Intermediate

Fundamental analysis

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Central banks explained

5-minute read

Whichever market you’re trading, it’s worth paying attention to the actions of central banks. Here, we examine how the Federal Reserve, European Central Bank, Bank of England and more affect traders.

What are central banks?

Central banks are the institutions in charge of safeguarding a country’s – or group of countries’ – economy. Each central bank operates a little bit differently, but in general, they have the mandate of:

  • Keeping the economy growing at a steady rate
  • Ensuring that inflation remains on target
  • Maintaining high employment

Simply put, central banks have the tricky task of ensuring that their economy is always growing without overheating. Rapid economic growth might sound like a good thing, but if left unchecked, it can lead to high inflation, overzealous investing and eventually even a crash.

The main weapon central banks have to control the economy is monetary policy. This means making changes to interest rates (among other things) and this has a huge impact on financial markets.

What are the major central banks?

The major central banks are those who set interest rates for the major global currencies :

  1. Federal Reserve Bank (USD)
  2. European Central Bank (EUR)
  3. Bank of England (GBP)
  4. Bank of Japan (JPY)
  5. Swiss National Bank (CHF)

 

Central banks

However, it’s worth paying attention to the central bank of any economy that you’re planning on trading in. If you think you’ve spotted a good opportunity in the ASX 200 index, then do some research on the Reserve Bank of Australia. Want to trade USD/HUF? Then you might want to find out what the Hungarian National Bank is going to do next.

Monetary policy and central banks

As we covered in the Introduction to financial markets course, interest rates might just be the biggest market movers of all.

Central banks set the base rate for their economy, which dictates how much commercial banks charge on their loans (including mortgages) and savings accounts. When rates are high, it costs more to borrow and you’ll make more from saving – meaning people and businesses are encouraged to do less with their capital.

When they’re low, on the other hand, you get cheap access to loans and poor performance from a savings account. People and businesses are encouraged to spend, invest and fuel the economy.

So when inflation is rising and growth needs to be tamed a little, central banks might raise rates. And during periods of slowdown, they’ll cut rates to try and spur growth.

Essentially, this all comes down to money supply. When rates are low, there is more money flowing around the economy – and as we know, high supply should drive the value of money down. When rates are high, money supply is tightened, lowering inflation and slowing growth.

Monetary policy aimed at promoting growth is often referred to as expansionary, while policy aimed at lowering inflation is called contractionary.

But what does all this mean for the markets?

Different asset classes will respond to interest rates in different ways. Let’s explore how stocks and indices, forex, commodities and bonds will react to high and low rates.

Forex

High interest rates tend to make an economy more attractive to foreign investors – because they can get a higher return on their capital.

But they’ll need to exchange their currency to get involved in the market, which creates demand and can see FX pairs rise when rates are high (as long as the currency with the high rates is the base).

Stocks and indices

High rates are usually bad for business. They discourage spending and mean companies have less access to the capital they need to fuel growth.

Low rates, on the other hand, can see stocks rise. Not only can businesses thrive, but investors are forced away from savings accounts – which can fuel demand for stocks.

Commodities

Commodities and interest rates have a complex relationship. But in general, when rates are high commodity prices tend to suffer.

Why? Because the opportunity cost of storing commodities increases in periods of high interest. A high rate in the US can also lead USD to rise, which is bad for commodities as they are USD-denominated.

Bonds

 

Bonds might just be the market with the closest relationship to interest rates.

When interest rates are low, bonds look like attractive investments – which increases demand and raises bond prices. On the other hand, high rates can put people off bonds, lowering demand and seeing prices fall.

Other monetary policy tools

Monetary policy can mean more than just setting base rates. After the 2008 recession, quantitative easing was employed by central banks around the world as a means to tackle low growth when rates were already at record lows.

They may also get involved in the forex markets, buying and selling their currency in order to control its price. Or they can require commercial banks to hold more reserve capital, effectively taking cash straight out of the economy.

How often do central banks meet?

Central banks don’t (usually) just change their monetary policy on the fly, though.

Most will have a calendar of regular meetings in which they decide whether interest rates should be maintained, raised or lowered – as well as the implementation of any other policies. These meetings tend to be major market events, as traders quickly try to adapt their strategies to the new conditions.

Central bank meetings and consensus

In general, the markets will have a consensus view on what a central bank might do next. Analysts will take the latest economic data and the stances of key central bank personnel into account and predict what they think the outcome of a meeting will be.

If the meeting goes as planned, you might not see much volatility in the short term – because any planned action has already been priced in by traders. If the central bank surprises the markets, however, you may see massive moves.

That’s why fundamental traders try to make their own prediction on what might happen next. They’ll pore over the latest GDP, employment, inflation and sales figures – then trade accordingly so they can get ahead of the market consensus.

In the next lesson, we’ll cover the key economic data to watch.

Monetary policy example

To see how all this works in action, let’s use an example.

The Bank of England (BoE) has the mandate of maintaining 2% inflation. When inflation is below 2%, it might consider using lower rates to increase money supply and kickstart the economy.

After several quarters of steady growth, economic data begins to show that inflation is dropping well below the BoE’s 2% target. So forex traders, expecting a rate cut in the near future, start selling GBP/USD and the pair’s price begins to fall.

At the next meeting of the BoE’s monetary policy committee, they announce that they believe the low inflation to only be a short term issue, and maintain current interest rates. Traders with short positions on GBP/USD rush to adapt their strategies. They may even swap to long trades, potentially causing GBP/USD to rise.

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Test your knowledge

Question {0} of {1}
The Federal Reserve decides to raise interest rates to new highs after a period of strong growth. What might happen to the S&P 500?
  • A It will rise
  • B It will fall
  • C Nothing
Question {0} of {1}
The ECB unexpectedly lowers rates to combat low inflation. What affect will this have on European bond markets?
  • A Prices will rise
  • B Prices will fall
  • C Nothing
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