Central banks are the primary participants in forex markets. They contribute to the overall stability of the financial system by maintaining inflation in the interest of sustainable economic growth. The banks intervene in financial markets in line with the defined monetary policy framework to regulate money supply.
A large part of the monetary policy implementation is monitored by forex traders as they seek to take advantage of currency movements resulting from it.
What are Central Banks?
Central banks are independent institutions that assist a country in the management of their commercial banking industry. These institutions are responsible for setting central bank interest rates and promoting financial stability in the economy.
They intervene in the financial markets through open market operations (OMO) and the central bank rate. The former describes the process by which government securities (bonds) are bought and sold in the open market. The latter refers to the interest rate central bank charges to the domestic banks of the country for borrowing money.
The central bank rate is set to increase or decrease economic activity. Though this may seem slightly counter-intuitive, an overheating economy leads to increasing demand and inflation which is what central banks aim to keep at a moderate level.
Central Banks and Forex Markets
Fractional Reserve Banking requires commercial banks to borrow funds from the central banks. Commercial banks accept deposits to ensure that sufficient cash is available to service daily withdrawals and lend the rest of depositors’ money to investors that need cash. Banks charge a higher interest rate on loans and pay lower rates to depositors to generate revenue.
The specific percentage of all depositors’ funds that are required to be set aside by the banks is defined by the central bank. If the banks fall short of this percentage, they can borrow from the central bank at an overnight rate, based on the annual interest rate of the central bank.
As central bank rates have a significant impact on the forex market, FX traders monitor these rates closely. Traders tend to follow yields and direct their investment towards countries with higher interest rates. You can learn more about how forex traders direct their investment on this site.
Forex traders look for subtle cues or ‘forward guidance’ by the chairman of the central bank to speculate the trend of interest rates. They interpret the language used by the chairman to determine whether there will be an increase or decrease in rates. This language is referred to as Hawkish/Dovish and has the potential to move the entire forex market.
Traders place a long trade in favor of the currency for which they believe the central bank is about to embark on an interest hiking cycle. If traders perceive the chairman’s language to be dovish, they look to short the currency or sell it in advance of acquiring it.
Changes in the central bank interest rates present forex traders with opportunities to trade on the basis of internet rate differential between two currencies via a carry trade. This is a strategy by which a target currency (high-yielding currency) funds the trade with a funding currency (low-yielding currency). Traders engage in such trades to capture the difference between the rates which can often be considerable depending on the leverage amount.
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