With major central banks issuing detailed ‘forward guidance’, are interest rates losing their influence on the foreign exchange market?
There is a growing distance in the relationship between interest rates and the currency market in the post-2008 credit crisis world. Interest rates in developed markets have stayed at historic lows for an unprecedented period since the crisis and major central banks have all embarked on a 'forward guidance' as a policy tool.
Through this tool, central banks are relying on detailed communication as a means to offer the market a 'heads-up' before taking action. Though this increased guidance is a welcome step by central banks to tame volatility and arrest violent shocks to the currency market, it has also curtailed speculation – a major aspect of foreign exchange trading.
What does this mean for traders?
- Forward guidance has largely illuminated the need to take huge risks on speculating upon which action a central bank may take; traders now have had to resign to central banks actually telling the market about what action they will take which forces many currency traders to focus less and less on policy meetings.
- This does, however, mean lower volatility in the forex market, which was intended by central banks to curtail the speculative approach traders had been taking before policy meetings, which left currencies vulnerable to violent shocks.
Your trading approach to interest rates?
In this new age of central bank communication, a forex trader may need to reconsider their approach to interest rates. There's less need to speculate whether interest rates are going up or down and more need to examine the fundamentals of a country's currency and the overriding stance of its central bank on a longer-term perspective.
Interest rates dictate flows of investment. Since currencies are the representations of a country's economy, it's considered crucial to understand the outlook rather than to speculate on short term fluctuations in it.
Former Fed chairman Ben Bernanke first coined the term "forward guidance" in December 2012 when he said the central bank would not raise interest rates until the unemployment rate in the US dropped to at least 6.5%, so long as inflation remained below 2.5%. Photo: Shutterstock
More onus on macro data?
As such, the onus falls to broader gauges of the relative strength or even weakness of a currency. Macroeconomic indicators need to gain more priority than interest rate meetings as they are more telling of a country's fundamental economic position.
By using macro indicators such as employment data, consumer price inflation or the Purchasing Manager's Index, a forex trader is relying more on empirical data and information to trade rather than speculation.
Interest rate meetings still matter
Even though forward guidance is a transparent communication tool by central banks, it doesn't necessarily mean that a central bank can no longer surprise the market. Forex traders now need to spend more time going through policy meetings with a fine toothcomb in order to truly gauge upcoming policy action by central banks. This means more focus on the tone of the language used by the central bank, the meeting minutes, economic forecasts and statements made by policymakers outside of the monthly interest rate meetings.