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How does monetary policy affect forex trading -by Ecork

– Reviewed by James Stanley, November 24, 2021

You may have heard a financial news anchor say something along the lines of, “The central bank governor came up a bit extremist Today after bouts of strong economic data.” The terms “Hockish” and “Dovech” indicate whether central banks are likely to tighten (hawks) or accommodate (doves). monetary policy.

Central bank policy makers decide whether they want to increase or decreasese interest ratesWhich has a huge impact on the forex market. policy makers Raise interest rates to prevent the economy from overheating (to prevent inflation from getting too high) and go down Interest rates to stimulate the economy (to prevent deflation and stimulate GDP growth).

Hard-line and pessimistic policies affect currency rates through a mechanism that central bankers prefer to call “forward guidance”. Policy makers try to be as transparent as possible in their communications to the market about where monetary policy may be headed.

Keep reading to learn more about hard and prudent policies and how to apply this knowledge to your own forex trades.

What does hawk mean?

the term extremist It is used to describe contractionary monetary policy. It can be said that central banks as well hawks if they Talk about tightening monetary policy by increasing interest rates or reducing the balance sheet of the central bank. The monetary policy stance is said to be tough if it anticipates interest rate increases in the future. It can also be said that central bankers are hawkish when they are positive about the outlook for economic growth and anticipate an increase in inflation.

Currencies tend to move more when central bankers change their tune from dove to hawk or vice versa. For example, if a central bank has been pessimistic recently, noting that the economy still needs stimulus, and then, in a later speech, they mentioned that they have seen rising inflation pressures and strong economic growth, you can see that the currency is rising against other currencies.

Some of the words that can be used to describe tight monetary policy include:

  • strong economic growth
  • Inflation increase
  • reduce the balance sheet
  • monetary tightening
  • raise interest rates

In general, the words used that refer to higher inflation, higher interest rates, and strong economic growth tend to result in a tighter monetary policy.

What do doves mean?

doves indicates the opposite. When central bankers talk about cutting interest rates or increasing quantitative easing to stimulate the economy, they are said to be pessimistic. If central bankers are pessimistic about economic growth and they expect inflation to fall or turn into deflation and they indicate this to the market through their future forecast or guidance, then they are said to be pessimistic about the economy.

Some of the words that can be used to describe dovish monetary policy include:

  • weak economic growth
  • Low/deflation inflation (negative inflation)
  • Increase the balance sheet
  • easing monetary policy
  • Interest rate cuts

Hawkish vs Dovish explained

The chart below provides a quick overview of the main differences between tight and prudent monetary policy:

The table below provides a more in-depth comparison of tight monetary policy versus tight monetary policy, highlighting the differences between the two and how they affect currencies.

hawkish monetary policies

Peaceful Monetary Policies

Raising interest rates to reduce inflation pressures

→ Currency can rise as capital inflows into higher interest rate currency

Lowering interest rates to stimulate the economy

→ A currency can depreciate with capital inflows into a lower interest rate currency

Reducing the Federal Reserve’s balance sheet by selling mortgage-backed securities (MBS) and Treasuries

→ Currency could rise with Treasuries sale and MBS may raise interest rates

Increase the Federal Reserve’s balance sheet through quantitative easing (QE). Quantitative easing is the purchase of MBS and Treasuries that increase the money supply in the economy to stimulate it.

→ The value of a currency can fall because an increase in the money supply leads to a decrease in the demand for currency

Future guidance from central banks includes positive data about the economy, economic growth and inflation expectations.

← Currency could rise as investors expect further interest rate hikes

Future guidance from central banks includes negative data on the economy, economic growth and signs of deflation.

→ Currency could depreciate as investors expect interest rate cuts

How to Trade a Hawkish or Dovish Central Bank

A slight shift in central bank tone could have dire consequences for the currency. Traders watch often Federal Open Market Committee meetings Minutes to look for minor changes in language that may indicate further price increases or reductions and try to take advantage of that.

Monetary policy tends to be pessimistic to hawks

Monetary policy in effect until January 1, 2019

The above image shows the current monetary policy position of central banks. When monetary policy of central banks The position moves more to the left (peaceful) their currency can fall against other currencies. If the monetary policy stance moves more to the right (hard) their currency may rise.

Trading a hawkish central bank is not as easy as buying a hawkish central bank currency or selling a pessimistic central bank currency. It is about changing interest rate expectations. Let’s look at two scenarios:

Scenario 1:

If the central bank is currently in a rate-raising cycle, the market will already have expected higher interest rates in the future. The merchant’s job is to watch for clues and economic data It can shift the central bank’s tone to either of them tighter From the present time, or to doves; Coins can move by a significant amount when monetary tones change from what they currently are.

Scenario 2:

Similarly, if the central bank is currently cutting interest rates and economic data she haswas negativeThe Market He would price in the current pessimistic monetary position. Traders will have to keep an eye on central banks ahead and economic data, which you can find at Economic calendarfor clues as to whether they would become more pessimistic From the present time, or extremist.

In late 2018, the Fed was very hawkish. “We are very far from being neutral at this point,” Federal Reserve Chairman Jerome Powell stated, which the market deemed hawkish (October 2, 2018). This means that the Fed still has to raise interest rates several times to reach the neutral rate. then at 28y In November, the Federal Open Market Committee released a monetary policy statement in which Jerome Powell said he saw interest rates as “slightly below neutral.” This shift in tone is similar to Scenario 1 above, where central banks shift their tone from hawkish to slightly pessimistic. Devaluation – see the graphs below that show what happened to Dollar Index (DXY) On October 2, 2018, and then on November 28, 2018.

October 2, 2018 – Federal Reserve Chairman Jerome Powell said “we’re a long way from being neutral at this point” triggering an appreciation dollar.

US dollar index 15-minute chart, the vertical line points to October 2, 2018.

On October 2, the Federal Reserve Chairman stated that rates are far from neutral

Nov 28, 2018 The Federal Reserve Chairman said interest rates are “a little below neutral,” indicating a shift in tone from hawkish to pessimistic. The depreciation of the dollar.

US dollar index 15 minute chart

Federal Reserve Chairman Jerome Powell said rates are just below neutral

It can be hard to keep up with central banks. At DailyFX we have a profile Central Bank Weekly Webinar Where we analyze the decisions of the Central Bank and keep you informed of the activities of the Central Bank.

If you are just starting out on your trading journey, it is imperative that you understand the basics of forex trading on our site New to the world of forex Instructs. We also offer a range of Trading guides To complement the development of your strategy and your knowledge of forex.

Chief Analyst, Tyler Yell of DailyFX sat down with former Federal Reserve Adviser, Daniel DiMartino Booth at audio notation Covering global central bank developments and the biggest lesson Danielle learned as a Federal Reserve insider.

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