Analyzing trends: how central banks influence the markets

What is a central bank? 

A central bank is a public institution with a monopoly over the financial system. It performs financial and banking services for the government and commercial banks. Therefore, it is of great importance to the economy as a whole. The respective Monetary Policy Framework defines its main tasks.  

Experience shows that central banks function best when they act independently of the government. Nevertheless, it also happens that politicians in some countries occasionally influence monetary policy. However, it should only take care of the fiscal policy. 

However, many developing countries have not yet achieved a complete transition from a controlled to a liberal economy. Instead, they still want to retain control over their economies. Nevertheless, such behaviour can often be observed in industrialized countries, especially when their economies disappear. 

What are the goals of the central bank? 

Central banks are supposed to serve the public interest. However, the individual tasks differ depending on the central bank. The most important responsibilities are usually to maintain price stability and, in some cases, to promote full-time employment and GDP.  
A central bank achieves this through analyses and instruments of monetary policy. Many central banks aim for a target inflation rate of 2%. Below you will find other possible tasks of central banks.

Objectives of central banks: 

• price stability: maintaining the currency's value at the inflation rate. 
• financial stability: stress tests for banks to reduce risks.
• economic growth: monetary policy measures after a fiscal policy has been exhausted.
• financial regulation: supervision and regulation of banks. 
• labour market promotion: reducing unemployment and promoting full-time employment.

Tasks of the central bank 

The main task of the central bank is to control the money supply. It uses various instruments for this purpose. The devaluation of money and the associated inflation are particularly relevant to it. This could cause a devastating wage-price spiral.  

This means a perpetual motion machine in which rising prices cause workers to demand wage increases. This, in turn, is at the expense of the companies' margins, which must raise their prices in response. Subsequently, consumers also react by demanding higher wages. 

An economic cycle.

Central banks also have other tasks. These include the printing of banknotes and coins. They also ensure that payment systems and trading in financial instruments function smoothly.  

Furthermore, they also manage foreign exchange reserves and inform the public about the economy. In addition, they supervise commercial banks and ensure they do not take excessive risks. In this context, they influence the reserve ratio. 

Means of action of central banks 

To achieve its goals, the central bank uses the following instruments: 

• rate cut or rate hike,
• Quantitative Easing program,
• tapper,
• market intervention,
• exchange rate pegs or unpegs,
• change in lending policies.

Relationship between commercial banks and central banks 

In most cases, banks borrow short-term capital. In return, they must deposit collateral for it. For this purpose, government or corporate bonds can be used.  

In this context, banks issue long-term loans in exchange for short-term deposits. In this context, however, they may experience liquidity problems because they cannot liquidate their funds quickly enough. In such a situation, the central bank then helps as a last resort to stabilize the financial system. 

A bank also usually does not have enough liquidity to meet demand. Therefore, it can borrow funds from the central bank. Central banks' reserves with banks are based on their deposits.  

For example, central banks may require a 1-to-10 ratio of reserves to deposits. However, they may also require no reserves at all. The interest rate that banks must pay in this regard to central banks is called the discount rate. 

Commercial banks then borrow money from the central bank to meet fractional reserve banking. In this regard, banks must have enough deposits to service daily withdrawals. The rest of the money is lent out, taking a higher interest rate than depositors receive from theirs.

Interventions and consequences of central banks in financial markets 

To control the rate of inflation, a central bank uses an accommodative or restrictive monetary policy. In this context, it raises or lowers the amount of money to control the devaluation of money. They can provide more liquidity, for example, by buying government bonds or lowering interest rates. In the following, you will learn how the FED controls business cycles and its effects on the economy. 

Effect of the restrictive policy of central banks 

When an economy prospers, and GDP grows, everyone earns more. Thus, they spend more money. However, the economy must grow because otherwise, more financial means meet fewer goods, which in turn causes inflation. This is because the money supply grows faster than the number of goods, which leads to price increases. If it is not controlled by the central bank as quickly as possible, this can have devastating consequences.  

But inflation can also be fueled by undersupply caused by reasons such as supply chain problems, as in the case of Corona. Another factor is the increase in the velocity of money in circulation because if a $100 bill is spent only once a year, it causes less inflation than if it had been used ten times in the same period. Thus, a reduction in the velocity of money in circulation acts like an increase in interest rates and vice versa. 

Ideally, the central bank raises interest rates when the economy is developing well with a low unemployment rate. This way, it can curb inflation before the wage-price spiral causes currency collapse. 

On the other hand, if interest rates are now raised, this, in turn, also increases the cost of borrowing. This makes the high debt levels of governments, companies, and, in some cases, private households all the more burdensome. 

However, the interest rate hike also causes many other financial resources to flow into the currency. After all, other asset investments will then be more worthwhile again. Bond investors, for example, are also trying to generate attractive additional returns via currency differentials.  

Another factor in this context is borrowers from other countries. Because these will, for example, try to hedge against the appreciation of the U.S. dollar when the loan currency appreciates avoiding possibly being driven into insolvency. 

Also relevant is that the goods and services from the country will become available at a lower price. So it becomes more attractive for the foreign country to obtain the offers with a discount. This will then, in turn, have a beneficial effect on the region's exports. 

For how long do central banks raise interest rates? 

Central banks cannot raise interest rates indefinitely. In the last ten rate hike cycles, the FED has always raised rates until the federal funds rate is above the PCE.  

A chart of the dependence of recession periods on the level of the interest rate. Source: The Board of Governors of the Federal Reserve System.

As you can see from the historical record, it has always been after a rate hike that the U.S. economy has fallen into recession. Furthermore, it is noticeable that since 1980 the interest rates can be raised less and less. 

Many economies are currently heavily indebted, so the financing costs for loans are also rising. However, some companies, private individuals, and states can then be driven into insolvency. The central banks then lower interest rates in response to the resulting recession.  

Effect of the accommodative policy of central banks 

When an economy shrinks and has a negative GDP, it is called deflation. In other words, it is negative inflation. In this case, central banks start lowering interest rates to stimulate the economy. This, in turn, causes companies to take loans for investments, creating jobs and growth. This, in turn, increases inflation. 

However, low-interest rates and a devaluation of the currency could also increase import prices, as the prices for goods and services now become more expensive. Thus, in turn, inflation then also rises due to higher import costs. 

How to use the central bank decisions for trading? 

The key interest rate is the most critical aspect of the development of the markets. This is because the indices depend significantly on their product and their anticipation. This is, therefore, one of the most critical indicators in trading, as it influences the stock and FX markets and many other areas of the economy. These include, for example, the commodity market, bonds, or real estate. 

In some cases, however, even individual statements by central bankers can provide initial indications of a change of course by the respective central bank. Therefore, market participants closely watch every word of the central banks, especially the U.S. Fed. 

Analysis: What traders should pay attention to both central banks by importance 

Due to the significant influence of major banks, traders should keep an eye on all news related to monetary policy. After all, these significantly impact stocks, bonds, and forex. The most critical factors in this regard include: 

• interest rate changes, 
• liquidity program adjustments, 
• FOMC meetings, 
• Jackson Hole,
• statements,
• dot plots, 
• FEDs Funds Futures.

The best way to keep track of all important dates of the Federal Reserve is to use the economic calendar. To be safe, you should also use a news ticker and Twitter to avoid missing any critical changes. 

In any case, central bank policy decisions significantly impact the markets. Therefore, greater volatility is to be expected. You should consider this when choosing your position size and Stop Loss. 

Dot plots 

In this context, dot plots are an essential tool. This is because the FED members use them to give their forecasts for interest rates in the coming years. It's a graph with an X and Y axis issued quarterly by the FED. 

Investors and economists closely watch the dot plots. The data eventually updates based on economic factors. However, the projections are likely outdated if significant events such as a financial crisis, inflation hikes, or war occur. Because they are published only every three months, short-term forecasts should be weighted more heavily than long-term ones.  

An example of dot plot, 2022. Source: The Board of Governors of the Federal Reserve System.

FED Funds Futures 

Another tool is the FED Funds Futures. With their help, you can even speculate on the expected FED interest rate changes. In addition, they are also a good indicator of market sentiment and expectations regarding interest rate changes. They are traded on the Chicago Mercantile Exchange (CME) and show the market expectations at the time when the contract ends. 

More precisely, they are monthly contracts valid for 60 consecutive months. Thus, in August 2022, you will receive one expiring in July 2027. To calculate, subtract the value of the FED Funds futures from 100. For example, at the current price of the FED Funds Futures of 96.95, the market expects an interest rate of 3.05%.  

What influence does the FED have on the currency? 

The key interest rate is the most important of all the factors that influence a currency. This is because as soon as a central bank injects money into the financial markets through an accommodative policy, the more excellent supply causes the currency to depreciate. In this regard, the increase in the money supply and its velocity of circulation cause inflation.  

For investors, a currency loses value due to low or non-existent interest rates. Therefore, they switch to more stable coins, which pay a return. Thus, falling interest rates tend to mean a falling currency. Conversely, rising interest rates are a bullish signal, as forex traders can earn an additional return from the interest rate differential. However, you need to consider a few more factors, which are explained below. 

Interpretations of central bank statements 

A central bank is sometimes an opaque institution. So there is sometimes room for interpretation of the statements. Therefore, understanding and interpreting the remarks are even more critical. This will give you a better understanding of why and how the markets move. 

Nevertheless, central bankers try to remain as transparent as possible. Otherwise, they would only risk their credibility. This, in turn, could lead to a recession since capital is as shy as a deer.  

In many situations, however, a central bank may consider it tactically wiser to appear clueless for various reasons. After all, this can sometimes have a calming effect on market participants. 

This explains why the Fed often misses the mark with its official forecasts. Because they usually wanted to realize it only after many other market participants. For example, they considered the increases in the inflation rate after the Corona pandemic to be only "transitory," although many reasons made this seem extremely unlikely. 

Therefore, a trader should always tune in to the central bankers. Thus, predicting their actions and reading between the lines is possible. In this context, you should also pay attention to the subtle nuances in the change of tone. So you can benefit in the best possible way from the adjustments of the expectation. Doing this gives you an edge, and you can trade it well with a tailwind and technical analysis. 

In this context, pay attention to which factors are most decisive for monetary policy and what central bankers pay the most attention to. After all, the most critical data can change temporarily due to the economic environment. Thus, you then know which dates from the economic calendar are currently of particular relevance. These can be, for example, the Non-Farm Payrolls or the Core PCE. 

Central bank vocabulary: about Hawks and Doves

The two terms Hawks and Doves are used to describe the attitudes of central bankers. Of course, these also change among members depending on market conditions. In this context, central bankers sometimes give very subtle hints, also known as forwarding guidance. They differ as shown below: 

The Hawks want to keep the inflation rate as low as possible. For this reason, they prefer higher inflation rates and a prudent monetary policy. In this context, they are less concerned about the state of the economy. So the next time you hear from a hawkish central banker, you now know that they want to raise the federal funds rate. 

The Doves, on the other hand, want to boost economic growth to support the labour market. Therefore, they prioritize low policy rates to achieve this. So dovish central bankers are concerned with keeping the economy through low-interest rates. 

Practice: trading strategies related to central banks 

Below you will find the most popular trading strategies related to central banks: 

Central Bank Newstrading Strategy 

The simplest strategy is scalping, while news trading is based on the decisions and statements of central banks. While in most cases, it is not yet the main movement, you can often still gain a few pips.  

However, if you do not react quickly enough, this can lead to higher costs due to increased slippage. Furthermore, you should be aware that not every broker allows you to trade during news and may temporarily suspend services. After a change in the interest rate policy, you can get higher security by waiting for a pullback. In addition, the slippage then also tends to be a bit lower.  

Should a central bank make a decisive change in direction, such a trend can last for several years. Thus, there are also further entry opportunities for you at the retracements. Good orientation for great entry opportunities are clusters of indicators. In this regard, you can use SMAs, EMAs, RSI, or Stochastic, whereby the higher time levels are preferred. 

However, it would help if you were careful because trading is not about physical equations but probabilities. Therefore, nothing is set in stone and does not have to come true. So it can also happen that the long-term trend does not coincide with the measures of the central banks. This is primarily due to the expectations of the markets and a possible loss of confidence in the statements of the central bankers. 

In this context, long-term trades are safer in case of decisive changes. Thereby, these are usually only run by short-term news against the trend. This, in turn, can temporarily lead to massive price distortions. However, the big trend should be right in the long term. 

Carry Trades 

Traders can execute so-called carry trades using the interest rate differences of two currencies. They borrow money in a country with low interest rates and invest it in a currency with higher interest rates.  

In doing so, they try to get the interest rates of high-yielding currencies over a low-yielding one overnight. In this case, the difference between the two interest rates is then calculated proportionally for the day. The risk of the carry trade is then that the purchased currency sinks. 

If you want to increase your chances in forex trading, you generally buy a currency with rising interest rates and sell one with decreasing ones. Accordingly, you invest your money in the currency with the highest real interest rates. In this context, you should not confuse real interest rates with nominal ones. Therefore, you have to subtract the inflation rate from it. 

What you should not forget: market expectations 

However, it would help if you were not so fixated on the respective news and its expected effect. Because the markets usually anticipate, and thus the events are already partly priced in. So, when the news is announced, there may be an opposite reaction. It is a typical example of "buy the rumor and sell the news." So market expectations are an essential factor as well. Usually, a currency follows the expected interest rate. 

Therefore, you should always compare the expectations in an economic calendar with the delivered data. The more significant the difference between expectation and reality, the stronger price movements you can expect. Because this fact has not been priced in yet. 

However, if the central bank's reactions are below expectations, the trend often contradicts the central bank's decisions. Therefore, you should also learn to trade the expectations to profit from the price developments as early as possible. 

 

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