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Central Banking and Forex Trading

Forex trading is strongly related to central banking. What central banks do with the interest rate is vital for a currency.

Lately, at the Federal Reserve of the United States initiative, the forward guiding principle was introduced. It stands for central banks giving market participants clues about the future monetary policy.

The idea was to avoid uncontrolled spikes in volatility and to let markets be guided via a better communication. To some extent, it functions.

When the Fed increased the rates this March 2017, the Forex market barely react. So well communicated the move was, that the U.S. dollar, the world’s reserve currency, depreciated.

It is difficult to look at the logic behind such a move. While the interest rates in the United States were hiked, the dollar dropped.

Currency pairs are formed by coupling two currencies. This leads to the natural comparison of the two economies the currencies represent.

This comparison starts from common economic indicators, continues with the monetary policies in the two countries/regions and ends with the interest rate between the currencies. The bigger the interest rate differential, the bigger the gap between the two currencies should be.

In other words, the Fed’s hike should have led to a higher dollar for the simple reason that the interest rate differential increased. That is, if you look at the EURUSD pair, for example.

The interest rate corridor in the Eurozone is well into the negative territory, while the US is hiking rates. Nevertheless, the EURUSD jumped on the move. What would be a logical explanation for such a thing?

Future Expectations

Since the forward guidance principle was introduced in the United States, other major central banks followed suit. To this day, the ECB (European Central Bank), BOE (Bank of England), BOC (Bank of Canada) and other important central banks from different jurisdictions are using it as a tool to better communicate their intentions.

But this didn’t change trading a bit. Forex traders, and not only, simply moved the focus and the reasons to buy or sell a currency pair.

Nowadays, Forex trading is about future expectations. What will happen with a currency or with a monetary policy in the years to come?

The answer to such a question may be relevant in a few years distance, but the reaction on the market is going to be seen now. Just like that, we have another prove that market is changing and traders, in the end, will have to change too. Super-computers are driving now prices. Trading algorithms are instructed to buy and sell a currency/currency pair based on economic news releases, monetary policy changes, and so on.

As traders, humans must adapt. The only way to survive in a market so competitive like the Forex market is is to focus on the bigger picture.

This is valid for both technical and fundamental reasons. Any trading decision should be based on both.

Let’s start with the technical picture of a currency pair. Different trading styles lead to different expectations too. Scalpers are traders that focus on short/very short targets. Targets like three or five pips are regular for these traders. To them, the bigger picture matters the least, not to mention the fundamental picture.

Traders that fit into this category are the ones most likely to automate their trading. From this point of view, the bigger picture in technical analysis doesn’t matter for the simple reason that the

Swing traders and investors are the ones that are interested in what a central bank says. They look at both the technical picture on the bigger time frames (like golden and death crosses on the monthly and weekly charts, possible reversal patterns like double or triple tops and bottoms, or candlestick patterns that suggest major tops or bottoms are in place) and have a bigger time horizon for their trades.

From this point of view, the initial market reaction to an event like the Federal Reserve raising rates in March 2017 is discounted. These traders are not in for the short-term profit, but for changes in the monetary policy that are confirmed on the bigger time frames.

Monetary policy is experiencing some troubling times. Different parts of the world have seen unprecedented steps being taken in the last years.

Capitalism as we know it has never been tested as it is today, at least from a monetary policy point of view. Fiat money and the fiat money role has been challenged to extremes.

In Switzerland, the interest rate on the Swiss Franc (CHF) is -0.75% for years. To put this in perspective, deponents in a Swiss Franc denominated deposit at a commercial central bank in Switzerland are paying the bank for the privilege of depositing their savings.

This is as crazy as crazy can be, and it goes on for some years now. Don’t expect it to end anytime soon, though, as normalization is not on the horizon.

The only major economy in the world that is looking for overheating scenarios is the United States economy. And this is the biggest economy of them all.

Globalization is telling us that if the biggest economy in the world is rising, or overheating, it will drag up the other economies as well. Hence, if the Fed starts normalizing its monetary policy, eventually, other parts of the world will start doing that too.

Places like Switzerland will have to let go to such extreme conditions like the one mentioned above. But the process will lag.

The thing is that the Fed already started to normalize: it ended the Quantitative Easing (QE) process and started to raise rates. So, a tightening process is already taking place.

The QE programs in the United States let the Fed with a $4.5 trillion balance sheet. More and more voices are stating the Fed’s intention to reverse this process.

If that’s the case, the Forex market will be the first one to react. Not only that volatility will increase, but uncertainty too.

For traders that listen to central bank’s forward guidance messages, this should not come as a surprise. The reason is that they are already positioned for the move, as they trade based on future expectations.