Why FX markets react to central banks?

This week has been jam-packed with major central bank decisions that have triggered wild swings across FX markets.

Here’s a quick catch up:

• US Federal Reserve: hiked by 75 basis points
   
• Bank of Japan: left benchmark rate unchanged
   
• Swiss National Bank: hiked by 75 basis points
   
• Central Bank of Norway: hiked by 50 basis points
   
• Bank of England: hiked by 50 basis points

READ MORE: (Sept 19 article) Trade of the Week: GBPUSD to sink further?

 

For an example as to how much a central bank can influence FX markets, consider how the equally-weighted USD Index (which measures the dollar’s moves against six other G10 currencies) has punched its way to a fresh two-year high, trading at levels not seen since the onset of the pandemic.

Such a spike in the US dollar came after the US central bank, also the world’s most influential central bank, informed markets that it has to push US interest rates higher than expected in order to combat stubbornly-high inflation.

Generally, larger rate hikes = stronger currency.

But there's a lot more to that story.

So here’s a timely reminder of the basics surrounding how central banks impact FX markets.

 

First, let’s begin with …  

What is a central bank?

A central bank is an institution that manages a country’s currency and money supply.

It also helps the economy achieve certain goals, such as keeping unemployment stable and low while ensuring price stability (keeping inflation under control).

 

What’s the main problem for central banks right now?

Currently, the number one problem facing most central banks around the world: red-hot inflation!

That is to say, central banks are scrambling to stop prices that consumers are paying from rising too much too fast.

Of course, the central bank wants to protect the public and make sure consumers can continue spending money to help grow the economy.

Otherwise:

• When things get too expensive, consumers may not be able to afford as much goods and services, which may lead to lowered spending.
   
• When overall spending sees a big drop in an economy, that would negatively affect the income that businesses and producers can get.
   
• Less income for companies may translate into cost-cutting measures (e.g. job cuts) in order for the business to try and survive.
   
• More people losing their jobs (higher unemployment) then leads to less spending power within the economy, which may ultimately spiral down to a shrinking economy a.k.a. a recession.

 

In short, inflation that’s out-of-control is bad news for the economy.

 

How are central banks trying to control inflation?

The main way that most central banks try and subdue red-hot inflation is by raising interest rates.

For the sake of brevity, here's the oversimplified "formula" for how it works:

Higher interest rates = lower demand / lower money supply = slower inflation

 

However, there’s a dark side to interest rate hikes as well.

If a central bank raises its benchmark rate(s) too high, too fast, that may destroy demand levels (drastically lowered spending) in an economy to the point that there’s a recession!

Hence it’s a tricky balancing act that central banks face right now.

They have to raise interest rates high enough to subdue inflation, but attempt to not do it too much so as to incur too much pain for the economy (e.g. too many jobs lost).

 

So how does all this impact currency markets?

Here are three key ways:

1. Economic resilience

Markets reward the currency of the economy that can better withstand these higher interest rates.

For example, the US dollar has surged to its highest levels against the British Pound since 1985, even though both the US Federal Reserve and the Bank of England have been raising interest rates.

Because markets believe that the US economy is better withstanding this ongoing rate hikes, better than the UK economy that’s facing its worst cost-of-living crisis in a generation, there has been more demand for the US dollar relative to the British Pound.

Hence, no surprise that GBPUSD has now reached its lowest levels since 1985.

 

 

2. The difference in yields between two countries

When a central bank raises its interest rates, investors also tend to sell off its government bonds.

When the prices of these bonds fall, their yields rise.

NOTE: Yields are a measure of how much an investor can earn from a particular asset.

Hence, the country whose bonds offer a higher yield then attracts more investors, who then demand more of that country’s currency in order to purchase its assets.

In fewer words, generally speaking, higher yields = stronger currency.

This is especially evident in USDJPY which has soared to its highest levels since 1998 earlier, almost touching the 146.0 mark before pulling back today.

When you consider the following yields on offer:

• US 10-year Treasuries: 3.53%
   
• Japanese 10-year government bonds: 0.228%

... no surprise that investors have been flocking to the US dollar and less so the Japanese Yen, considering this massive gap between US and Japanese yields.

 

 

 

3. Currency intervention

A currency that weakens too drastically can also have negative consequences on the economy.

For one, a weaker currency makes imports more expensive, which means consumers in that country have to fork out more money to buy imported goods and services. As Economics 101 would teach us: when prices go up, demand/spending goes down.

Hence, a central bank may intervene to support its ailing currency, like the Bank of Japan announced today (Thursday, Sept 22nd).

That announcement strengthened the Yen against the US dollar, with USDJPY then briefly spiking below the psychologically-important mark.

 

 

With all that said, hopefully it is now clear what central bankers say and do often do have a massive impact on FX markets, as we’ve seen all of this week.

And there are more key decisions and announcements to be made in the months to come, seeing as this global battle against inflation is far from over.

So make sure you keep watching this space for the latest developments surrounding upcoming central bank decisions.

 

central banks rate hikes inflation