Central Banks Monetary Policy- How it Affects your Forex Trading

There are many different ways to trade on the Forex market from technical analysis, fundamental analysis, automated systems and signal providers but the reasons behind why the market moves remain the same. Although the currency market moves in what might appear to be an erratic pattern, when you look at the reasons the market has moved it becomes clear. The biggest underlying reason is the monetary policy of the central bank that the base currency is related to.

One of the most common questions I get asked with regard to fundamental analysis is; “So, if the currency is so strong why did it fall back X amount of pips?” The answer is simple; there is always going to be periods in currencies strength where major investors and retail investors are going to take profit. Very often this will be at previous levels of support and resistance or psychological numbers. This profit taking is also the reason why many inexperienced traders will experience reversals when they enter a trade on a new high or low for the day.

So now we have removed the myth that the currency market goes where the traders want it to; we are going to look at the bigger picture and the real reason why the markets are moving. When you trade Forex you trade one currency against another so in effect you are trading a push, pull situation. Very rarely do central banks release monetary policy information at exactly the same time, so it is easy to assume that the currency pair will move dependent on the information being released from a particular central bank.

It is the central banks’ job to control a countries economy through monetary policy; if the economy is moving slowly or going backwards there are steps the central bank can take to boost the economy. These steps, whether they are asset purchases or printing more money, all involve injecting more cash into the economy. The simple supply and demand economic projection occurs and a currency will devalue.

When the opposite occurs, and the economy is growing, the central bank will use various methods to keep that growth steady and in-line with other economic factors such as wages and prices. Whatever the central bank do or in fact don’t do will affect the currency of that country. Sometimes it is within the central banks’ interest to purposefully affect the value of a currency. For example, if the economy is heavily reliant on exports and their currency value becomes too high importers of those countries commodities will seek cheaper supply; hence directly affecting the economy.

It is important as a trader to keep an eye on the following economic alerts related to a countries economy so we can pre-empt what the central bank will do. This will give us a very good idea which direction the currency will go.

Interest Rates

If the economy is doing well the central bank will eventually hike interest rates. When this happens or when it is talked about by the central bank you will see the value of that currency rise. Investors will shift their assets to that currency to gain better returns.

Employment Situation

Decreases in employment will result in a slow economy and eventually the decrease of interest rates having the opposite effect of an interest rate hike.

Trade Balance

The smaller the trade deficit of a country the stronger the currency will be. However, a weaker currency will result if the deficit increases as currency will be sold off commercially.

Gross Domestic Product (GDP)

GDP is the prime indicator of a countries economy. If the GDP is good then this will be a sign of higher interest rates to come hence a higher currency value.

If you follow the central bank and the policies they are putting in place to keep the economy stable you will always know which direction that currency should be moving in. As previously mentioned you will always get corrections in these prices which will cause pull backs on the overall trend. This is not a change in policy and as long as nothing fundamentally has changed the price will return to what we call the fair price (the price it reached when recent information was released by the central bank). These pull backs are perfect trading opportunities. Using technical analysis you can pin point the entry prices for the perfect trade. Unfortunately this is information for another article.

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