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Central Bank Policy
Just following up with a question from a video we recently did in today’s session on the process we follow for conducting fundamental analysis. A subscriber asking, why is Central Bank policy so important to traders?
The thing we need to keep in mind is that Central Banks are by far the biggest driver of asset prices and volatility in both the short as well as the medium term. Now, the reason for this, of course, is because the actions affect the most important part of the economy, and that is interest rates and the money supply.
Now the biggest driver for currency valuation, in the short term, medium term, long term, overall, will always be interest rates, and the overall money supply. Now, yes, they can be short term factors that obviously also affect the value. But mostly, it’ll be the overhanging theme with regards to interest rates and where the market thinks rates are going.
So when a Central Bank is expected, for example, to hike rates that is usually seen as a positive input for the currency, and this is because higher interest rates mean that savers and investors will get a higher return for investing and saving in the country, and thus that leads to appreciation, and anticipation of higher rates is usually also a good sign for the overall health of the economy.
Because when rates rise, it usually comes as a result of higher inflation, which is obviously caused by higher growth. So remember that the Central Bank is tasked with keeping prices stable, and for most Central Banks, that means keeping inflation close to 2%. And when inflation starts to rise, the Central Bank will be expected to hike rates to cause borrowing costs to rise, and thus try to slow down the economy and cause prices or inflation to fall. And vice versa is also true, when a Central Bank is expected to cut rates that’s usually not a good sign for the overall health of the economy. And because they will obviously need lower rates when they see inflation moving lower and of course growth moving lower.
So when inflation falls, the Central Bank will be expected to jump in and cut rates to cause borrowing cost to fall and trying to kickstart the growth in the economy. So when interest rates are expected to either rise or fall, that affects the value or the expected value of the relevant currency. And as Central Banks are responsible for changing interest rates, their comments and policies are always very, very important.
Now, of course as traders, we know that the markets move based on expectations. So when a central bank is expected to cut rates that should normally lead to a weakening of the currency in the run up to the event. And if a bank is expected to hike rates, the currency should appreciate in the run up to the event. Now, the actual effect of the hike or the right, or a whole decision, can be less and more important based on two very important factors. Firstly, what are the markets expecting for rates going forward after that hike or after that cut?
Are there more hikes expected, more cuts expected, or other bank expected to go on hold and secondly, whether the bank gives clear forward guidance on where they think the economy is going, and thus the policy might be going in future.
So let’s put this into a scenario. Imagine that the bank is expected to cut rates, we can expect traders to sell the currency into that event, but the extent of the selling will be dependent on what they think the right path is going to be going forward, right.
So if the market thinks that the bank will go neutral after this cut, then the selling might be more muted as opposed to when they think more cuts are coming after that one. And this is also where forward guidance and rate statements are so critically important for us. So, if we know that the bank is concerned about inflation, for example, and they say that they will hike rates if inflation reaches 2.8% just as an example, then inflation data will be watched very, very closely for clues on where the bank will be taking rates next.
So if inflation is currently sitting at let’s say 2.5%, and suddenly jumps to 2.9%, which is higher than the bank said they would hike from, then of course the market already from that inflation number start to price in higher interest rates. And thus it will start to buy that currency. So you see, it’s, it’s not only about Central Banks, or only about interest rates, or only about economic data, or only about forward guidance, it’s about everything combined and how that is currently shaping the markets expectations about the future rate path of interest rates, and the market is always, always forward looking right.
So they will always try to front run policy changes before they actually occur. So this is also why many inexperienced traders often lose money when they try to trade Central Bank policy announcements and statements. There’s so much information being shared. And the slightest nuance can change the expectations completely.
So these events can be tricky to navigate, if you’re just starting out with trading, especially the fundamentals.
So yes, these events can offer some of the best trading opportunities out there, but they can also create lots of volatility and if you’re not experienced into how to manage your risk in those environments, of course that can be very, very dangerous for you as a novice trader.
So looking back to why Central Bank policy is so important, they can create some of the best trading opportunities in seeing how the market reacts towards events, how the market reacts towards data, it’s not always gonna be about like we said the right word itself or the data itself, but how the market thinks that changes the expectations for that particular Central Bank going forward.
Now and to help you out with what type of things the market is currently focused on, of course, on a weekly basis, we release the, the fundamental drivers report that basically gives you a current bias, fundamental bias, for each of the major currencies, and goes into more detail into what exactly the market is focused on right now in terms of monetary policy. And then on a more daily basis of course, we also have the current sentiment drivers that will also key out the key features, and fault out the key features the market is currently expecting from rates, for each of the individual currencies. And then of course, going to the Currency Research section.
We’ve also implemented the new Interest Rate Probability Tracker, that basically tracks OIS contract prices, to see how the market is currently pricing, pricing and potential changes in terms of Central Bank monetary policy. So that’s just a quick video on why it is so important to traders, and a little bit of guidance on how we can use that to better spot tradable opportunities in the market.