A central bank is an institution that is responsible for setting the monetary and interest rate policies for the country in which they reside. This means that it’s the job of the central bank to make sure that the economy is stable and growing while the prosperity of its nation's citizens continues to strengthen. This is no small task either because most major nations are rather large and have a lot of moving parts within their economy.
Introduction to Central Banks
All developed nations have their own central bank that is tasked with controlling the country’s monetary policies. The monetary policy actions of the central bank will directly influence the price movements of the country’s currency. This is because they have full control over the available money supply and set the interest rates. This makes them a big deal to the Forex market.
Control over interest rates, money supply, monetary policy, and much more is why central banks are so important to watch for all Forex traders. Everything that they do will have a certain degree of impact on the price of their currency, and therefore, will have an impact on the trading decisions that Forex traders will take.
There will be many times when the central banks will dictate how a trader will navigate Forex the market. In fact, when central banks need to make decisive policy actions these are the times when it’s actually less risky and there are more pips to be made. Even though it can be more volatile in these times it can make for very safe trades if a trader has an excellent understanding of the fundamental situation with central banks and the Forex market.
One of the things that a Forex trader needs to do is monitor what the central banks are doing and saying. The process for monitoring central banks is quite simple. But before a trader gets too bogged down worrying about all the policies and intricacies of the central banks, all they really need to understand is what the central banks are thinking or what is currently concerning them the most right now in real-time. Traders typically do not need to concern themselves with things that the central banks themselves are not concerned with. This makes the interpretation of a central bank a bit simpler.
It’s important for when a trader is analyzing a central bank to appreciate that there are only one or two things that they need to concern themselves with at any given time. The things that Forex traders need to be concerned with are the exact same things that the central banks are saying they are concerned with. Whatever they are concerned with is going to drive their decisions on how they are looking to enact their monetary policies to keep the economy stable and growing. As a consequence of this analysis, traders get insight into where interest rates may be headed in the near future.
Why Traders need to know what Central Banks are thinking
The reason traders need to know what a Central Bank is thinking is that if traders know how the central banks are thinking, what they are happy and unhappy with, then they can use that information to try and predict how the market will react to that information in the very near future. This is because big institutional players are searching for these same clues because they too are trying to get in on developing price trends as early as possible. It’s human nature to want to predict where the price of something is heading so that we can make the most money with the least risk in the shortest amount of time possible. This is the thought process of the big players and is the same process that retail traders want to be in tune with.
Since the actions that the central banks take will move the price of currencies, this can offer us some excellent trading opportunities to trade around.
Questions to be constantly be asking about Central Banks
• What are the central banks thinking? • What is their next possible move on interest rates and why? • How is their nation’s economy performing? • What is the central bank concerned with? • What economic data has the central bank stated they are watching closely? (These will be the economic data sets that traders want to monitor closely as well).
Central Banks and Interest Rates
Before we dive into central banks it makes sense to prep you on interest rates first. The Forex market is all about interest rates. It obsesses over what interest rates are for a particular nation and, more importantly, where they think interest rates are heading over the medium and long term outlook. Remember that the expectations are one of the most important things the Forex market will attempt to price in and nowhere is this truer than when it comes to interest rates.
The Forex market will aggressively try and price in its expectations of future interest rate policy virtually every day. This is because there are so many asset management firms that are heavily dependent on the interest paid for holding particular currencies in their portfolios. These large asset management firms rely heavily on guaranteed interest payments from central banks and government bonds. Many of the largest asset management firms in the world are heavily invested in multiple countries and therefore need to watch the particular currencies of the countries they are invested in quite closely.
As we will explore in depth later on, if interest rates are rising in a particular nation then this is generally considered to be a positive thing for the native currency.
If interest rates are falling within a particular nation then this is typically a bad thing for the native currency.
Let’s keep it that simple as that for now and dig deeper later after studying some other relevant items first.
So why are we telling you this about interest rates right now? Well, it’s the central bank of each nation that controls the interest rate for their respective nation. So if the Forex market is obsessed with interest rates and the path they are headed on, then it makes logical sense that we would want to get to know the central bank of the nation’s currency that we are interested in trading.
Because the central banks control interest rates this forces the Forex market participants to become laser focussed on what each individual central bank is talking about and doing in the market. The market also pays very close attention to the individual central bank members as well. We will get into why that is important in an upcoming lesson.
We will also go over all the various ways that we can figure out what central banks are thinking about and what they are doing as we progress throughout this training. Don’t worry, everything will all fit in place by the time you get to the end of the training.