Central banks control interest rates and interest rates are important for a currency.
That is what you should take away from this section of the book. In the following
section I will explain what central banks do, show using real-life examples why they
are so pivotal to FX and thus why I watch them to inform my trading.
least seven or eight times a year, to decide policy. The most important central banks
in the G10 are:
US Federal Reserve (Fed)
European Central Bank (ECB)
Bank of Japan (BOJ)
Bank of England (BOE)
Reserve Bank of Australia (RBA)
The People’s Bank of China (PBOC) is also one to watch, even though it does not
stick to a rigid timetable to announce policy decisions.
What central banks do
Central bank operations are complex, with a variety of different roles and
responsibilities. I am going to give you a simplified version here and then explain
what their work means for FX.
Central banks are the government entities involved in controlling a country’s money
supply; they have the power to take money out of the economy or pump it back in. In
doing so, they have a few main tasks:
1. Manage economic growth
2. Keep the currency stable
3. Some central banks also have a mandate to move the workforce towards full
employment (the US Fed has this duty).
Essentially central banks monitor the economy. They like nice, steady economic
growth and when they see things moving too fast or slow they need to get involved
to try and steady the ship.
So, if an economy is growing too fast there will be a fear of overheating. When this
happens asset bubbles can form, which tend to pop and then cause recessions. A
central bank wants to avoid this. Symptoms of an overheating economy include
rising inflation and a fast pace of growth. When they see this the central bank can
hike interest rates. By doing this they try to remove some of the heat from the
economy by making money more expensive, thus trying to limit investment, cool
consumption and cause a managed slowing down.
When central banks raise interest rates they make money more expensive. People
prefer to save rather than spend because they earn more on their deposits. The
amount of money in circulation tends to fall, which means that the value of money
tends to rise.
Let’s say the economy starts slowing down sharply, as we saw during the financial
crisis in 2008. Back then major central banks around the world cut interest rates as
they wanted to make money cheap to disincentivise people from saving, instead
encouraging people to spend and invest in the economy to try to boost growth. This
means that central banks are putting money back into the system by making it cheap
– this increases the money supply and tends to cause the currency to fall in value. In
crude terms:
Central banks raise interest rates = currencies rise
Central banks cut interest rates = currencies fall
will be the next policy decision, will they tighten or loosen interest rates and will
currencies go up or down? There are three particular things traders should watch out
for when it comes to central banks:
1. Monetary policy decisions and any press conferences held by the president or
governor of the bank (this is particularly relevant for the ECB and the Fed).
2. Minutes from central bank meetings, which give an insight into the thought
process behind policy decisions and can be useful for predicting what central
banks will do next.
3. Central bankers make speeches throughout the year that give an insight into
what they are thinking, how they see the economy and what they might
decide at the next policy meeting. Economic calendars usually include data
for central banks, when bankers are speaking, etc.
There is also a bit of lingo that traders need to be aware of when it comes to central
banks:
Hawkish: when central banks are concerned that the economy may be
growing too fast and may be about to hike interest rates they are referred to
as hawkish.
Dovish: when central banks are worried the economy is slowing down too
fast and may be about to cut interest rates they are referred to as dovish.
So, FX markets are sensitive to changes in monetary policy and also to minutes and
speeches from central bankers that give an insight into their thoughts.
Here are a couple of examples of this.
September 2012 meeting in which it sounded worried about economic growth,
making a cut in interest rates more likely than a hike.
This caused an immediate dive in the Aussie. The circled area indicates the point of
release of the dovish RBA minutes and the impact they had on AUDUSD – it caused
the Aussie to sell off for most of the day. If I wanted to trade around the minutes
there were a few things that I could do:
1. Check what the market was expecting. In this instance the RBA had left rates
on hold in September so the markets expected the minutes to be fairly
neutral.
2. Once the minutes had come out and the dovish message had been digested, a
short AUDUSD trade could be placed around 1.0470-80 with a target of
approximately 60 pips, with a 20 pip stop (see the risk management section
for more on trade set ups).
This would have made a nice intra-day trade: the market was taken by surprise by
the RBA sounding so concerned about the state of the economy, so placing a short
AUD trade could make a small profit. It could also work as a long-term trade,
especially if you thought the RBA may cut rates later in the year.
In that case a short position could be entered with a much wider stop and lower
profit target. A long-term trade would require more preparation: for example it
would be worth looking back over recent economic data from Australia to see if the
economic data had started to deteriorate and thus would justify a cut in rates by the
RBA.
example, USDJPY is very sensitive to changes in stance by the Federal Reserve.
Figure 1.13 shows USDJPY and US Treasury yields. Treasuries (US government
debt) tend to move closely with changes in Fed policy and are a good way to gather
the market’s view on whether the Fed is dovish or hawkish.
The first thing to note about government debt is that price moves inverse to yields:
so when central banks are hawkish, Treasury bond prices fall and yields rise; and
when banks are dovish, Treasury bond prices rise and yields fall. This relates back to
the earlier section when I described how central banks control money: when the
economy is strong they hike rates, which pushes up interest rates and pushes down
the price of debt as fewer investors want to borrow money. When interest rates fall
this pushes up the price of debt as more investors want to borrow, but it also pushes
down interest rates.
The main thing you should know is this: falling Treasury yields (the Fed is dovish)
tends to be dollar negative, while rising Treasury yields (the Fed is hawkish) tends to
be dollar positive.
Why is this relationship so close?
US Treasuries are very popular investments to hold and are the most traded
government securities in the world. The Japanese are some of the world’s largest
holders of US government debt, holding nearly 1 trillion dollars’ worth. Thus, when
Treasury yields fall, as they had been doing since the first quarter of 2012, it means
that the price of Treasuries rises. This means that the USD value of Japan’s holding
of Treasuries rises, and to hedge themselves some Japanese traders start selling
USDJPY.
Of course, the forex market is influenced by so many factors it can be hard to claim
one group of people cause the movement in a currency cross, however this
explanation is well known in the currency markets and I believe it goes some way to
explaining the traditionally close relationship between Treasury yields and USDJPY.
crisis in 2008 had been weaker than expected. Since central banks in the UK, US,
Japan and the euro zone had already cut rates to extremely low levels they then had
to use unconventional measures to try to boost growth.
This included quantitative easing (QE), whereby the central bank buys government
debt to try to depress long-term interest rates and interest rates on mortgages. The
Federal Reserve in the US embarked on its third round of QE in September 2012 in
another attempt to boost the US economy. This is a largely untested strategy in the
history of central banking, and time will tell if it has an effect on the economy.
The intended impact of QE is to limit currency strength; however it depends on how
aggressive the central bank is. As you can see in Figure 1.14 – where QE2 and QE3
are circled – the dollar is very sensitive to QE and it tends to lead the currency
weaker.
but this is a popular technique with large investment banks and hedge funds so it is
worth the retail trader being aware of it so they know how the big guys make
decisions in the FX market.
Since two currencies are always traded together and interest rates can determine the
value of a currency, a popular trading strategy is to buy a currency with a higher
interest rate and sell a currency with a lower interest rate. This is called the carry
trade.
For example, interest rates in Australia were 3.5% in June 2012; in contrast, US
interest rates were at 0%. Due to this, the Aussie dollar was a more attractive
currency to hold relative to the dollar. Indeed, this was the case for most of the
period from 2010 to 2012 and as a result AUDUSD has been in an uptrend in that
time, as you can see in Figure 1.15.
But you will notice that this pair has been extremely volatile, with some large
swings up and down. The carry trade is volatile so traders need to be on their guard.
Part of the reason for this volatility is that central banks can change policy
unexpectedly and their movements can be hard to predict with accuracy.
Here is another example. Although interest rates in the euro zone in autumn 2012
were higher than they were in the US, EURUSD did not present a good opportunity
for the carry trade as the rate differential was only 75 basis points. However,
changes in the difference between US Treasuries and German Bunds (using Germany
as a benchmark for the entire currency bloc) can impact the direction of EURUSD.
As you can see in Figure 1.16, the difference between German and US bond yields
had been trending lower at the start of the year and again from June to October. This
means that German bond yields were lower than US bond yields, which weighed on
EURUSD.
But how can that be when euro zone interest rates are higher than US interest rates?
The currency market can also react to the expected change in rates – thus, as the euro
zone economy deteriorated at a faster pace than the US economy in 2012 German
bond yields fell, which weighed on EURUSD.
bank. However, currency traders need to keep an eye on other banks as well.
The Bank of Japan (BOJ) and the Swiss National Bank (SNB) in recent years have
directly intervened in the forex market to weaken their currencies and thereby
protect their export sectors and boost growth. I will use two examples to show the
different effects that central bank intervention can have on the FX market.
1. Bank of Japan intervention to weaken the yen in
March 2011
The BOJ wanted a weaker currency to stimulate growth in the country after a major
tsunami and earthquake caused an economic disaster in March 2011. The BOJ and
other central banks decided to sell yen in a multilateral attempt to weaken Japan’s
currency.
Although the exact amount of yen sold is unknown, it was not enough to keep the
yen weak for long. Instead this type of FX intervention was more of a gesture to
show solidarity with Japan in its hour of need. This was not deemed aggressive
central bank intervention.
As you can see in Figure 1.17 where the timing of central bank intervention has been
circled, although USDJPY jumped from 79.00 to 86.00 in a matter of days, it soon
started to weaken again.
2. Aggressive intervention by the SNB
In contrast, the Swiss National Bank (SNB) embarked on an aggressive bout of
intervention in August 2011 after EURCHF fell to its lowest ever level. This caused
the SNB to worry about Switzerland’s export-dominated economy that relies on a
weak exchange rate to make its exports competitive.
Thus, the SNB decided to instigate a floor in EURCHF at 1.20. That meant that it
would buy EURCHF to ensure that the pair got back to this level and stayed there.
The cost was that the SNB had to buy billions of euro, but the upside was that it
helped to protect the Swiss economy.
This is extremely aggressive action from a major central bank and is very rare. As
you can see in Figure 1.18 – which shows the aftermath of the intervention from
December 2011 onwards – the FX market took the SNB’s action seriously and
EURCHF has barely budged from 1.20 since the floor was put in place.
That is what you should take away from this section of the book. In the following
section I will explain what central banks do, show using real-life examples why they
are so pivotal to FX and thus why I watch them to inform my trading.
The major central banks
Most countries in the world have a central bank. They tend to meet monthly, or atleast seven or eight times a year, to decide policy. The most important central banks
in the G10 are:
US Federal Reserve (Fed)
European Central Bank (ECB)
Bank of Japan (BOJ)
Bank of England (BOE)
Reserve Bank of Australia (RBA)
The People’s Bank of China (PBOC) is also one to watch, even though it does not
stick to a rigid timetable to announce policy decisions.
What central banks do
Central bank operations are complex, with a variety of different roles and
responsibilities. I am going to give you a simplified version here and then explain
what their work means for FX.
Central banks are the government entities involved in controlling a country’s money
supply; they have the power to take money out of the economy or pump it back in. In
doing so, they have a few main tasks:
1. Manage economic growth
2. Keep the currency stable
3. Some central banks also have a mandate to move the workforce towards full
employment (the US Fed has this duty).
Essentially central banks monitor the economy. They like nice, steady economic
growth and when they see things moving too fast or slow they need to get involved
to try and steady the ship.
So, if an economy is growing too fast there will be a fear of overheating. When this
happens asset bubbles can form, which tend to pop and then cause recessions. A
central bank wants to avoid this. Symptoms of an overheating economy include
rising inflation and a fast pace of growth. When they see this the central bank can
hike interest rates. By doing this they try to remove some of the heat from the
economy by making money more expensive, thus trying to limit investment, cool
consumption and cause a managed slowing down.
When central banks raise interest rates they make money more expensive. People
prefer to save rather than spend because they earn more on their deposits. The
amount of money in circulation tends to fall, which means that the value of money
tends to rise.
Let’s say the economy starts slowing down sharply, as we saw during the financial
crisis in 2008. Back then major central banks around the world cut interest rates as
they wanted to make money cheap to disincentivise people from saving, instead
encouraging people to spend and invest in the economy to try to boost growth. This
means that central banks are putting money back into the system by making it cheap
– this increases the money supply and tends to cause the currency to fall in value. In
crude terms:
Central banks raise interest rates = currencies rise
Central banks cut interest rates = currencies fall
Central banks in action
The trader should always be interested in what the central banker will do next: whatwill be the next policy decision, will they tighten or loosen interest rates and will
currencies go up or down? There are three particular things traders should watch out
for when it comes to central banks:
1. Monetary policy decisions and any press conferences held by the president or
governor of the bank (this is particularly relevant for the ECB and the Fed).
2. Minutes from central bank meetings, which give an insight into the thought
process behind policy decisions and can be useful for predicting what central
banks will do next.
3. Central bankers make speeches throughout the year that give an insight into
what they are thinking, how they see the economy and what they might
decide at the next policy meeting. Economic calendars usually include data
for central banks, when bankers are speaking, etc.
There is also a bit of lingo that traders need to be aware of when it comes to central
banks:
Hawkish: when central banks are concerned that the economy may be
growing too fast and may be about to hike interest rates they are referred to
as hawkish.
Dovish: when central banks are worried the economy is slowing down too
fast and may be about to cut interest rates they are referred to as dovish.
So, FX markets are sensitive to changes in monetary policy and also to minutes and
speeches from central bankers that give an insight into their thoughts.
Here are a couple of examples of this.
Minutes from the RBA and AUDUSD
Figure 1.12 shows AUDUSD in the aftermath of dovish minutes from the RBA’sSeptember 2012 meeting in which it sounded worried about economic growth,
making a cut in interest rates more likely than a hike.
This caused an immediate dive in the Aussie. The circled area indicates the point of
release of the dovish RBA minutes and the impact they had on AUDUSD – it caused
the Aussie to sell off for most of the day. If I wanted to trade around the minutes
there were a few things that I could do:
1. Check what the market was expecting. In this instance the RBA had left rates
on hold in September so the markets expected the minutes to be fairly
neutral.
2. Once the minutes had come out and the dovish message had been digested, a
short AUDUSD trade could be placed around 1.0470-80 with a target of
approximately 60 pips, with a 20 pip stop (see the risk management section
for more on trade set ups).
This would have made a nice intra-day trade: the market was taken by surprise by
the RBA sounding so concerned about the state of the economy, so placing a short
AUD trade could make a small profit. It could also work as a long-term trade,
especially if you thought the RBA may cut rates later in the year.
In that case a short position could be entered with a much wider stop and lower
profit target. A long-term trade would require more preparation: for example it
would be worth looking back over recent economic data from Australia to see if the
economic data had started to deteriorate and thus would justify a cut in rates by the
RBA.
Fed monetary policy and USDJPY
Some currency pairs are particularly sensitive to central banks’ monetary policy. Forexample, USDJPY is very sensitive to changes in stance by the Federal Reserve.
Figure 1.13 shows USDJPY and US Treasury yields. Treasuries (US government
debt) tend to move closely with changes in Fed policy and are a good way to gather
the market’s view on whether the Fed is dovish or hawkish.
The first thing to note about government debt is that price moves inverse to yields:
so when central banks are hawkish, Treasury bond prices fall and yields rise; and
when banks are dovish, Treasury bond prices rise and yields fall. This relates back to
the earlier section when I described how central banks control money: when the
economy is strong they hike rates, which pushes up interest rates and pushes down
the price of debt as fewer investors want to borrow money. When interest rates fall
this pushes up the price of debt as more investors want to borrow, but it also pushes
down interest rates.
The main thing you should know is this: falling Treasury yields (the Fed is dovish)
tends to be dollar negative, while rising Treasury yields (the Fed is hawkish) tends to
be dollar positive.
Why is this relationship so close?
US Treasuries are very popular investments to hold and are the most traded
government securities in the world. The Japanese are some of the world’s largest
holders of US government debt, holding nearly 1 trillion dollars’ worth. Thus, when
Treasury yields fall, as they had been doing since the first quarter of 2012, it means
that the price of Treasuries rises. This means that the USD value of Japan’s holding
of Treasuries rises, and to hedge themselves some Japanese traders start selling
USDJPY.
Of course, the forex market is influenced by so many factors it can be hard to claim
one group of people cause the movement in a currency cross, however this
explanation is well known in the currency markets and I believe it goes some way to
explaining the traditionally close relationship between Treasury yields and USDJPY.
Unconventional central banking
In 2012 the pace of global growth had slowed after the recovery from the financialcrisis in 2008 had been weaker than expected. Since central banks in the UK, US,
Japan and the euro zone had already cut rates to extremely low levels they then had
to use unconventional measures to try to boost growth.
This included quantitative easing (QE), whereby the central bank buys government
debt to try to depress long-term interest rates and interest rates on mortgages. The
Federal Reserve in the US embarked on its third round of QE in September 2012 in
another attempt to boost the US economy. This is a largely untested strategy in the
history of central banking, and time will tell if it has an effect on the economy.
The intended impact of QE is to limit currency strength; however it depends on how
aggressive the central bank is. As you can see in Figure 1.14 – where QE2 and QE3
are circled – the dollar is very sensitive to QE and it tends to lead the currency
weaker.
Interest rate differentials
Interest rate differentials are a fairly sophisticated strategy for the retail FX trader,but this is a popular technique with large investment banks and hedge funds so it is
worth the retail trader being aware of it so they know how the big guys make
decisions in the FX market.
Since two currencies are always traded together and interest rates can determine the
value of a currency, a popular trading strategy is to buy a currency with a higher
interest rate and sell a currency with a lower interest rate. This is called the carry
trade.
For example, interest rates in Australia were 3.5% in June 2012; in contrast, US
interest rates were at 0%. Due to this, the Aussie dollar was a more attractive
currency to hold relative to the dollar. Indeed, this was the case for most of the
period from 2010 to 2012 and as a result AUDUSD has been in an uptrend in that
time, as you can see in Figure 1.15.
But you will notice that this pair has been extremely volatile, with some large
swings up and down. The carry trade is volatile so traders need to be on their guard.
Part of the reason for this volatility is that central banks can change policy
unexpectedly and their movements can be hard to predict with accuracy.
Here is another example. Although interest rates in the euro zone in autumn 2012
were higher than they were in the US, EURUSD did not present a good opportunity
for the carry trade as the rate differential was only 75 basis points. However,
changes in the difference between US Treasuries and German Bunds (using Germany
as a benchmark for the entire currency bloc) can impact the direction of EURUSD.
As you can see in Figure 1.16, the difference between German and US bond yields
had been trending lower at the start of the year and again from June to October. This
means that German bond yields were lower than US bond yields, which weighed on
EURUSD.
But how can that be when euro zone interest rates are higher than US interest rates?
The currency market can also react to the expected change in rates – thus, as the euro
zone economy deteriorated at a faster pace than the US economy in 2012 German
bond yields fell, which weighed on EURUSD.
Central bank intervention
As you may have gathered, the US Federal Reserve is the most influential centralbank. However, currency traders need to keep an eye on other banks as well.
The Bank of Japan (BOJ) and the Swiss National Bank (SNB) in recent years have
directly intervened in the forex market to weaken their currencies and thereby
protect their export sectors and boost growth. I will use two examples to show the
different effects that central bank intervention can have on the FX market.
1. Bank of Japan intervention to weaken the yen in
March 2011
The BOJ wanted a weaker currency to stimulate growth in the country after a major
tsunami and earthquake caused an economic disaster in March 2011. The BOJ and
other central banks decided to sell yen in a multilateral attempt to weaken Japan’s
currency.
Although the exact amount of yen sold is unknown, it was not enough to keep the
yen weak for long. Instead this type of FX intervention was more of a gesture to
show solidarity with Japan in its hour of need. This was not deemed aggressive
central bank intervention.
As you can see in Figure 1.17 where the timing of central bank intervention has been
circled, although USDJPY jumped from 79.00 to 86.00 in a matter of days, it soon
started to weaken again.
2. Aggressive intervention by the SNB
In contrast, the Swiss National Bank (SNB) embarked on an aggressive bout of
intervention in August 2011 after EURCHF fell to its lowest ever level. This caused
the SNB to worry about Switzerland’s export-dominated economy that relies on a
weak exchange rate to make its exports competitive.
Thus, the SNB decided to instigate a floor in EURCHF at 1.20. That meant that it
would buy EURCHF to ensure that the pair got back to this level and stayed there.
The cost was that the SNB had to buy billions of euro, but the upside was that it
helped to protect the Swiss economy.
This is extremely aggressive action from a major central bank and is very rare. As
you can see in Figure 1.18 – which shows the aftermath of the intervention from
December 2011 onwards – the FX market took the SNB’s action seriously and
EURCHF has barely budged from 1.20 since the floor was put in place.
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