How To Profit From Central Bank Policy Divergence

There’s a great way to find the best currency pairs to trade. Trading the best pairs gives you a higher chance of making more pips. But few retail traders know about this.

In this article we show you how to do just that!

Here you’ll learn about Central Bank Policy Divergence. You’ll also learn how to use these policies to make profitable trading decisions.

But first, let’s understand what a central bank is and what it does. 

What Is A Central Bank? 

Central Banks are responsible for setting the monetary policy of the whole nation.  According to the European Central Bank it’s their job to ensure that the economy is stable & growing.  

A central bank’s primary focus is to manage inflation. And also to reduce unemployment, while enabling economic growth.

They also exist to ensure the banking/financial system is as stable as possible and doesn’t crash.

A central bank has several mandates that it follows which are not limited to the above.

It can also include issuing and maintaining the value of their currency. As well as serving as last resort lender to other banks and acting as the government’s banker.

Every Central Bank action can also influence the price movements of its currency.

This is why Central Banks are so important for Forex traders to watch.  

What Is Monetary Policy? 

Monetary policy is the way that central banks influence how much money is in their country’s economy. It also influences how much it costs to borrow money.  

Central Banks have a variety of policy tools which they can use to achieve their mandate.

These tools may be used when the central bank feels the economy is over-heating or needs propping up.

It’s important to remember that monetary policy is different to fiscal policy 

Monetary policy and fiscal policy should work hand in hand.  But according to a Wall Street Journal study, this doesn’t always happen.  

The monetary policy implemented by a central bank will generally change over time. This will depend on which cycle the economy is in and how long the cycle is expected to last.  

This is why central bankers pay so much attention to the economic data of their country.  

They need to track current economic conditions. They also need to predict and prepare for the next phase of the economic cycle.  

 By doing this they are able to minimise any adverse effects to that country and its currency.  

The national bureau of economic research regularly studies the US economy. In the chart below they show that the US economy is expanding.  

In 2018, it became the second longest expansion period since 1950.  

  

It’s the Federal Reserve’s job to manage this type of economic expansion. They’ll prepare policy tools in advance. This will ensure the US economy does not overheat. 

Major Central Banks 

There are 8 major central banks that every forex trader should know.   

According to Investopedia, these central banks have the most tradeable currencies.  

Information about their monetary policies are found below:

United States – Federal Reserve

European Union – European Central Bank 

Japan – Bank of Japan 

United Kingdom – Bank of England

Switzerland – Swiss National Bank

Canada – Bank of Canada

Australia – Reserve Bank of Australia

New Zealand – Reserve Bank of New Zealand

These central banks also have the most influence over the global economy.

But the most influential of all is the U.S. Federal Reserve. This is because the US dollar is the most traded currency in the world followed by the Euro. 

The structure of each central bank is slightly different.  So are the number of members and the number of times these banks hold policy meetings per year. 

It is these policy meetings and interest rate statements that all Forex traders need to be aware of. 

How Do They Determine Monetary Policy? 

Central Bankers are very good economists. They spend a lot of time analysing and monitoring economic indicators.

This is so they can make future economic forecasts and plan ahead.

They do this because the results of monetary policy can take time to have full effects on an economy. According to the Bank of England, it can take up to two years.

But, even central bankers sometimes get forecasting wrong.

Bloomberg studied the major central banks for their forecasting accuracy. They found the Bank of England has the worst track record for predicting inflation 

These failings were shared in a speech by the Bank’s chief economist, Andrew Haldane. 

Errors in economic forecasting can be problematic. This is because forecasting economic direction is key to making monetary policy decisions.  

Furthermore, it is also critical for the credibility of the Central Bank. 

So far we understand central banks, what they do and how they determine monetary policy.  We also know where traders can find these policies.  

Why Central Bank Policy Is Important To FX Traders 

It’s not enough for FX traders to only know each central bank’s current monetary policy.  

It is also important to understand the main economic indicators. The individual aspects of the economy are also important.  

Knowing what each central bank is currently focussed on can provide an edge.  

Why?  

As mentioned above, Central Banks don’t always get their economic forecasting correct. 

Traders can also track economic indicator trends. 

They can determine which policy tool would be most effective. This helps them predict what the central bank might do next.  

This two-fold forecasting gives traders an edge when trading monetary policy divergence. 

Hawks, Doves And Neutrals 

We know that central banks are generally made up of committee members 

Each member has their own opinion about monetary policy. These biases help them decide which monetary policy tools to use next.

This opinion is the central banker’s bias or stance.

In forex terms there are three main biases known as:hawks, doves and neutrals. 

Hawks are central bankers who want higher interest rates. They generally believe that the economy is performing strongly.  

 They prefer higher rates to help keep inflation in check. 

Doves are central bankers who want lower interest rates. They generally believe that the economy is performing poorly.  

They feel the economy needs lower rates to help stimulate inflation/growth. 

Neutrals are central bankers in the middle who want interest rates to remain on hold.  

They want to see key economic indicators trend in one direction. They make monetary policy alterations based on those trends. 

It is important to note that not all central bank members are equal. This means that not all central bankers have voting rights 

But, this does not stop non-voting members from expressing their opinions. And it does not stop the forex market from acting on what they say. 

Why Forex Traders Care About Central Banker’s Stances 

It’s important to know each central bank’s monetary policy. It’s also important to know the bias of each central bank member.

This is because traders make money from the markets through change.

Change causes volatility in the markets. This volatility can then provide potential profitable trading opportunities.  

These changes can result from deviations in economic data points. They are also affected by change in monetary policy. A shift in a central banker’s opinion can also have an impact.

Sometimes a hawk will indicate a dovish stance or vice versa. This type of shift has a huge market impact. 

This says that the central banker is now less positive about the state of the economy. And instead believes the economy may need stimulating

The market would also want to know why and what caused this change in stance. 

These bias shifts could reveal long term changes. This includes the direction the central banker believes the economy is heading.  

The economic data itself sometimes supports this shift in bias. Traders then speculate on this as a trading opportunity.  

In this example, the opportunity would be to sell the currency.

It’s always important to be aware whenever any central banker is due to give a speech 

Policy Divergence Explained 

According to the Cambridge dictionarydivergence is when two things become different.  

Central bank policies diverge when they are either different or start becoming different. 

For example – a hawkish Federal Reserve policy and a dovish Reserve Bank of New Zealand policy.

Or a hawkish Bank of Canada policy and a neutral Reserve Bank of Australia monetary policy.  

FX traders try to identify divergences in central bank policies. This provides them with excellent money-making opportunities. 

Case Study – NZDCAD Short Trade 

We’ve learned what central bank monetary policy divergence is and how to identify it.   

Let’s take a look at an example of how to actually make some pips using this knowledge.

The first chart below shows that in July 2017 the Bank of Canada embarked on a hawkish monetary policy. They increased interest rates to 0.75%.  

This was the first rate hike in seven years.   

This was a big change! 

They also continued their hawkish monetary policy stance. They conducted further rate hikes with the second increase following in close succession.   

This was a surprise change! 

 

The next chart shows the rate policy of the Reserve Bank of New Zealand. They maintained a neutral monetary policy. They kept the Official Cash Rate (OCR) on hold.  

This was after having held a dovish monetary policy since June 2015. 

 

This illustrates two central banks with diverging monetary policies 

Trading is based on expectations. FX traders interpret diverging policies in a clear manner.

In this case, they believed the Canadian Dollar should strengthen. And that the New Zealand Dollar should weaken. 

The obvious opportunity was to sell the New Zealand dollar against the Canadian dollar.

The NZDCAD weekly chart below shows this period of policy divergence. You can see a clear downward trend. 

 

The Bank of Canada increased rates in July 2017. They conducted another surprise hike in September 2017. 

These surprise changes to monetary policy are clear trading opportunities.  

You could have profited from this NZDCAD short trade using any timeframe of your choice. 

This pair went on to fall over 500 pips!  

Of course, you would also have needed to use good risk and money management.

Note: It’s useful for you to know that trading divergence is not only limited to forex and monetary policy.  

There are also divergence opportunities in inter-related markets once you understand the correlations.  

It’s also important to be aware that currency moves can be caused by politics and external factors 

Price may move in a direction that is contrary to the expected direction of monetary policy. 

Summary 

In this article we looked at the meaning of central bank policy divergence. We learned how to select a currency pair based on this information and how to profit from this knowledge.

We also covered central banker’s bias and the importance of forecasting. This applies to both central bankers and traders.

We then looked at the real-life case study of the NZD and CAD. That scenario resulted in divergence that yielded hundreds of pips!  

If you have any questions or comments about this article please leave them below.  

We value all feedback and will use them to create new articles and content in the future.

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