Every developed nation has a central bank with a core duty to ensure currency stability and that the interest rates of its nation are set correctly. Contrary to what you might think, central banks want to inform the market about their intentions. They do this in order to ensure that price remains stable and under control, and to avoid large swings in price. A volatile currency is bad for domestic businesses as they import and export goods, so central banks release information in order to assist traders in pricing their currency. This article will explain when every trader should follow central bank policy and give a brief rundown of the key central banks from major nations, with links to their websites.
Isn’t fundamental analysis pointless?
Perhaps you have heard the explanation that all news is already priced into the chart. Well, that explanation is not only unhelpful, but it is also untrue. If you think about it for a moment it’s obvious; how can a central bank’s policy be priced into the market if the policy has only just been released? Furthermore, it is worth reflecting why virtually every single institutional trading firm spends large sums of money to get economic data releases as fast as possible. A Bloomberg terminal costs $2,000 a month and is only available on a minimum 24-month contract. Following central bank policy can be a very beneficial practice for the savvy trader. For example, when the Bank of Japan issued a quantitative easing program in April 2013, it injected large sums of money into Japan’s banking system resulting in the Yen rapidly devaluing, going from around 80.00 to 115.00 over the course of 14 months. You see this example shows two things. Firstly, it shows that it took 14 months for the price to reach the expected 115 level, so it can hardly be said to have been priced into the market. Secondly, it shows the impact of a central bank’s monetary policy. If you had been tuned into that central bank event, you would have had 14 months to benefit from the information. In the chart below you can see how the Bank of Japan’s QE program influenced the USD/JPY currency pair.
Isn’t Central Bank policy too difficult to follow?
You may be convinced that following central bank policy is a good idea; however, you may be wondering whether you can understand it without a finance degree. The good news is that although it may seem impenetrable at first and too complicated to grasp, all you need to focus on is what the central bank itself is focusing on. Four key areas of central bank focus.
The main areas that the bank focuses on are a set of four economic indicators as follows:
• Production (manufacturing data/housing/construction/services)
• Employment (people in work, full- vs. part-time, wage growth)
• Growth (GDP)
The two most important indicators are inflation and growth; these are areas to pay particular attention to. Of these two, the single most important area is inflation. Inflation concerns the costs of goods and services; all banks have a target rate or band that they would like their inflation level to be at. It is usually around 2%, but each central bank will clearly state its own policy.
Four ways central banks can ensure price stability:
1. Interest rates
To control inflation rising above the target level banks will raise interest rates. When a central bank increases interest rates, the value of the currency goes up. Conversely, if inflation is low the bank will cut its interest rates which will encourage people to spend their money and not save. When a central bank cuts its interest rates, the value of the currency goes down. If you look at the price chart below you can see that in July 2017 the Bank of Canada surprised the markets by raising interest rates. This was unexpected to the markets and, over the next two months, CAD gained over 500 points. Savvy traders likely benefited from this rate decision.
2. Quantitative easing
Known as QE, and widely used after the 2008 financial crisis, it is simply a term for the printing of money. It stimulates growth and investment in a country’s economy and simultaneously devalues a nation’s currency. Any central bank about to embark on a QE program will see its currency weaken. On the other hand, as a central bank unwinds its QE program the pressure will be on for that nation’s currency to strengthen.
3. Central bank language
An altered phrase or any indication of an outlook change can move currencies as traders react to any change in emphasis. A recent example is from the Reserve Bank of New Zealand who announced in early August that their interest rates would now be ‘lower for longer’. Markets instantly priced in a more dovish RBNZ and tuned-in traders likely benefited from this phrase.
4. Price control
Central banks will sometimes try to keep a currency at a certain level. The most famous example is that of the Swiss National Bank that maintained a 1.2000 floor in the EUR/CHF pair for a number of years. More recently the Hong Kong Monetary Authority is defending the 7.85 peg against the US dollar. A word of caution, a nation cannot defend a level indefinitely and market fundamentals will eventually win through. A sober reminder of this was when the Swiss National Bank removed the EUR/CHF peg in January 2015.
By following the core messages from the central banks’ monetary policies you will not only know which data releases are important, but you will also benefit from understanding the likely currency direction. Furthermore, in the age of the internet, you can google the reaction to certain data announcements and look up what currency analysts are saying. Fundamental analysis works, is trusted, and is followed by nearly every single professional trader. So, make it work for you. In order to aid in your pursuit of following the central banks, this article will give a brief rundown of some of the world’s largest central banks and provide links to their websites.
Eight of the world’s largest central banks
US Federal Reserve
The Federal Reserve is the most important central bank in the world with the US dollar being the most traded currency in the world, comprising around 70% of all transactions on any given day. It is clear why the Federal Reserve is a very closely watched bank that influences all other central banks across the world.
European Central Bank
The European Central Bank (abbreviated to the ECB) is the central bank of the 19 European Union countries which have adopted the euro. Their main task is to maintain price stability in the euro area and so preserve the purchasing power of the single currency. The European Central Bank was established on June 1st 1998 and is one of the world’s largest central banks.
Bank of England
The blueprint for modern central banks emerged from the founding of the Bank of England (BOE). The BOE was created in 1694 in order to help fund a war against France. The Bank of England today is run by the Monetary Policy Committee referred to as the MPC.
Bank of Canada
The Bank of Canada, although run by the Canadian government, is ultimately owned by the people of Canada. The Bank of Canada was built and has remained in Ottawa since its opening. It contributes an average of $1.7 billion in profit each year to the Canadian government.
Bank of Japan
The Bank of Japan is responsible for setting monetary policy for Japan. Japan is a very export-dependent economy which means it wants a weaker currency in order to help its export market. It works hard to prevent excessive strength in the Yen and the Central Bank has occasionally entered the market to artificially weaken its currency by selling the Yen against the USD and EUR.
Swiss National Bank
The Swiss National Bank has two head offices; one in Zurich and one in Bern. The basic governing principle of the bank is to pursue a reliable monetary policy for the benefit of the Swiss economy and the Swiss people.
Reserve Bank of Australia
The monetary policy of the Reserve Bank of Australia (abbreviated to RBA) consists of a Governor, currently Philip Lowe, a deputy Governor, and 6 independent members appointed by the Government. They meet 11 times a year, on the 1st Tuesday of every month except January.
Reserve Bank of New Zealand
The Reserve Bank of New Zealand has just one person acting as central Bank Governor. That Governor is ultimately responsible for making the decision on the country’s interest rate. It has a target rate of between 1-3%. The Reserve Bank’s primary function, as defined by the Reserve Bank of New Zealand Act 1989 is to provide “stability in the general level of prices.” The Reserve Bank is responsible for the independent management of monetary policy to maintain price stability. It releases Monetary Policy statements four times a year in each quarter. Failure to meet inflation targets can mean dismissal of the Governor.