Intermediate
Fundamental analysis
4.5 minute read
Central banks
Whether you’re trading stocks, forex, commodities, indices or something else entirely, it’s likely that the prices of your chosen markets will be affected by the actions of central banks.
What are central banks?
Central banks are institutions that are responsible for managing the monetary system for a nation (or a group of nations). They have a range of responsibilities, including overseeing monetary policy, keeping inflation in check, ensuring high employment levels and maintaining currency stability.
In addition, central banks will:
- Issue currency to control money supply
- Function as the bank of the government
- Regulate the credit system
- Oversee commercial banks
- Manage exchange reserves
- Act as a lender of last resort
However, to traders, the most important action from central banks is changing interest rates as part of their monetary policy.
Major central banks
Almost every economy has its own central bank, but traders pay most attention to the ones attached to the most-traded currencies:
- US Federal Reserve Bank (USD)
- European Central Bank (EUR)
- Bank of England (GBP)
- Bank of Japan (JPY)
- Swiss National Bank (CHF)
- Bank of Canada (CAD)
- Reserve Bank of Australia (AUD)
- Reserve Bank of New Zealand (NZD)
Central banks and interest rates
Central banks must maintain a tricky balancing act. If the economy grows too quickly, then rapid inflation will make prices too high for consumers. On the other hand, if it grows too slowly, then unemployment will soon follow.
The main mechanism they have to keep this balance in check is the base interest rate.
How do interest rates work?
Interest rates work by either encouraging saving or spending – with a trickle-down effect for the rest of the economy.
Businesses borrowing money to grow their bottom line, and individuals buying houses, are vital to a growing economy. Lowering interest rates encourages both, resulting in growth.
But when growth gets out of hand, it can lead to excessive inflation. It can even cause reckless spending that risks an economic crash. By raising interest rates, central banks can slow things down.
Example
Say, for example, that the UK economy is struggling. Banks are concerned about the situation and reluctant to loan out capital. They are scared they might not get it back.
High interest rates
In this environment, high interest rates will encourage banks to hold on to their money. Why? Because they can earn a good return by keeping it with the central bank, where they know it is safe. So they will in turn charge higher interest on loans – as they present a relatively higher risk.
This makes it more difficult and expensive to borrow money. Small businesses may keep their purse strings tight, and prospective homebuyers may be priced out of mortgages. Spending remains low overall and the economy continues to struggle.
Low interest rates
However, if the Bank of England (BOE) reduces interest rates, holding on to capital looks a lot less compelling. Banks can no longer make much return from keeping money with the BOE – but can borrow it at a low cost.
That means they can offer low interest rates on loans to businesses and individuals. These loans are now worth the risk, because there isn't a safer option readily available.
With more access to cash – and lower rates on their savings accounts – those businesses and individuals are encouraged to spend and invest. The higher spending kickstarts the economy into growth.
How interest rates affect the markets
All of this doesn't just affect businesses and homebuyers, though. It also has a significant impact on traders.
Let's take a closer look at how rates affect forex and stocks.
Forex | Shares and indices |
|---|---|
Like any financial asset, currency prices are set by supply and demand. Investors will flock to economies with comparatively high interest rates, because they can get a higher return. But to invest in foreign economies, you need to buy currency. This will increase demand for a currency with high interest rates, causing its price to rise. Some investors take advantage of this relationship using a carry trade. In this strategy, you buy a currency with a high interest rate while selling one with a low rate. If you can earn enough interest to cover any fluctuations in the exchange rate between the currencies, then you can make a profit. | The relationship between the stock market and interest rates is less direct, but they still interact heavily. High interest rates decrease consumer spending and make it more expensive to borrow capital. Both of these outcomes tend to be bad for businesses – which means that interest rate rises often hurt stocks and indices. Low interest rates, on the other hand, can boost stock markets by creating an environment in which businesses can thrive. They can access cheap loans that enable them to expand their operations. In a low-rate environment, savers will also get a poor rate by holding capital with a bank. So they may be forced to invest in the stock market instead – further increasing demand for shares. |
However, traders and investors won’t just wait until a rate announcement before taking a position. Instead, they scour multiple sources for any clues to what a central bank might do next.
Central banks pay a lot of attention to various economic indicators when deciding their next course of action. So traders will also pore over these releases and attempt to second guess what is about to happen.
They’ll also pay attention to the key staff at a central bank, to ascertain whether important decision makers are hawks or doves:
- Hawks are proponents of higher interest rates to fight inflation
- Doves want lower interest rates to promote economic growth
You may also hear central banks overall described as hawkish or dovish, depending on their policy at any given time.
Because the markets pay such close attention to central banks, an anticipated interest rate move will usually be priced in long before it actually arrives. Major moves, then, often arise when a central bank confounds the markets’ expectations.
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