Foreign Exchange Cyclicity & The Role of Central Banks

 

Recognizing the macroeconomic cycle and decoding the intentions of central banks are the two key elements of the long-term success of any Forex investor.

 

Identifying Two (2) Major Types of Forex Currency Cycles

 

It is important for any Forex investor to take advantage of the cyclical nature of the Foreign Exchange market. There are two main types of cycles in the Foreign Exchange market:

 

(i) Long-Term Macro Cycles

In the long run, Forex currencies tend to coordinate with the general macroeconomic environment and follow the interest rate cycle. The monetary goals of Central Banks play a massive role in the macro-cycles of exchange rates.

 

(ii) Speculative Cycles & Contrarian Trading

In the short-term, Forex currencies tend to follow speculative cycles. These cycles are coordinated by large institutional players that carefully open speculative positions in the derivatives market. These positions create trends, and trends create price breakouts. When price breakouts occur, the market sentiment changes and retail traders join the party by opening late positions. As retail traders enter the market, institutional players close their positions and the trend immediately reverses. This is why being contrarian to the general market sentiment really matters when trading Forex in small timeframes.

 

 

Central Banks and Foreign Exchange Reserves

 

Central Banks, and their policies, play a massive role in the Forex market. Central Banks have the tools and incentives to control their domestic exchange rate. In theory, central banks can create as much supply of their domestic currency as they wish.  Never trade against these five (5) central banks:

• US Federal Reserve (FED)
• European Central Bank (ECB)
• Bank of Japan (BoJ)
• Bank of England (BoE)
• Swiss National Bank (SNB)

 

Foreign-exchange reserves refer to money held in one or more reserve currencies, mostly the US dollar, the Euro, the Japanese Yen, the Swiss Franc, or the British Pound Sterling. Gold reserves are also incorporated in the aggregate foreign exchange reserves.

• The US Dollar accounts for 64% of all known central bank foreign exchange reserves
• The Euro accounts for 20% of all known central bank foreign exchange reserves

 

Key Monetary Policies of Key Central Banks

 

The general goals of the central bank include maximum employment, stable growth, stable inflation, moderate interest rates, and stability in the financial system.

 

• US Federal Reserve

The FED implements a balanced monetary policy giving a lot of weight to inflation and unemployment. The FOMC argues that annual inflation of 2% percent is most convenient over the long-term. If inflation grows in the US higher above 2%, the USD will rise in anticipation of an imminent rate hike. As concerns unemployment, FOMC estimates a median value of 4.1% over the long-term. If the unemployment rate grows above 4% the USD will go down on anticipation of upcoming lower interest rates.

 

• European Central Bank (ECB)

The Eurozone suffers from high unemployment and a low inflation rate. In such a macroeconomic environment, ECB is forced to implement a flexible monetary policy by keeping the Euro interest rate significantly lower than the USD interest rate. The ECB aims to maintain inflation rates close to 2% over the medium term. Note that the course of the German economy is very influential towards any monetary decision taken by the ECB. 

 

• Bank of England (BoE)

The inflation goal is 2% over the medium term and an annual CPI rate within 1% of the target. The growth of the UK economy is not very high but the unemployment rate is falling and stays within the long-term targets of BoE (below 4%).

 

• Bank of Japan (BoJ)

The Japanese economy has suffered historically from weak growth and low inflation. Since 2013, the Bank of Japan has applied various monetary policies and used controversial tools in order to boost growth and achieve the target of 2% inflation. Note that the Japanese economy focuses always on exports and BoJ will not tolerate an expensive Yen for long periods.

 

• Swiss National Bank (SNB)

The Swiss Franc is traditionally a safe haven for Forex investors, especially during times of financial turmoil. The economy of Switzerland is characterized by stability, low inflation, and negative interest rates. As the Swiss economy is focusing on exports, the SNB implements a very loose monetary policy to prevent the Swiss Franc from appreciating against the other Forex major currencies.

Key Fundamental Indicators to Monitor

 

There are quite a few economic indicators that can have a serious impact on the exchange rates, for example:

 

(1) Interest Rate Differential

Higher interest rates attract more foreign capital and create speculative money inflows. Currently, we are in an era of low interest rates, so rate differentials are considerably tighter than in previous decades.

 

(2) Economic Growth & Inflation

Strong GDP growth and high inflation is the perfect mix for currency appreciation. On the other hand, weak growth and low inflation work in favor of tighter interest rates and lead to currency depreciation.

 

(3) Unemployment Figures

Unemployment figures have proven very crucial towards changes in the monetary policies of central banks. That is especially true as concerns the decision-making of the US Federal Bank.

 

(4) The Role of Legislation

If there is new legislation that makes an economy more open to foreign investment and external trade, it is good news for the domestic currency. On the contrary, a less free economy or legislation against capital mobility makes the domestic currency look less attractive to foreign capital.

 

 

Conclusion on Forex Fundamentals and Market Cyclicity

 

Understanding the macroeconomic cycle and the real intentions of central banks is the key to success when investing in the Foreign Exchange. Fundamental analysis requires constant review. When monetary policies shift then key exchange rate trends shift as well.

In shorter timeframes, speculative market cycles can occur. These speculative trends do not last long, and prices tend to reverse to their mean. For these short-periods, what matters most, is to be contrarian, and that means create positions opposite to the general market sentiment. Speculative trends create false price breakouts, and the trading of false breakouts is one of the most successful short-term Forex trading strategies.

Overall, the best advice is to follow the macroeconomic cycle in the long term and be contrarian in the short term.

 

■ Forex Market Cyclicity & Central Banks

Forex-investors.com (c) -Content Copyright Protection