All Eyes on Central Banks

While Central Banks have always featured heavily in the minds of forex traders, their actions have taken on a whole new significance of late. Financial reporters have also been generous in doling out space to stories about Central Banks, writing stories with headlines like “Central bankers add to equities’ momentum” and “Currency Traders Hold Fire, Await Central Banks.”

Traditionally, forex traders eyed Central Banks for one reason: interest rates. The theory was simple: currencies with higher interest rates tended to outperform in the short term. This trend was especially reliable in the years leading up to the housing bubble, as carry traders ensured that high-yielding currencies rose while low-yielding currencies stagnated or fell.

Even in the context of the credit crisis, traders have continued to monitor the rate setting activities of Central Banks. Interest rates in every industrialized country are currently locked at record low levels, but anticipation is already starting to build that the beginning of a tightening cycle is just around the corner. Current expectations are for the US to lead the way (first to lower, first to rise), followed by Australia, New Zealand, and Canada. The Bank of England and European Central Bank are further away on the curve, while rate hikes are a remote possibility in Japan, a perennial favorite of carry traders.

Interest rates are now only a small part of the equation, however. Most Central Banks have implemented additional strategies, known variously as quantitative easing, asset purchases, liquidity programs, etc. The goal of all of these programs is to stimulate the money supply and stabilize financial markets, by injecting newly-minted money directly into capital markets. Traders initially focused on which Central Banks were involved in quantitative easing. After nearly every bank introduced some version, it quickly became a question of scope. In this respect, the Fed and the Bank of England are in first and second place, respectively. Now, traders are waiting to see not only when these programs will end, but also when they will be unwound. If there is a perception (and even worse, a reality) that some Central Banks are waiting too long to draw funds out of the market, this could foster (concerns of) inflation, and consequently, currency depreciation.

Finally, there is the issue of direct currency intervention. The Swiss National Bank became the first western bank to intervene on behalf of its currency. Its actions are directly responsible for holding the Swiss Franc down. The Bank of England meanwhile has used its quantitative easing program to influence the Pound, while the Banks of Korea and Brazil are buying Dollars on the spot market to depress their respective currencies. Paranoia is clearly running high, and some traders are apparently concerned that the Fed could be next. Just when you thought the surprises were over.