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Central Banks Set Interest Rates Since central banks, also known as reserve banks, play the crucial role of setting interest rates they need to be followed and studied by a fundamental (and even technical) Forex trader. Central banks want to achieve financial stability of their currency (i.e. battle inflation) and maintain overall economic growth in their country. Their primary responsibility is to oversee the monetary policy of a particular country or group of countries (in the case of the European Union). Monetary policy refers to the various efforts made to effectively control and manage the amount of money circulating within a nation. Skilled investors are able to properly identify which currency will experience an increase in interest rates based upon a central bank’s statements and incoming financial data. Those investors that are correct in their speculations can predict how the respective currencies should move, and as a result should be able to take the proper long or short positions. Central Bank’s Role in Fighting Inflation Central banks act in ways to lessen the effects of inflation on an economy. Inflation refers to a rise in price levels which causes a fall in the purchasing power of a currency. Inflation accounts for an entire basket of goods and services, not just an increase in the price of one item. Monitoring prices of a particular basket is known as indexing and provides a reliable method of tracking inflationary movement. Inflation’s effects can be felt on just about everyone within a society regardless of whether one engages in trading or not. At times of high inflation, employees will demand more money for their work as the previous hourly wage no longer reflects the same value. In order to pay their employees more, businesses have to raise their prices so that they can also manage to raise the wages of its employees. www.cmsfx.com Inflation and Oil (Example) Inflation Interestingly, inflation can be set off by the increase in price of just one crucial item (food or energy) as well. An example of a volatile commodity that can cause inflation is oil. An increase in the price of oil would cause many other items that use it as an input in the production process (such as gasoline) to also increase in price and therefore begin the inflationary process. Inflation poses a problem to the population because it erodes people’s wealth and standard of living as their bank accounts and wages seem to diminish while prices get higher. The purchasing power of the currency decreases and the currency loses strength. Therefore inflation’s erosive nature necessitates the actions taken by the central bank. Affects of Inflation on Interest Rates and Investment If inflation is a concern then the central bank will raise interest rates to appease the inflationary pressure. Higher interest rates will cause inflation to slow because it will cost more for companies and consumers to borrow from banks to fund either investment spending or consumption (i.e. for consumers it will be harder to refinance a mortgage on a house to free up spending money). With more restrictive access to money, economic activity slows down and so do inflationary pressures. The higher interest rate will cause the currency to appreciate in the eyes of investors, both domestic and foreign, as they will benefit from a higher yield on the country's assets. If the currency is now appreciating relative to other currencies, then Forex traders will buy into it in order to trade with the trend, sending even more money towards that economy. It is therefore a delicate balance that central banks have to strike. They would like higher interest rates to strengthen the currency and promote foreign investment, but they must be aware that higher interest rates hurt domestic businesses and consumers that rely on borrowing money from banks. In the following pages, we shall look at an example of interest rates and central banks, and their impact on the Forex market at work. * Home * >Forex Education * >Online Forex Course Table of Contents Close Forex Basics Lessons Lesson 1. Introduction to the Foreign Exchange * What is Forex? * Operation * Aspects of Trading Lesson 2. How Trading Works and Terminology * How Forex Trading Works * Explanation of Margin and Leveraged Trading * Risk Management Lesson 3. A Sample Trade * Setting Up An Example * Opening two Positions * Initial Changes, 4 Hours Later * The Next Day, 24 Hours Later * Candles Can Paint A Story of Wild Activity - 26 Hours Later * Retraction from a Big Move - 30 Hours Later * Two Days Later - 48 Hours Later Analysis and Trading Lessons Lesson 4. Exchange Rates and Supply and Demand * Calculations of Exchange Rates * Supply and Demand * Actors that Affect Supply and Demand * Central Banks Lesson 5. Central Banks and Interest Rates * The Role of Central Banks * Market Reactions to Central Banks – FOMC Example * FOMC Example Continued * Central Banks You Need to Know Lesson 6. Fundamental Analysis * What are Fundamental Factors? * Reaction of the Forex Market to a Fundamental Release * Macroeconomic Indicators * Inflation and Inflation Indicators * Employment Indicators Lesson 7. Technical Analysis * Chart Types * Trends * Concept of Support and Resistance * Trend Reversal Patterns * More Reversal Patterns - Various Tops and Bottoms * Continuation Patterns * More Continuation Patterns Lesson 8. Risk Management – Creating A Trading Methodology * Structuring a Plan for Trading * Risk Management Techniques * Using Exposure Per Trade in Examples * Psychology of Trading * A Trader’s Journal Progress Meter 0 out of 8 Lessons Completed! Lesson 5: Central Banks and Exchange Rates 5.3 Market Reactions to Central Banks - FOMC Example www.cmsfx.comWe will attempt to show how important interest rates are to currency movements by examining price action on the Forex market during a recent central bank tightening campaign. The following example focuses on the EUR/USD pair. Let’s investigate the implication of the United States Federal Reserve’s interest rate decisions to the value of the US Dollar. Dollar Gaining www.cmsfx.com EUR/USD - December 2004 - December 2006: The Euro started 2005 at a high exchange rate, 1.3500 Dollars per Euro. US interest rates had been hovering at very low rate of 1% prior to this time and the Euro was appreciating. In 2005, on the other hand, there was steady Euro depreciation. The US central bank, the Federal Reserve, continued a campaign, started in July 2005 to gradually raise interest rates from 1%. At every subsequent meeting of the Federal Open Market Committee (FOMC), federal officials increased the base interest rate by .25%. Financial markets reacted to this gradual hiking campaign by favoring and strength ending the Dollar. When 2006 started, the EUR/USD pair traded around 1.2000, a change of 13 cents or 1300 pips. The central bank's actions were a major cause for the Dollar appreciating in 2005. Trend Reverses www.cmsfx.com EUR/USD - March 2005 - April 2006: In December ‘05, at the 1.2000 level, the Euro finds support and begins to gain (second rectangle). At this time investors are speculating that the Fed tightening campaign is likely coming to an end. Similar speculation, and Euro appreciation, happened between July and August ‘05 (first rectangle). In February the Fed’s base rate was raised to 4.50%. Speculation that the Federal Reserve would finally pause after 15 straight rate hikes continued throughout March and the first half of April, creating an upward trend favoring the Euro. * Home * >Forex Education * >Online Forex Course Table of Contents Close Forex Basics Lessons Lesson 1. Introduction to the Foreign Exchange * What is Forex? * Operation * Aspects of Trading Lesson 2. How Trading Works and Terminology * How Forex Trading Works * Explanation of Margin and Leveraged Trading * Risk Management Lesson 3. A Sample Trade * Setting Up An Example * Opening two Positions * Initial Changes, 4 Hours Later * The Next Day, 24 Hours Later * Candles Can Paint A Story of Wild Activity - 26 Hours Later * Retraction from a Big Move - 30 Hours Later * Two Days Later - 48 Hours Later Analysis and Trading Lessons Lesson 4. Exchange Rates and Supply and Demand * Calculations of Exchange Rates * Supply and Demand * Actors that Affect Supply and Demand * Central Banks Lesson 5. Central Banks and Interest Rates * The Role of Central Banks * Market Reactions to Central Banks – FOMC Example * FOMC Example Continued * Central Banks You Need to Know Lesson 6. Fundamental Analysis * What are Fundamental Factors? * Reaction of the Forex Market to a Fundamental Release * Macroeconomic Indicators * Inflation and Inflation Indicators * Employment Indicators Lesson 7. Technical Analysis * Chart Types * Trends * Concept of Support and Resistance * Trend Reversal Patterns * More Reversal Patterns - Various Tops and Bottoms * Continuation Patterns * More Continuation Patterns Lesson 8. Risk Management – Creating A Trading Methodology * Structuring a Plan for Trading * Risk Management Techniques * Using Exposure Per Trade in Examples * Psychology of Trading * A Trader’s Journal Progress Meter 0 out of 8 Lessons Completed! Lesson 5: Central Banks and Exchange Rates 5.4 FOMC Example Continued Let's continue examining how the market reacts to changes in the US interest rate outlook. We turn to 2006. Euro Uptrend Continues 1. On March 28th the Federal Open Market Committee (FOMC) continued their campaign to hike rates by increasing the base rate for the 15th consecutive time by .25% to 4.75%. Even though the FOMC raised rates, which would favor the currency, the Euro continued climbing against the Dollar. Investors and traders kept up the speculation that the Federal Reserve was ready to end their campaign. The only question was how much further further they would go. www.cmsfx.com EUR/USD - December 2005 - May 2006 2. On April 14th, Greg Ip, a prominent Wall Street Journal reporter that follows the Federal Reserve closely, wrote that its officials were divided regarding the need for further tightening, fueling investors’ expectations that the base rate would stop at 5%. This news along with other Dollar negative factors (a standoff with Iran over their nuclear ambitions) accelerated Dollar losses for the next four weeks. www.cmsfx.comThe EUR/USD pair went from trading at 1.2100 to 1.2900 which is a significant 800 pip move that translates to a change of $8,000 dollars for a 1 Lot position. Whether the position gained or lost the 800 pips depends on whether the open position was a buy or sell of the pair. 3. On May 10th, the FOMC met and raised the rate to 5%. In the announcement that accompanied the rate hike the Federal Reserve officials said that “further tightening would depend on incoming economic data”. This statement clouded the intentions of the FOMC for their next meeting, which was scheduled for June 29th. A couple of days later when the pair closed in on 1.3000, it stopped trending and entered a ranging market as investors analyzed what the Federal Reserve would do next. www.cmsfx.com Federal Reserve Chairman Moves Markets with Hawkish Talk on Interest Rates The start of June brought some clarification to investors and traders. The still new Federal Reserve chairman Ben Bernanke, at a speech, said that “recent inflation measures were higher than his comfort zone”. These comments were regarded as highly “hawkish” a term to mean an official that favors higher interest rates. “Dovish” statements are those that favor cutting rates. Bernanke's comments caused the Dollar to immediately strengthen as it seemed that the base rate would not stop at 5%, contradicting the earlier speculation that had built up following the Wall Street Journal news report and analysts predictions. www.cmsfx.comIn the next 7 trading sessions, the EUR/USD moved from 1.2950 down to 1.2550 a change of 400 pips (or $4,000 for a 1 Lot position). We have already explained what role inflation plays in the considerations of central bank officials. The Dollar strengthened on the changing US interest rate outlook, touching the older upper (green) trendline we had drawn previously in March/April. From this point, the pair enters another, larger ranging market with price bouncing between 1.2900 and 1.2500. The ranging market developed because investors and traders were unsure about what would happen next since higher inflation readings meant that the FOMC could continue raising rates. If inflation did not pose a problem then the FOMC could pause in their rate hiking campaign. Now that we have taken you through an example of how central banks impact the Forex market let’s take a closer look at the main central banks. 5.5 - 8 Central Banks You Need to Know The world’s central banks possess similar forms of operation and structure although their long term goals may vary. There are eight major central banks within the world economy today: 1. US Federal Reserve Bank (USD) 2. European Central Bank (EUR) 3. Bank of England (GBP) 4. Bank of Japan (JPY) 5. Swiss National Bank (CHF) 6. Bank of Canada (CAD) 7. Reserve Bank of Australia (AUD) 8. Reserve Bank of New Zealand (NZD) www.cmsfx.com Federal Reserve Bank- United States The Federal Reserve The most influential bank is the US Federal Reserve Bank because the US dollar is the most heavily traded currency. The Federal Reserve’s Federal Open Markets Committee (FOMC) decides on interest rates and is made up of 7 governors of the Reserve Board and 5 of the 12 district reserve presidents. The Federal Reserve meets 8 times a year and its key official is Ben Bernanke, the chairman of the Federal Reserve. Twelve regional Federal Reserve Banks were created so that the economic operations of the United States can be monitored efficiently. The FOMC committee meets about every six weeks. The FOMC is comprised of members from the Federal Reserve Board that are both appointed and approved through joint efforts of the President, Congress and regional Federal Reserve Bank presidents. The decisions made by the FOMC are closely watched by investors both within and outside of the US because it gives traders an idea of the economic sentiment, which can be used to predict possible interest rate movements. www.cmsfx.com The European Central Bank European Central Bank The European Central Bank was established after the creation of the Euro in 1998. It oversees the actions of the other member European central banks such as the Banque de France or Ufficio Italiano dei Cambi. The European Central Bank has a group similar to the Federal Open Markets Committee that helps decide on the changes that may need to be made to monetary policy. The committee is known as the Governing Council and is comprised of 6 members of the executive board of the European Central Bank in addition to all the governors of the national central banks from the countries which use the Euro. The Governing Council meets twice a week but only changes policy at 11 of these meetings. The key official associated with the Governing Council is Jean-Claude Trichet, who is the President of European Central Bank. www.cmsfx.com The Bank of England Bank of EnglandThe Bank of England consists of a committee known as the Monetary Policy Committee. It is comprised of 9 members, which include a governor, 2 deputy governors, 2 executive directors and 4 outside experts. The main official associated with the Bank of England is a man by the name of Mervyn King who is the governor of the Bank of England. The Monetary Policy Committee meets once every month in order to discuss any policy changes. www.cmsfx.com The Bank of Japan Bank of Japan The Bank of Japan also has a committee that consists of the Bank of Japan governor, two deputy governors along with 6 other members. It meets once or twice a month and the key official associated with the Bank of Japan is Toshihiko Fukui who is the governor of the Bank of Japan. www.cmsfx.com The Swiss National Bank Swiss BankThe Swiss National Bank has a very small committee that consists of just 3 people and is typically more conservative as far as interest rate movements are concerned. The committee meets quarterly and the key official associated with the Swiss Bank is Jean-Pierre Roth who is the Chairman of the Swiss National Bank. The Royal Bank of Canada The Bank of Canada also has a committee which is known as the governing council. The governing council consists of the governor of the Bank of Canada, the senior deputy governor and four deputy governors. The committee meets about 8 times a year and the key official associated with the bank is David Dodge, who is the governor of the Bank of Canada. The Reserve Bank of Australia The Reserve Bank of Australia consists of a monetary policy committee which contains a central bank governor, deputy governor, the secretary to the treasurer and 6 independent members appointed by the government. The committee meets about eleven times a year and the key official for the Reserve Bank is Ian Macfarlane, who is the Governor of the Reserve Bank of Australia. The National Bank of New Zealand Finally, the National Bank of New Zealand unlike all the other banks has no committee. In fact, all the power of monetary policy lies in the hands of one individual: the central bank governor. The decision is made about 8 times a year by Alan Bollard who is the governor. 6.1 What are Fundamental Factors? www.cmsfx.comIn the currency market, there exist two basic types of analysis: fundamental analysis and technical analysis. Technical analysis will be discussed in the next lesson. Fundamental analysis gauges the intrinsic value of a country's economy, and judging on its expected future performance, positions are opened to take advantage of the anticipated trends in the currency market. Fundamental Factors News that has an impact on the economy both directly and indirectly is considered a fundamental factor. These fundamentals are separated into three major categories: economic factors, financial factors, and political factors which include crises. Economic and financial factors have the biggest impact on currencies movements. The reason that economic and financial data releases are watched is the uncertainty concerning the release's outcome or results. The fundamental reports are kept under strict secrecy up to the time of the actual occurrence. Central banks, for example, change the discount rate confidentially and even though the markets closely watch these events, sometimes the outcomes do not coincide with the predictions. The deciding factor in whether a fundamental release will have an effect on the currency market is how closely the actual results come to economists' predictions. If the fundamental release matches predictions then it should have already been "priced in" to the market beforehand. However, if the release strays from the anticipated numbers, then it will have a bigger impact on the market. The dates and times of economic data release are well known and are anticipated by the market. There are many resources available on the Internet concerning financial, and economic indicators. CMS provides an Economic Calendar for the dates of critical fundamental announcements and events. Political factors can include elections, high level talks, and crises. Some political factors, such as a presidential election or a G-7 meeting are scheduled beforehand and can be anticipated. A political crisis such as a nuclear test by a rouge nation such as N. Korea, or a terrorist attack such as 9/11 can have dramatic effects on the currency markets and are almost impossible to predict. However, only big political events that can affect the patterns of trade or working of an economy or group of economies will have an effect on the financial markets. Next we will look at an example of a fundamental release and a political crisis. * Home * >Forex Education * >Online Forex Course Table of Contents Close Forex Basics Lessons Lesson 1. Introduction to the Foreign Exchange * What is Forex? * Operation * Aspects of Trading Lesson 2. How Trading Works and Terminology * How Forex Trading Works * Explanation of Margin and Leveraged Trading * Risk Management Lesson 3. A Sample Trade * Setting Up An Example * Opening two Positions * Initial Changes, 4 Hours Later * The Next Day, 24 Hours Later * Candles Can Paint A Story of Wild Activity - 26 Hours Later * Retraction from a Big Move - 30 Hours Later * Two Days Later - 48 Hours Later Analysis and Trading Lessons Lesson 4. Exchange Rates and Supply and Demand * Calculations of Exchange Rates * Supply and Demand * Actors that Affect Supply and Demand * Central Banks Lesson 5. Central Banks and Interest Rates * The Role of Central Banks * Market Reactions to Central Banks – FOMC Example * FOMC Example Continued * Central Banks You Need to Know Lesson 6. Fundamental Analysis * What are Fundamental Factors? * Reaction of the Forex Market to a Fundamental Release * Macroeconomic Indicators * Inflation and Inflation Indicators * Employment Indicators Lesson 7. Technical Analysis * Chart Types * Trends * Concept of Support and Resistance * Trend Reversal Patterns * More Reversal Patterns - Various Tops and Bottoms * Continuation Patterns * More Continuation Patterns Lesson 8. Risk Management – Creating A Trading Methodology * Structuring a Plan for Trading * Risk Management Techniques * Using Exposure Per Trade in Examples * Psychology of Trading * A Trader’s Journal Progress Meter 1 out of 8 Lessons Completed! Lesson 6: Fundamental Analysis 6.2 Reaction of the Forex Market to a Fundamental Release Lets take one through an example of how to use a fundamental data release to trade Forex. Then we will show an example of a political crisis. Release of a Fundamental Indicator (Non-Farm Employment Change) On November 3rd, 2006, the United States Department of Labor released a monthly report called the Non Farm Payroll. This fundamental indicator (the term for a report or release) measures the change in employment in the United States for the previous month, excluding the farming sector. www.cmsfx.com For this release the figures came in above expectations of economists. As a result the Dollar strengthened that day as the data suggested that the labor sector of the US economy was doing better than expected. As you can see, on November 3rd, there was a huge surge as price moved downward from around 1.2770 to 1.2680, a move of 90 points, or "pips" in forex lingo. There aren't any other candles in the surrounding time period where price moves as much as the 30 minutes after the release of the Non Farm Employment data. A Political Crisis www.cmsfx.com Nukes This chart shows the reaction of the currency market to a geopolitical crisis. In this crisis, North Korea detonated a nuclear weapon in a test of their nuclear capabilities. How a particular currency will respond to geopolitical dangers depends on many factors. Here, the Japanese Yen suffers because it is a neighbor of North Korea and because the two countries have tense relations they are opposed to each other militarily. Obviously, any attack by North Korea on Japan would damage the Japanese economy. When traders got wind of these developments on Friday, October 6th, they sold the Yen and bought the Dollar. The price changed around 100 pips, meaning the amount of Yen you needed to get one Dollar went up from 117.90 to 118.90. Or, in other words it now cost one more Yen to buy a US Dollar. Safe Haven www.cmsfx.comSince a nuclear test by North Korea is very Yen negative, the Dollar would do better since it's the opposite currency in this particular pair. The Yen's weakness withstanding, the Dollar would have still gained on this geopolitical event because it is considered a "safe haven" currency. During times of danger, investors will move their money out of riskier investments and put them into more stable ones. Since the US is the sole superpower left in the world, it naturally attracts those investors that want to park their money in a safer economy. www.cmsfx.comThe US's "safe haven" status doesn't always work in times of danger in the world. If there is a geopolitical event that directly affects the United States, such as a terrorist attack, or something less immediate, such as military posturing against a state like Iran investors might sell the Dollar. Traders would be worried that the threats might come to action and there would be a war between the two countries. A war with Iran weakens the Dollar because the US economy is so tied to the oil market, of which a large proportion travels through the Persian Gulf. A military engagement against Iran would disrupt oil deliveries and cause hardship for the American economy in other ways. So, as we mentioned before, there are many factors to consider during a political crisis to see what effect it will have on a particular currency. © 2011 Capital Market Services, LLC. All rights reserved. Privacy Policy and Risk Disclosure