Central banks’ effect on the FX market – what every trader should know

Regardless of where you live, the monetary system in your country is greatly affected by the central bank, and the actions taken by it will probably have a meaningful impact on the economy - and especially on the FX market. If you are a trader, you should probably be aware of these dynamics, especially today in 2022 when state intervention in monetary systems has become so common, mainly due to the pandemic.

It is now convenient to trade FX, considering brokerages like INFINOX offer attractive trading costs, fast trade execution, and plenty of currency pairs to get involved in. Understanding how the central banks influence rates is, thus, an important part of the process, particularly when it comes to fundamental analysis.

Central banks influencing the FX market

Controlling the supply of money

At a basic level, central banks are in charge of controlling how much money there is (or isn’t) out there. They do this by raising or lowering interest rates. Simply put, when rates are low, the price of cash is low, incentivizing banks, companies, and the wider public to take on new loans. The monetary supply increases, which diminishes the purchasing power of money, so the currency weakens against other peers.

Supply of money and impact on currency pairs

In the opposite scenario, raising rates no longer incentivizes borrowing, and as older loans mature, in the absence of new ones, the monetary supply shrinks. This could possibly happen this year, as the BoE and the Federal Reserve are expected to continue lifting interest rates.

Direct interventions

You should also know that some central banks, especially those of emerging markets, intervene in the currency market in order to prevent the exchange rates from weakening or appreciating too much. A currency that is too strong can harm exporters while favoring importers, and in the case of a currency that is too weak, the exact opposite applies.

Analysts at the leading trading brand INFINOX emphasize that traders need to monitor news and central bank announcements, because such interventions generally produce strong price action movements. These are not the kind of situations in which one would like to be caught wrong-footed.

Forward guidance

No central bank wants volatility in the currency space, which is why they provide markets with forward guidance, meaning they communicate with the public about expected policies. In doing so, you have more predictability with regards to how things can change in the future. Both short-term interest rates changes and asset purchases (which are generally conducted to suppress long-term rates) influence the risk sentiment, so you should be aware that currencies can fluctuate when such changes occur.

Tightening monetary policy is a difficult process, mainly because it has a deflationary effect. You can see that these days central banks are shifting their stance, but at a mild pace, since they aim not to create solvency risks, or weaken the already-fragile economic recovery.

Is the FX market too big to control?

You might also ask why central banks can control a market that accounts for over $6 trillion in daily trading volumes. In some situations, their actions might have limited influence, but it’s how banks and financial institutions react to what central banks do that basically drives the markets in one direction or another.

Trading on central bank monetary policy decisions can be tricky, especially if you are a beginner and still need to develop trading skills. That is why sometimes it’s best to wait and see how the market digests the news, and only then look for trade opportunities.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes