
However, announcements do not guarantee actual changes but can be a good opportunity to seize the trend that follows outlook change. That said,the future direction of interest rates matters the most as the current rate is already priced in.
Consider current interest rates, but most importantly interpret announcements to know where rates are going, and the currency will follow. It is also important tonote how frequently acentral bankholds its meetings. Some are more frequent than others, which can offer more trading opportunities. Sometimes acentral bankwill announce surprise interest rate changes, which cannot always be predicted and can have a significant effect on the forex market.
So, How Central Banks affect your Trading Decisions？
Usually higherinterest rateslead to currency appreciation, especially when it is backed by solid economic conditions and steady growth. Currencies tend to depreciate affected by lower interest rates and expansionary monetary measures applied by central banks. Central banks‘ decisions have a direct impact on price directions in the forex market. Make sure to follow the changes in central banks’ language for better trading decisions.
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