The Role of Central Banks in Forex Trading

A country’s economy changes based on various factors, such as the latest natural disaster, international event, or national headline—its current state defined by the value of its currency in the global economy.

This allows traders from that country to make favorable (or unfavorable) deals, depending on the exchange rates that are determined by the apex financial institution in any country, the central bank.

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What Is a Central Bank?

The foreign exchange (forex market) is the world’s largest financial market, its total value of daily trades dwarfing even stock markets. The 2019 Triennial Central Bank Survey of FX and OTC derivatives markets estimated that $6.6 trillion of value was traded in forex daily that year. The central bank’s role is to fix its own currency’s price in the forex market for a nation (or group of nations), through the following pathways:

Setting Interest Rates

The central bank always decides interest rate policies. Lower interest rates generally encourage investors to borrow money, while higher interest rates encourage (and sometimes even enforce) savings.

The central bank tracks economic indicators constantly, making changes to interest rates that immediately affect the market. Traders should constantly track major announcements from the central bank and look for indicators of whether the interest rates will rise or fall.

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Open Market Operations

Central banks can also rely on Open Market Operations (OMO) to influence the supply of a currency. In the U.S., the Federal Reserve is the nation’s central bank. It purchases U.S. Treasury securities in the open market when it wishes to increase the money supply and sells them to reduce it.

A central bank can protect the currency from economic shocks using OMOs. The central bank’s activity in OMOs also affects the interest rates.

Foreign Exchange Interventions

Foreign exchange interventions are another set of tools that central banks have to influence the forex market. This involves the central bank stepping in and stabilizing the exchange rate of its native currency with others.

When a currency’s value crashes in the forex market, the central bank can provide liquidity to stabilize it. The central bank also tracks the exchange rate of a nation's currency against its trading partners and uses foreign exchange interventions to keep it at an acceptable level.

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Quantitative Easing

Another tool central banks use to influence the forex market is quantitative easing (QE). On the surface, it looks like another OMO, but while OMOs can involve both buying and selling securities, QE only involves buying government and corporate bonds to increase liquidity in the market.

Why Central Banks are Important for the Forex Market

Though the value of the forex market is greater than even the stock market, individual investors are responsible for a very small percentage of the total trades. Commercial banks, hedge funds, and multinational corporations are likelier to trade and speculate in the forex market.

Central banks are also key players in this ecosystem. Their actions influence the investing behavior of other actors in the forex market, and those trading in it must follow them closely.

Forex investors have to follow the announcements and actions of the central bank to judge whether its outlook is “hawkish” or “dovish.” A central bank taking a hawkish approach will raise interest rates to bring spending down when it reaches levels that will lead to a bubble.

Meanwhile, most of the time, central banks would like to encourage spending and stimulate the economy. So a dovish central bank slashes interest rates to increase borrowing, injecting money into the economy and increasing liquidity levels.

To better understand forex trading, you should study and analyze the behavior of your country’s central bank.