Forex Trading Fundamentals

Whereas fiscal policy (taxing and spending) is the purview of governments and policymakers, monetary policy is the domain of central banks such as the US Federal Reserve, the European Central Bank (ECB), Bank of Japan (BOJ) and Bank of England (BoE). The idea is that central banks use interest rates together with the purchase or sale of bonds to influence market liquidity. The value of a free-floating currency is based on supply and demand. So if a central bank buys its own currency and holds it in reserve, this reduces the supply and should therefore boost the value of that currency. The central bank can devalue its currency relative to others by selling its reserves back to the market. This increases the supply of the currency and should lead to a decrease in valuation.

Depending on their mandates, central bankers work to ensure that the monetary conditions are right for the economy for which they have responsibility to prosper. This generally means ensuring price stability (controlling inflation) while promoting a sustainable level of growth. It can also mean (as in the case of the US Federal Reserve) working to ensure “maximum employment.”

Central banks regularly hold meetings to discuss and make changes to monetary policy. Typically this is achieved by raising or lowering key interest rates. However, we have also seen a number of major central banks engage in quantitative easing (QE), or money printing as it is often referred to. This is where the central bank creates money and introduces it into the market via financial institutions such as commercial banks. The central banks do this by purchasing bonds and other securities held by qualifying financial institutions as collateral for their normal business. The theory is that the financial institutions will lend out these extra funds in the wider market so adding liquidity and boosting economic activity.

As we’ve seen, central banks can tighten monetary policy by raising rates and reducing or even reversing their bond purchases. Typically this will see the relevant currency rise in value – all other factors being unchanged. Central banks loosen monetary policy by reducing interest rates or adding to their bond purchases. In effect, this adds to liquidity and therefore cheapens the relevant currency.

As a consequence, central bank meetings are extremely important events in the FX trader’s calendar. However, it is worth noting that central bankers often try to manage expectations ahead of key meetings. They do this through speeches and communications with the media. Quite often, it is a comment from a significant central banker ahead of a key meeting that can lead to the most dramatic market reaction. This is because it can signal a sudden change in outlook which catches investors unawares. Consequently, it’s vitally important to identify key members of every major developed world central bank and know in advance when they are due to deliver a speech or give an interview.