There are lots of various factors that affect the value of currencies.
In the bigger scope of things, central banks probably play the biggest role. The reason for this is because are in control of monetary policy.
One of the most conventional monetary policy elements are short-term interest rates. When interest rates change it can drastically affect currency values.
However, there are also more unconventional monetary policies. One of the most influential in recent years has been Quantitative Easing.
In this article, we’ll explore what Quantitative Easing is and how it works. We’ll also explain why it’s important for Forex Traders.
The points we’ll discuss in the article are:
- Central banks and Monetary Policy
- What exactly is Quantitative Easing
- When is Quantitative Easing used?
- Which central banks implemented QE?
- How Quantitative Easing works step by step
- Does Quantitative Easing work?
- The implications of Quantitative Easing on Currencies
Central Banks and Monetary Policy
So, why are central banks so important for Forex traders? As mentioned above, they are responsible for setting monetary policy.
It is their responsibility to keep their economies healthy. Every central bank has specific mandates which they operate under.
For the most part, their main goal is to keep prices and economic growth stable. The way they accomplish this is by setting the required monetary policy.
The central bank manages a country’s money supply by adjusting monetary policies. The policies adopted could be either expansionary or contractionary.
Their process for achieving their mandates differ depending on the different economic cycles.
Below is a list of monetary policy tools according to the Federal Reserve Bank of St. Louis:
- Changing the discount rate
- Altering the Reserve requirements
- Increasing or lowering Interest on Reserves
- Conducting Open market operations
Of all these tools the most watched and followed is changes in the discount rate. Interest rates are one of the biggest influencers on currency values.
So, where does Quantitative Easing fit into these four tools? Well, QE is part of Open Market Operations.
What Exactly Is Quantitative Easing
Quantitative Easing is a large-scale expansion of Open Market Operations (OMO). This is when a central bank buys and sells government securities on the open market.
The main aim of OMO is for the central bank to adjust interest rates. As the central bank buys government bonds their demand rises.
Thus, performing OMO keeps interest rates low. That is done in order to lower longer-term borrowing costs.
So, how is normal Open Market Operations different from QE? The size and quantity of the purchases during QE is much larger.
For example, the FED’s QE program took their balance sheet from $800 billion to $4.5 trillion dollars.
This massive increase in their balance sheet occurred in 7 years. That is why QE is considered as an unconventional Open Market Operation.
It involves the central bank creating tons of new money and injecting it into the banking system. So, where does the central bank get this new money?
Well, basically they create it out of thin air. This is often why QE is referred to as the printing of money.
But, it’s important to understand that no real or physical money is created. The money that is created is in the form of balance sheet credits.
According to FXCM, this is also called central bank reserves. This new money is then used to buy government securities from commercial banks.
That is how the new money that was created is injected into the financial system. Buying government securities from commercial banks increases their reserves.
The BOJ was one of the first central banks to initiate a QE program from 2001 to 2006. After the global recession of 2007 many other central banks used it as well.
When Is Quantitative Easing Used?
So, why would central banks need to implement QE anyway? Something as drastic as that is only required in extreme cases.
Usually this is only required when standard monetary policies are not working.
A good example of this was after the global financial crisis of 2007. A lot of things changed in the aftermath of the crisis.
The world’s largest economies were in a lot of trouble.
Unemployment was running high. Business and consumer confidence were at low points.
In addition, housing markets were a mess. Many businesses and consumers were defaulting on their loans.
This occurred around the world as economies tried to recover. Central banks intervened in order to stop the bleeding and stimulate their economies.
The first step which central banks took was to lower their interest rates. In a normal economic downturn, the lower rates would have stimulated the economy.
However, the crisis was so large that even 0% interest rates did not help. Some countries like Japan and Sweden even cut rate to below 0%.
When rates are already close to or below 0% there is a limit to conventional policies. The danger was that Economies fell into a liquidity trap.
A liquidity trap is when low rates have no effect on aggregate demand. This usually occurs during times of extremely low business and consumer confidence.
Commercial banks were unwilling to hand out loans. Similarly, consumers were unwilling to spend and take out loans.
As a result, economies kept contracting and was on its way to a major depression.
Central banks had to find another way of stimulating their economies. Thus, they turned to Quantitative Easing to get their economies out of the mess.
QE would allow them to increase economic expansion apart from cutting rates further.
Which Central Banks Implemented Quantitative Easing?
In terms of history, Japan was the first to launch QE back in 2001 – 2006. In addition, they also restarted their QE program in 2012.
The Federal Reserve was the first one out of the blocks after the crisis. They implemented a first round of QE in 2008 after the crisis.
After this, they implemented an additional 3 rounds of QE until 2014.
The Bank of England also ran multiple implementations from 2009 to 2016. The total size of their QE spending is estimated at 375 billion Pounds.
The ECB started QE in 2015. They purchased almost 2.6 trillion Euros on the asset purchasing program.
How Quantitative Easing Works Step By Step
One of the main goals of QE is to improve credit markets. Central banks accomplish this by making cheap money available in the economy.
When there is low borrowing costs companies and consumers are more willing to spend.
Companies are more willing to take loans to invest in their businesses. Likewise, consumers are more willing to take loans for houses, cars and furniture etc.
So, how does the QE process work step by step?
Step 1 – New Money
The central bank creates new electronic money and adds it to their own balance sheet.
Step 2 – Buying Financial Assets
Secondly, the new money is used to buy financial asset from Commercial banks. The assets are predominantly government bonds.
Step 3 – Lowering Bond Yields
As the central bank buys government bonds, they increase their demand on the open market. Thus, the increase in demand leads to an increase in their prices.
This drives the bond yields lower, which makes them less attractive for investors.
Step 4 – Lowering Interest Rate expectations
Government bond yields are a barometer for interest rates. Thus, when they fall or rise, they affect interest rate expectations.
As bond yields fall due to bond purchases it also lowers interest rate expectations.
Step 5 – Lowering borrowing costs and higher bank reserves
The central bank buys their bonds from commercial banks. Thus, they drastically increase the reserves of the banks.
This makes the banks more willing to lend out money. Likewise, the lower interest rates and expectations lowers borrowing costs.
Step 6 – Businesses and Consumers spend and stimulate the economy
At this stage the environment is perfect for economic expansion.
You have banks that are more willing to lend. In addition, you also have business and consumers who are more willing to borrow.
As more loans are given the economy starts to expand. Furthermore, the expansion leads to higher demand which leads to more jobs.
More jobs mean more demand which further stimulates the economy. Before you know it, the economy is recovering as more and more expansion occurs.
Does Quantitative Easing work?
It depends on who you ask.
There is a lot of speculation about whether Quantitative Easing has worked. The answer would depend on what the goals and outcomes was.
Let’s take inflation as an example. One of the theories of QE is that it will boost inflation.
But in the case of Japan and the UK this was not the case. In both countries’ inflation kept falling despite low rates and asset purchases.
Thus, if inflation is the goal then the there is evidence that it does not work.
Some who claimed QE would see inflation skyrocket was left wanting. Most of the central banks that ran QE programs struggled to get inflation to rise.
The challenge here was with commercial banks. If all the money created was given to the public to spend inflation might have been a problem.
But many commercial banks kept the excess credit as reserves. Thus, all the new money did not make it into the real economy.
This is one of the arguments against something like helicopter money. Some suggest a better option would have been to give governments the money.
They could use the money for fiscal policy to directly spend it in the real economy. But the implications that could have on inflation is unclear.
2. Economic Growth
So, what about QE and economic growth? One of the goals of QE is to boost economic growth.
The BOE spent close to 375 billion Pounds on their QE program. Furthermore, they estimate that this only added 1.5% to 2% of GDP growth.
Which means it took 375 billion Pounds to create 23 billion of spending in the economy. That is hardly effective.
One of the biggest challenges facing QE is in fact commercial banks. The central bank relies on commercial banks to lend out the money they receive.
But commercial banks might choose not to lend it out. They might use it to invest in high risk assets for maximum profit.
This actually led to a 20% boost in stock prices in the UK alone. Thus, the wealthiest 5% of the population became even wealthier.
In 2016, Standard & Poor reported that high risk assets values rose by 600 billion Pounds. The report also noted that real wages fell by 8% over the same period.
Thus, the new money created by the central bank doesn’t always make it into the real economy. As a result, the impact on economic growth was not as large as it could be.
One of the areas where QE did have a positive impact was on liquidity. The banking industry was in a heap of trouble after the financial crisis.
A lot of banks went bankrupt causing widespread panic for business and consumers. As a result, commercial banks were not willing or able to lend out money.
The massive increase in extra credit gave banks ample reserves. This gave them more money to lend but also gave them well needed liquidity.
They claim that it created a broad-based easing in financial conditions.
4. The case of the United States
Some speculate that the Federal Reserve had the most successful QE program. Mainly because the US is much better off now than it was before QE.
According to the Fed, the first rounds of QE boosted economic activity by 3%. They further explained that it revitalized the US housing and labour markets.
But others argue that the US economy would have recovered without it.
Some Fed member also argue against it. Stephen Williamson said there were many reasons to doubt QE’s effectiveness.
Some use Canada as an argument against it. Canada did not engage in QE and had very similar economic conditions to the US.
From 2007 to 2016 real GDP performance between Canada and the US were very similar. Thus, it begs the question whether all the stimulus was really required.
There are also those who say the real problems for QE is still coming. As central banks unwind their balance sheets economic conditions will get very tight.
The Implications Of Quantitative Easing On Currencies
Business and consumers have grown used to abundant cheap money. As QE has never been done before no one knows what effect the unwinding will have.
So, what does all this have to do with Forex Trading?
Well, QE had a tremendous affect on currency values. It all comes down to the law of supply and demand.
It states that as the supply of something increases its price should begin to fall. In contrast, if demand increases the price should begin to rise.
We already know the goal of QE is to drastically increase the money supply. Thus, as the supply is ramped up the relevant currency should depreciate.
There is also a second factor QE plays on the currency. We saw earlier that it affects interest rates by pushing down government bond yields.
We also know that interest rates are a major driver for currency values. Thus, QE also depreciates the local currency due to falling rates.
This knowledge can provide Forex traders with unique trading opportunities. One of the best examples of this was on the EURUSD pair.
The Federal Reserve announced an end to their QE program in 2014. But, the ECB only announced the start of their own asset buying program in 2015.
This created a tremendous monetary policy divergence. One which could have provided great trading opportunities.
The next opportunity to look forward to is the unwinding of central bank balance sheets. As central banks no longer see a need for stimulus, they will unwind the asset purchases.
This portfolio rebalancing can create opportunities going forward. So, make sure to read up on investment bank analysis regarding these topics.
Also, make sure to analyze central bank policy stance regarding their balance sheets. Any announcements of Quantitative Tightening can be market moving.
These events might not come around very often but when they do, we can be ready.
Knowing how currencies respond to these policies are essential. Learning about policies like these help us contextualize current policies.
It also helps us understand why certain things are important for traders. Central bank statements and their policy decisions matter.
Our job as Fundamental traders is to learn how to take that info and profit from them.
We wish you all the best in your development and progress as a trader.
If you have any questions or comments, feel free to let us know in the comment box below.