A Glimpse At Forex High-Volatility Events: Bank Rate Decisions
It should come as no surprise that central banks play a pivotal role in the value and general movement of currency values. Central banks are present in most major economies around the world; whether it is the United States Federal Reserve, European Central Bank, or the Central Bank of Russia. Monetary policies from governments and these central banks alike drive currency prices up and down depending on their interpretation of the general economic outlook.
A central bank may guide policy in either a single nation, or several. For example, the Federal Reserve presides over the United States while the European Central Bank represents a number of countries in the European Union. The policy decisions of these entities may come at different times throughout the month depending on other economic circumstances. Bank rate decisions typically take place around the same time every month.
Exercising "Control" Over Currency
The interest rate that the central bank exercises control over is the rate at which banks are able to loan money to one another in that region. Everything else in the financial sector trickles off of this point of information in some way because the rates at which banks are loaning to one another directly affects their own rates and fees. That, in turn, will be passed along to whichever bank or consumer is receiving loans.
Central banks employ different tactics to guide the value of an associated currency. There are some actions that have fairly predictable repercussions, but it should be noted that there is nothing to stop investors from going the opposite direction for no reason at all. Reaction can never be assumed in dealing with the forex market because humans can be unpredictable creatures; and humans are ultimately what drive currency values. Though many trades are executed via bots and Expert Advisors, they are also programmed by people with a certain perspective and bias on the way the market moves.
An unexpected rate change can fuel drastic movements as traders scramble to cover their positions and capitalize. Any decision that is different than the projection has the potential to cause drastic waves in the market, even if it is as small as a quarter of a percent. That is why a forex trader should always consider these events as high risk, ensure their positions are protected, or close out open trades.
A lowering of a currency's interest rate is often executed to facilitate spending and encourage greater circulation. Carry traders and investors typically want to hold positions that pit a low interest rate currency versus a high interest rate currency so as to maximize the difference in rates. That difference creates greater profits for the investor. Furthermore, it encourages banks in the affected economy to take on new debt and provide loans. That quarter of a percent can result in massive savings for regular financial institutions. The lower rate creates more breathing room between the lender and consumer for loans.
A tightening of policy and higher rate is indicative of officials that want to curb growth and spending. The question becomes- aren't those things always good? Like many things, moderation is key. An extreme pace can lead to greater problems in unexpected inflation with too much money chasing too few goods. That gives sellers the power to inflate their prices, which in turn devalues the currency at local levels. That devaluation will have greater effects on the overall scope of the currency as it loses buying power. Thus, it is essential for central banks to keep a short leash on growth to ensure it doesn't happen too quickly.
What About Simple Carry Trading?
Carry traders will invest in a high interest rate currency with a low interest rate currency to profit off of the difference in rates. While this may seem like a fool-proof way to profitability, the carry trader must still be worried about the general fluctuations of both currencies over the long-term. A carry trade is going to need to be held to build any appreciable profit. Unfortunately, that gives either currency more time to shift and bump out the profit generating interest rate.
A carry trade is very vulnerable around the time a rate decision is due to be announced. In the event that there is a surprise decision, the severe movement can wipe out profit and throw the trade into negatives within minutes of the trade. Surprise decisions can kick off new trends, which may run counter to the carry trader's position. The trader should exercise great caution when these decisions are on the horizon.
Predicting Bank Rate Decisions
A number of circumstances can be looked at to try and predict an upcoming bank rate decision. Some of the more common indicators include:
- Housing Data
- Subprime Data
- Employment Rates
- Consumer Spending
Housing is often seen as an important economic indicator as it shows that people are confident enough in their jobs and finances to make a long-term investment. Buying a house is typically the biggest investment the average person will make in their life. That makes Housing and Subprime data strong consideration points.
Employment data can be viewed in different ways. High rates and a tight leash will often see unemployment rates rise as loan opportunities dry up and businesses spend less. Lower rates encourage spending across the board, including for picking up new employees or launching new business ventures. Should that environment reach a level plane, it can be a strong indicator that the economy is slowing down.
Many people view inflation as just a bad thing. The reality is far more complex. Little to no inflation can mean the economy has stopped growing in a meaningful way. Therefore, the central bank may feel the need to cut rates to encourage lending and spending. A moderate amount of inflation is a good thing, assuming that rates keep pace with wages.
Lastly, consumer spending is a fairly straightforward indicator of how the public perceives the strength of the economy. Consumers slow frivolous spending if they are not confident in the economy and their fiscal security.
Central Banks And Rate Decisions
There are many catalysts for the movement of currency values on the forex markets. Central bank rate decisions should be considered a major one. It is worthwhile to keep an eye on Federal Reserve announcements even if the trader does not have positions involving the USD. Rate changes for United States banks can impact other economies since the United States is such a larger consumer of foreign goods. One can never be sure how far the ripples of the impact of a rate change will reach.
This post was written by Daniel Lindsay, a private forex trader and blogger based in London Follow him on Google + and check out his other blog posts on MahiFX.
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