Forex for Beginners: Central Banks

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If the market makers can be considered as the `micro’ manipulators working at the pip level and above, the central banks are at the other end of the scale, at the macro level. They are the `big picture’ market manipulators, and as such operate in a number of ways.

The mandate for most central banks around the world is very simple. It is to create a stable economic environment which encourages growth, creates prosperity for the people of the country, and where inflation is kept low. All of this is generally achieved with one simple mechanism – interest rates. As well as being responsible for monetary policy, central banks are, of course, responsible for the currency of the country in every respect.

Whilst most central banks are considered to be independent of their government, it would be naive to think that they are not fully aware of the views, ideas, and policies of each administration as they come and go, and also of the effect that monetary policy may have within the framework of government policy. Most governors and presidents of the central bank are ‘called to account’ by their lords and masters, the government, generally on a regular basis through monthly meetings and public hearings.

The game changer in terms of the role of central banks, and certainly for those currencies mentioned in the previous chapter, was the financial crisis which enveloped the world in 2007/2008. Up to this point, one of the primary forces to drive the foreign exchange markets was interest rates, for one simple reason. Return on investment. If assets in one currency are offering a better return on investments than assets in another currency, then investors and speculators would seek out the higher-yielding currency, either in terms of the currency itself, or to invest in assets denominated in that currency such as bonds and equities.

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It was the interest rate differential that was the number one focus, and when interest rate changes were announced by the central bank, the markets paid attention and moved as a result. And this is what I was referring to in my introduction when I described this ‘loss of predictability’. Interest rate differentials, which were once considered the ‘arbiter’ of exchange rates, no longer apply. The rulebook has been thrown out of the window, and the ‘old rules’ no longer apply.

Since the financial crisis, interest rates around the world have fallen sharply, as central banks desperately tried to stimulate their economies. These have fallen to such an extent that interest rate differentials are now almost completely eroded. The US at 0.25% is now on a par with Japan at 0.1%, with the UK at 0.5% and Europe at 0.75%. Canada is at 1%, New Zealand at 2.5% and Australia at 3%. Switzer-land languishes at 0%. As a result, investors and speculators around the world have been searching out currencies with higher yielding interest rates in the Far East, Latin America, and India.

No doubt in the future, interest rate differentials will return and become the primary force they once were, but not for many years, as the financial crisis has also led to a global economic collapse, plunging most economies deep into recession. The problem for the central banks, and particularly for those with strong export markets, has been to ensure that these markets were protected, by keeping interest rates low for as long as possible, which they have all continued to do, either covertly or overtly. Whilst rising interest rates generally signal growth and a strong economy, they also attract inflows of money, hunting out the higher yields I mentioned above. It is a double-edged sword for many central banks around the world, and one they have to manage carefully, which many of them do, by direct intervention. The Bank of Japan and Swiss National Bank are classic examples, but other central banks also intervene directly when the home currency becomes too strong, and begins to threaten its competitiveness in world markets.

The simple message that has become very clear over the last few years is this. Each central bank in every country is now only interested in one thing – preservation of its economy and protection of its markets. Until the current crises end, interest rates will continue to remain relatively insignificant – but they will return to their dominant position in due course.

Next, and as the counterbalance to the above, many central banks embarked on various programs of ‘quantitative easing’ or QE for short.

All this means in simple terms is printing money, or adding money to the system if you like, and they do this by buying bonds. However, you don’t need to understand how they do this just that they do! What is happening here is that a central bank is simply increasing the amount of money in circulation, which should, in theory, weaken the currency, since there is more of it in circulation! But has this happened so far? The short answer is yes, and no. The US dollar did indeed weaken when the first program was introduced but has since recovered. The Japanese have been trying this approach for years, with little success, and only recently have they made some progress following a change in government. The Swiss have tried and each time the exercise was a failure.

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All of this is played out in the currency markets which increasingly have become a battleground for these leviathans of the major economies. The term currency wars are appropriate and have become the norm and the backdrop for forex trading. At this point, you may be wondering why I am explaining all this in a book entitled Torex for Beginners’ and the answer is this. I believe it is important that you have an understanding of the big picture. Many traders come to this market with little or no knowledge of the forces that drive it. I believe that to succeed, you need, at the very least, to have some idea of the many and varied forces which play out in the world of foreign exchange.

To combat the market makers we have an answer, and it’s called VPA. The central banks, on the other hand, are a law unto themselves and are becoming an increasingly dominant force in their own right. A decade or so ago, it was their monetary policy and interest rate decisions that were the focus. Now for us as forex traders, it is the extent to which a central bank is likely to intervene, coupled with programs to maintain low-interest rates and a weak currency to boot. In other words, decisions designed to keep their political lords and masters happy.

Finally, of course, central banks not only `manage’ free-floating currencies such as those outlined in the last chapter, either overtly or covertly, but also in those currencies which are pegged, often to the US dollar.

These types of arrangements range from fixed pegs, where the currency is managed in a range, or informal ‘dirty float’ regimes and others, where the currency is allowed to float free and with no public statement on when or where intervention is likely to occur. Each central bank takes its own very different approach.

Some are straightforward, and what you see is what you get. Examples here would be Australia, Canada, and New Zealand whilst others are highly political, such as the ECB in Europe. The Bank of Japan and Swiss National Bank are openly interventionist and protectionist. Away from the major currency pairs, some central banks are happy to see strength in their currency, such as the Bank of Mexico which is seen as non-interventionist, whilst Brazil’s central bank is perceived as the complete opposite.

Therefore, in summary.

First, be aware that the framework of the forex market is very different for the reasons I have outlined above. The old forces which once drove the markets have changed dramatically in the last few years. Normal service will be resumed, but not for some years – at least 5 or more in my opinion, with economies unlikely to recover much before 2015. At that point, we may start to see interest rates becoming the focus once again, but until then, the above conditions will prevail for the foreseeable future.

Which leads me neatly into the final group of forces which drive the markets, and these are back to the micro level, and here it’s the economies and economic data.