Forex Fundamentals 3: Central Bank
Most countries have either a central
bank or a small group of banks that control their respective
currencies. Along with the government, the central bank generally
plays a large role in monitoring the economic health of the country.
Interest rates are one of the primary
ways that central banks control a country's level of inflation.
Also called the Fund Rate, the interest
rate set by the central bank is the rate at which the central bank
lends to all other banks in the country, which has a ripple effect on
all other interest rates affecting consumers.
As an investor, a rate increase means
you can get a higher return, whereas a rate reduction means a lower
return. Likewise, as a trader, it is important to know that generally
a rate increase will cause a currency to appreciate in value, whereas
a rate decrease will cause the currency to depreciate in value.
However, other factors play a role in currency value, which is why a
currency with a lower central bank fund rate may actually be
appreciating against a currency with a higher rate.
In the US, the Federal Reserve aims to
keep inflation at 2%.
If the inflation is too high then the Federal
Reserve will raise interest rates (generally good for investors) in
order to increase the cost of borrowing to consumers, which slows
down consumer spending and thereby slows down inflation. As noted,
for an investor, an interest rate increase in a country is generally
ideal, assuming overall economic health, because investors can get a
higher return on their money if they invest there.
Similarly, if inflation is too low,
then the Federal Reserve may lower interest rates in order to
stimulate consumer borrowing (now cheaper to borrow) and thereby stimulate economic activity
to increase growth and inflation.
The US Dollar should appreciate in
value if the Federal Reserve raises interest rates, because more
investors will want US Dollars for the higher return. Conversely, if
the Federal Reserves lowers interest rates, then the US Dollar will
generally depreciate – but again currency value depends on many
Forex Fundamentals 4: Retail Sales
Retail Sales numbers measure the sales
of all consumer goods sold in the economy, which helps indicate the
health of the economy. This number is important because consumer
spending makes up typically about 68% of the primary measure for
productivity: GDP (Gross Domestic Product).
Productivity is arguably the most
important variable in economic growth, with increased productivity
correlating to increased growth. So monthly Retail Sales numbers
indirectly provide insight into the overall productivity, growth, and
health of the economy.
Forex Fundamentals 5: Trade Balances
If you imagine that a country is a
business, then the trade balance would be similar to the business'
balance sheet of revenue and expenses. When the business (country)
sells goods and services to consumers (other countries) it receives
revenue. Likewise, when a business (country) purchases goods and
services from consumers (other countries) it incurs expenses.
The difference between the sales
(exports) and the purchases (imports) is the business' profit. This
is essentially what the trade balance is for countries.
Obviously, a positive trade balance is
better for a country just like a positive profit is better than a
negative loss for a business. However, it is not uncommon for the largest and strongest economies to have a negative trade balance as is the
case for the US economy. Recently, the US has had a monthly trade
deficit in the negative $40 billion range.
US imports of automobiles and other
consumer products is a major source of the monthly trade deficit in
the United States.
In such a case, where a country has a
large negative trade balance, investors may perceive a shrinking
trade balance (such as a reduction to -$35 billion) as a positive
sign for economic health.
Generally, a positive trade balance (or
less negative) indicates increased economic growth and production.
Forex Fundamentals 6: House Price
The House Price Index (HPI) is used to
estimate the health of the housing market, which is another method
used to estimate the health of the economy as a whole. This measure
is generally expressed as a percentage change in the sales of new
In the US, normally a positive
percentage between 0.5% and 1% is a good sign of economic growth.
However, this particular index is extremely susceptible to
Even if the HPI is negative, it could be viewed as a
positive sign if the HPI is better than expectations (such as -0.3%
when the expectation was -0.6%).
Forex Fundamentals 7: Central Bank
Regularly scheduled throughout the
year, the agencies that control monetary policy in each country have
meetings to make decisions about topics like the fund rate. These
meetings and the resulting announcements typically can have a huge
effect on the market, even if no changes are made.
The reason why is because investors and
traders are trying to "read between the lines" and
determine what the central bank may decide in the future.
speakers are described as being dovish or hawkish.
Dovish means that interest rates may be
lowered, or remain at their current low level, in order to allow for
greater inflation and economic growth. Conversely, hawkish means that
interest rates may be raised, or remain at their current high level,
in order to limit excess inflation (which also slows economic
Dovish is generally great for economic
growth, but it is bad for investors (due to low interest rate) which
means it is often a negative for the currency's value. Hawkish can be a
negative for economic growth, but since excessive inflation is
reduced coupled with the high interest rates, investors often prefer
However, both the terms dovish and hawkish are
You may read one article where a
speaker is described as being hawkish while another article describes
the same speaker as being dovish. It is important to consider the
author's reasoning for saying a speaker or central bank is being
hawkish or dovish.