Do I need to monitor central banks when trading?
According to the European Central Bank, a central bank is “a public institution that manages the currency of a country or a group of countries and controls the money supply – literally, the amount of money in circulation.”
A central bank influences and implements the country’s monetary policy, it has privileged control over the production and distribution of money and it regulates commercial banks. Such is their power that central bank governors rarely make statements because, when they do, the impact on markets is immediate. In July 2012, during the euro financial crisis, the President of the European Central Bank, Mario Draghi, said that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. His words reverberated across markets and stabilised them.
So, central banks are important because they guide the market. Say, the economy is going well and inflation is rising. A central bank may then decide to increase interest rates in order to make loans more expensive, slow growth and keep prices under control. This would strengthen the country’s currency, affecting forex trading and the value of your portfolio.
What do I actually need to look out for?
Four central banks have the strongest influence on world economy: the Federal Reserve (U.S.), the Bank of England (U.K.), the European Central Bank or ECB (Eurozone) and the Bank Of Japan. Each one’s approach is determined by their government’s stance, the national context and the governor’s preference. Some are described as hawks, and they tend to keep interest rates high and inflation low, whereas others are called doves and they’re more likely to allow high inflation if it accelerates growth.
Central banks issue regular reports, which are very important. The most important indicators are:
- GDP (Gross Domestic Product) – Is it rising or falling? This is the one figure that describes the state of the economy at a glance.
- Employment – Are jobs being created or lost?
- Retail Sales – Are people willing to spend?
- Consumer Price Index – Inflation or deflation? Hawkish central banks usually adjust interest rates to keep inflation around 2%.
In anticipation of these reports, markets develop a certain momentum , i.e. they move strongly in a specific direction. Once they’re released, you need to ask yourself: are the indicators what the market expected? If so, then prices will have adapted in advance. If not, you may see them moving erratically. It’s then up to you to decide which trades to focus on, and whether to hold your position or not .
The underlying factor that we haven’t discussed in all these is politics. In times of turmoil or unexpected election results, trading becomes a speculator’s playground as people attempt to predict what will happen next. In times of stability, politics is a fully predictable backdrop to your trading journey. It’s worth bearing in mind that, ultimately, it’s a country’s leadership that determines whether a central bank behaves like a hawk or dove.
Bitesize basics
- Central Banks control a country’s monetary policy and money supply. Influenced by the government’s approach, a central bank may be described as a hawk or a dove with the former more likely to take steps to limit inflation.
- Central Banks issue regular reports. The main indicators to look out for are GDP, Employment, Retail Sales and Consumer Price Index.
- Central Bank governors have a huge influence on markets and can stabilise them with a single word.
- In anticipation of a statement or report, markets will adapt. But if indicators aren’t as expected, markets may start acting erratically or adjusting violently.
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