Central Bank Policies That Affect the Forex Market

Every country has its own Central Bank that functions as Banker's Bank as well as monetary authority. Because of that, Central Bank policy can have huge impact on the country's currency.

Every country has its own central bank that functions as Banker's Bank as well as a monetary authority. Central banks usually have mandates to print money, withdraw money, and do other policies in order to maintain monetary and economic stability in the country. Because of that, central bank policies can have a huge impact on the country's currency.

In its role, central banks may make use of several instruments. Two of the most conventional are interest rates and open market operations. But apart from the two instruments, there are also currency intervention and verbal intervention.

Interest Rates

One of the central bank's main roles lies in its authority to determine interest rates which then will be used to consider bonds yield, asset return, and interbank rates. Changes in asset returns will then influence investor's interest to hold a certain currency. Because of that, interest rates increases and decreases may hold a huge influence on the forex market.

Interest rates hike is a part of tight monetary policy that is usually taken when the inflation rate is considered high. The aim is at least to reach the inflation target by stemming price increases and halting capital outflow from the country.

Meanwhile, interest rate cut is a part of loose monetary policy that is usually taken when inflation rate is considered low (disinflation or deflation). It aims to boost prices and attain the inflation target; although it could also be used as a manipulation tool so the country's exchange rate could somehow weaken and lift the country's competitiveness.

Examples:

• At the beginning of 2014, The Fed started to get rid of its loose monetary policy by gradually reducing the amount of its Quantitative Easing stimulus. Fed efforts to normalize its monetary policy have been expected to go in the direction of monetary tightening that may lead to major capital outflow out of emerging markets. Consequently, the Turkish central bank, Türkiye Cumhuriyet Merkez Bankasi (TCMB), hiked rates drastically from 4.5% to 10% around the same time.
  
  
• The Fed had maintained interest rates at a record low of 0.25% since December 2008 (the peak of the Subprime Mortgage crisis) in an effort to contain market fall through looser purse strings. Since then, the US economy has gradually improved up to the the point where inflation rate started to step up. Therefore, the Fed is expected to hike rates this year.

Interest Rates = Demand For Dollar

How do interest rates influence forex?

Interest rates add value to every country's currency. Higher interest rates in relation to a currency means it offers relatively higher return compared to any other currency. On the other hand, investors always hope for high returns for any of their investments, including forex. This way, interest rates determine the demands of any currency.

The higher interest rates in a country, the demand for their currency will rise too because investors will want to have them. Higher interest rates will invite foreign capital and cause the exchange rate to rise.

The opposite may happen with lower interest rates. When a country's central bank lowers their interest rates, their exchange rates will undergo depreciation. In this respect, interest rates influence the exchange rates of one currency against the other, especially major currencies.

As an illustration, let's use EUR/JPY. Say the BoJ (Bank of Japan) interest rate is 0.1% and ECB (European Central Bank) is around 0.5%. If BoJ increased its interest rates to 0.5%, then their interest rates will be the same as ECB. However, these changes will entice investors to move their assets to Yen, because they want to get some profit from the changes. Such movement will cause the rise of demand on Yen so that its exchange rates against Euro will rise too.

On the contrary, if BoJ lowers their interest rates to 0.05%, investors will sell their Yens and move their investment into other kinds of assets like bonds, property, or another currency with higher interest, Yen's exchange rates will decrease.

On another note, differences in interest rates between two currencies may cause carry trade.

Carry trade is a method of forex trading where a trader buys a currency with higher interest rates and at the same time sells a currency with lower interest rates in order to gain profit from that difference. The higher interest rates of a certain country, the potential of it being carry traded will be higher too.

Interest Rates on Major Currencies

Exchange rates movements illustrated above will happen only when there are changes in interest rates or if there are rumors that changes are being considered.

Central banks will consider such policy at times when their country suffers high inflation, large trade deficit, etc. That's why rumors in regard to changes that will be made (usually mentioned by central bank governors) could seriously affect a certain country's exchange rates.

One example came from AUD.

In 2013, the Reserve Bank of Australia (RBA) cut their interest rates twice. Even further, until December of that year, the governor repeatedly mentioned the possibility of a third cut. As a result, AUD became one of the worst major in 2013, having entered a bearish trend that went on until 2014.

Generally, central banks in Japan, European Union, and other advanced nations are committed to preserving low interest rates. This is because interest rates are used as standard interest for deposits and loans.

If the central bank raises interest rates, then loan interest will rise too. As a result, people will find it hard to pay back loans or make new loans, even though they may need it to sustain their business. In order to maintain continuous economic growth, low interest rates are considered better than high ones.

The aforementioned circumstances turn interest rates decision by major central banks to be a major event in the forex market. Minutes and even hours before the announcement are usually marked by sideways price movements where forex traders waiting patiently for the news.

Then, just a few minutes after the news, the price will move fast up or down. This made for a risky trade.

Some traders avoid trading in such times, while others may prefer to trade exactly during those times.

Open Market Operations

Open market operations may refer to the central bank policy to print money to buy securities with the aim of channeling liquidity to the economy (stimulus). It is a part of loose monetary policy. Central banks can also take the opposite direction in tightening their purses by selling securities to reduce money supply.

While running loose monetary policy, the money printed by the central bank effectively increases the amount of its balance sheets, so it is also sometimes called an expanding central bank balance sheet.

Bonds buying are commonly done according to some attached conditions, hence not all kinds of bonds in the market will be bought by the central bank in open market operation.

Several variations of open market operation that are widely talked about are the ones that were or are done by the Fed, Bank of Japan, and European Central Bank.

• The Fed's Quantitative Easing (QE)
  In Quantitative Easing, the Fed printed money to buy sovereign bonds in the market. This way, The Fed aimed to inject liquidity into banks so they could hand it out to the economy as loans or such and with it boosts economic growth.
  
  
• Bank of Japan (BoJ) Stimulus
  Although Fed QE is more well-known, actually QE pioneer is Bank of Japan who launched the program in 2010-2011. In the program, BoJ schemes to buy trillion yen of bonds each year to boost inflation and growth. So far, though, it has been largely considered unsuccessful.
  
  
• ECB Long-Term Refinancing Operations (LTRO)
  As the central bank for the Eurozone, ECB lends funds to Eurozone banks with super low rates so the banks could produce profits by using it in the financial market or channel it to the real economy through lending. The LTRO is a short-term loan that usually has to be returned in 3, 6, or 12 months. Because the LTRO is less successful than expected, the ECB later launched Targeted Long Term Refinancing Operations (TLTRO) in 2014. Contrary to LTRO, TLTRO specifically aimed to boost lending to the real economy and matured later (All TLTROs will mature in September 2018).

Currency Intervention

Currency exchange rates vital role in supporting a country's competitiveness, trade balance deficit, and stabilizing macro economy made it important for the Central Bank to monitor it closely. That is also why central banks all over the world often intervene to purposefully strengthen or weaken their currency exchange rates.

An illustration of how central bank currency intervention tries to stem currency volatility when currency XXX depreciated against the USD

When a currency rises to a level that is considered too expensive, central banks will weaken it so the country's external sector competitiveness does not suffer and bring about unwanted consequences.

On the other hand, if a currency falls to an extremely weak level, central banks will lend a hand so the fall could be contained to an acceptable level. Interventions are usually done by selling or buying foreign currencies.

A leading central bank that probably does the most interventions in the forex market is the Swiss National Bank (SNB):

In 2011, the CHF shot up against the Euro and worries the SNB, so it decided to put the CHF in a peg against the Euro at 0.7 CHF per Euro. In order to maintain the peg, SNB regularly prints CHF to buy Euro in the market. That way, SNB cheapen the CHF and created demand for the Euro. Not long ago, the peg was removed and SNB now is considering several alternatives to maintain cheap CHF through other methods.

Verbal Intervention

Verbal intervention, sometimes also called moral suasion, could take various shapes and aim for different goals. It could be an appeal for the public not to do things that may depreciate the currency, or the opposite, jawboning (statements aimed to trip currency appreciation), or others.

Verbal intervention is possible because the financial market is always watching over central banks' statements and reacts based on them.

For example, in July 2014, after The Fed's Janet Yellen said that biotech and social media stocks are overvalued, the stock market drops almost in an instant with Twitter, Facebook, and LinkedIn leading the pack by falling up to 1%.

Similar reactions also frequently occur following other central banks' press conferences.

In 2014, the governor of Reserve Bank of Australia (RBA) repeatedly state that AUD is overvalued, and every time he said it, the AUD dropped (only to rise again later, and for him to repeat the same trick). As such, central banks' speeches are closely watched and marked with three bulls in the fundamental calendar.