Forex Trading: Leverage Central Banks for Profit

Forex Trading enthusiasts, as well as traders in general, don't solely rely on technical analysis. They also engage in another discipline that follows different rules and requires equally diverse skills: fundamental analysis. This term refers to the study of everything happening outside the market, with the aim of forecasting price trends. Conducting fundamental analysis means following the most important events (known as market movers), predicting their outcomes, and consequently, anticipating the impact they will have on the market. Some of the most significant market movers involve central banks. By analyzing them, it's possible to forecast prices, albeit with a considerable margin of error. Here's a guide on how to profit from central banks.

What Central Banks Do

Central banks are the top financial institutions of a country or a region sharing the same currency. The latter is the case with the ECB, the European Central Bank, which oversees the entire Eurozone. Central banks have various tasks, the most important of which is maintaining inflation around acceptable levels that can foster healthy economic growth. The "best" inflation, so to speak, is one that approaches 2%. If it's higher, there's a dangerous erosion of purchasing power and the proliferation of financial bubbles. If it's lower, the economic system stalls and enters a spiral that, among other things, leads to a decrease in consumption and job losses. Some central banks also intervene in macroeconomic issues and directly promote growth, as well as indirectly through the inflation lever. What tools do central banks use? Essentially, two. The first is manipulating the cost of money, i.e., the interest rates at which they provide money to national banks, commercial banks, etc. The lower the rate, the greater and faster the circulation of money will be, characteristics that positively influence economic growth. The higher the rate, the slower and lower the money circulation will be. If, for many reasons, not least the crisis, money circulates so little that even zeroing rates is not enough, then banks resort to Quantitative Easing, which is a real financing of public activities, albeit sometimes indirectly. This is done through the purchase of debt securities issued by national entities (banks, but also governments, etc.).

How to Profit from Central Banks

What does all this have to do with Forex? It's simple; all these actions influence the value of currencies. Moreover, there are other actions taken by central banks that can profoundly impact the market. For example, statements by prominent figures at press conferences or other occasions. Below are three situations in which central banks heavily influence the market. Interest Rate Announcement. Generally, central banks, or rather their respective boards, decide interest rates during meetings. These are held, on average, every month or month and a half. They culminate with the announcement of interest rates via a press release and a related press conference that takes place a few hours later. These events are indicated in the economic calendar well in advance. Why do interest rates affect prices or, more precisely, the value of currencies? It's simple: they directly modify the money supply, and this, like any other asset, influences its value. If the rate is lowered, the currency depreciates. If the rate is raised, the currency appreciates. Now, the trick is to predict the central bank's decisions. The trader must ask: will the central bank increase or decrease rates? Obviously, no one has a crystal ball, but the institutions themselves drop hints about their intentions. Statements by officials, macroeconomic forecasts, and press releases are all "clue" sources. It's also a good idea to rely on the forecasts of experts, analysts who publish their predictions in various capacities. Studying current economic events can also be helpful: if the economy worsens, especially if it does so for a long time, it's likely that the central bank will opt for a rate cut. Macroeconomic Forecasts and Data. As already mentioned, economic conditions influence central bank decisions. It's true that central banks should officially - some more than others - limit themselves to keeping prices under control, but it's equally obvious that, given the immense power they have, they take on - again, to varying degrees from institution to institution - the hopes of economic growth in their respective countries. Ultimately, if conditions are deteriorating, rates are likely to be cut; if conditions are improving, rates are likely to be reconfirmed or even raised. Now, the trader should ask: what are the economic parameters to keep an eye on? The first, and most important, is inflation, which is also the domain of central banks. Inflation growing beyond 2% will push central banks to raise rates. Inflation decreasing and below 2%, or approaching that level too slowly, will push central banks to lower rates. Another economic parameter to consider is, of course, the Gross Domestic Product, which is the sum of a country's wealth. Some banks, but not all (the Fed much more than the ECB), care about the labor market, so the unemployment rate must be considered. These data can be analyzed regardless of central banks. In fact, they are issued by national institutes. In reality, central banks also take the stage from this point of view. When? Simple, during the press conferences after the rate announcement! It's a tradition that during press conferences, central banks provide a fairly in-depth outlook not only on prices but also on economic conditions. If the outlook is favorable, then the impact on the currency is positive (appreciation). If the outlook is unfavorable, the impact is negative (depreciation). Forward Guidance. This aspect is the most difficult to analyze and use for trading purposes. This term refers to the set of "non-technical" statements, or at least not anchored to the publication of official data or outlooks, that a prominent central bank figure, usually the president, makes in order to generate a climate of confidence that, alone, positively impacts markets. To understand the meaning of Forward Guidance, it's good to give an example. In 2011, speculators were ready to prey on Europe, causing debt imbalances and creating strong political and economic instability. The feeling, in fact, was that the euro would dissolve under the blows of the crisis. It was Mario Draghi, precisely with a very strong Forward Guidance, who convinced everyone, investors and non-investors alike, that the euro would survive. It would survive because the European Central Bank would do everything to keep it alive. Mario Draghi's "Whatever it takes" has entered, not by chance, the collective imagination. Now, Forward Guidance statements have an extreme impact on markets. The reason is simple: they come when the market - whether due to crisis or instability - is very susceptible; they express a very solid intention; they project far into the future. The trader's job is to ride the wave, act close to the statements if he's good, avoid trading during the statements like the plague if he doesn't feel capable of "riding the tiger".