Central banks

Whether you are trading stocks, currency pairs, commodities, indexes, or other instruments, it is highly likely that the actions of central banks will influence prices in the selected markets.

What are central banks?

Central banks are organizations that manage the monetary system of a country or group of countries. They have various responsibilities, including overseeing monetary policy, keeping inflation under control, supporting a high level of employment, and ensuring the stability of the national currency.

In addition to this, central banks:

• Issue currency and control the money supply

• Act as the government’s bank

• Regulate the credit system

• Oversee commercial banks

• Manage foreign exchange reserves

• Fulfill the role of the lender of last resort

For traders, however, the most important tool of central banks is changing interest rates, which is part of their monetary policy.

Major central banks

Almost every economy has its own central bank, but traders tend to focus on those connected to the most traded currencies:

Major global central banks on the map

• Federal Reserve Bank of the USA (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 delicate balance. If the economy grows too quickly, it can lead to rapid inflation, causing prices to become too high for consumers. On the other hand, if the economy grows too slowly, it can lead to unemployment.

The main tool that central banks need to monitor and keep under control is the key interest rate.

How do interest rates work?

Interest rates influence decisions about saving or spending, and their changes have a broader impact on the entire economy.

Businesses that borrow money for expansion and individuals purchasing homes are key to economic growth. Lowering interest rates supports these activities, which leads to economic growth.

However, if the economy grows too quickly, it can cause high inflation. This can lead to reckless spending, threatening the stability of the economy. By raising interest rates, central banks can slow down growth and keep inflation under control.

Example

Let’s imagine that the economy of the United Kingdom is facing challenges. Banks are cautious and reluctant to lend money because they fear they may not get it back.

• High interest rates

In this case, high interest rates encourage banks to keep their money in the central bank, where it is considered safe. They charge higher interest rates on loans because lending money is riskier. This makes borrowing money more difficult and expensive. Small businesses may become cautious and decide not to invest, and potential homebuyers may have trouble securing mortgages. As a result, spending remains low, further weakening the economy.

• Low interest rates

If the Bank of England (BOE) lowers interest rates, holding money in the central bank becomes less attractive. Banks don’t earn much from holding money there, but they can borrow it at low rates. This means they can offer low-interest loans to businesses and individuals. These loans become more appealing since other options are less favorable.

In this way, businesses and individuals can gain easier access to cash, motivating them to make more investments and spend more. These increased expenditures subsequently stimulate economic growth.

How interest rates affect the markets

Interest rates not only affect businesses and homebuyers but also have a significant impact on traders. Let’s take a closer look at how interest rates influence forex and stock markets.

Forex

Like any other financial asset, currency prices are influenced by supply and demand.

Investors typically focus on economies with high interest rates because they offer higher returns. If you want to invest in a foreign economy, you must buy its currency. This leads to increased demand for the currency with high interest rates, which in turn causes its value to rise.

Some investors take advantage of this relationship through a strategy called carry trade. In this strategy, they buy currencies with high interest rates and sell those with low interest rates. If they can earn enough interest to cover exchange rate fluctuations, they can make a profit.

Stocks and indexes

The relationship between interest rates and the stock markets is not as direct but still strongly affects market trends.

High interest rates reduce consumer spending and make borrowing capital more expensive, which negatively impacts businesses. Therefore, an increase in interest rates can often hurt stocks and indexes.

Conversely, low interest rates can support stock markets by creating an environment where businesses can grow. They have access to cheap loans, which allow them to expand their operations.

In an environment with low interest rates, savers receive low returns on their savings, which may motivate them to invest in stocks. This increases demand for stocks and supports market growth.

Traders and investors, however, do not just wait for interest rate announcements. Instead, they scan various economic indicators to anticipate the next move of the central bank.

Central banks and decision-making

Central banks take various economic indicators into account when making decisions about their next steps. Traders, therefore, analyze this data and try to predict what will happen next.
Traders also monitor key central bank officials to determine whether they are in favor of high or low interest rates. These individuals may be described as hawks or doves:

• Hawks are proponents of higher interest rates to fight inflation.

• Doves prefer lower interest rates to support economic growth.

Central banks can be referred to as hawkish or dovish depending on their current policy.

Since markets pay close attention to central banks, expectations regarding interest rate moves are often priced in before they actually happen. Significant market movements typically occur when the central bank changes its decision or causes confusion about market expectations.