We just have a quick question here from Lauren asking for more insight into how central banks basically try and influence their currency price. Now there’s various tools Lauren that a central bank can use in order to influence currency prices.
Of course, there are some times when central banks can directly intervene to weaken their domestic currency by basically selling their own currency and buying foreign ones.
A good example of this would be the Swiss National Bank. However, in this video, we’ll focus on the influences that are more useful for us as traders.
Now by now you should know that interest rates are probably one of the most effective tools that a central bank can use. And short-term interest rates are the primary tool that they will use to try and keep to their policy mandates, which for most developing economies and countries and central banks would be price stability and stable economic growth. So as price stability is a core mandate, one of their key concerns of course is keeping inflation as close to their inflation target as possible.
Now for most developed economies, that’ll be an inflation target of 2%, but for others like Australia they might have a target band of between one and 3%. So where inflation is heating up in the economy and moving way above that target, they will most probably hike interest rates to try and cool down the economy, which should bring inflation down as well. And when inflation is cooling too fast, they will try and cut interest rates to try and obviously restimulate growth, which should in turn bring prices back up.
Now, when the central bank changes interest rates, it basically affects something called interest rate differentials, which is a big deal for investors that are looking for higher yield.
So, when your currency does not offer attractive yields, it brings down the attractiveness for investors that wants to invest there. So if the yield is low, there should be other things that attract investors, right? Like safety or less risk of defaulting.
By the way, that is part of the reason why developing, or let’s call it emerging market countries offer such high yields, because investors require more incentive as there are often a whole slew of risk associated with emerging market countries like their governments, the economies, corruption, et cetera. So higher reward obviously higher risk. So after interest rates the bank can also try and manipulate the money supply in the economy.
So, when we think of a currency, we should always think of it in terms of a asset that is also sensitive to supply and demand dynamics. So, when there is more demand for something compared to supply of course, we can expect price to theoretically go up. And when there’s an oversupply versus demand, then of course we can expect the price to go down. So, coming back to currencies, when there is excess currency available in the country, theoretically that should weaken the currency, and when there is more demand than supply, of course the currency price should go up.
Now, there are many ways that the central bank can affect the money supply. More traditionally, they can perform something called open market operations. And that is where they will basically buy and sell treasuries in the open market, which is why it is called open market operations. Now, this transaction works both ways.
So, if they want to increase the money supply, basically bringing the currency value down, they will buy treasuries in the open market. So they will actually pay cash for a bank’s treasuries. And that cash will as a result increase the bank’s reserve.
So when there’s more reserves, meaning there’s more supply and less demand for cash, banks will require lesser interest on lending out that money to other banks, right? So that in turn will bring your borrowing cost lower, which in turn should lead to lower interest rates across the board, and of course then a weaker currency. And vice versa is always true.
If they start to sell treasuries across the board in the open market, banks will need to take their money and buy treasuries from the Fed.
Which means that the money will be taken out of the system, which means they will have lesser reserves, which means less reserves, lesser supply, which should see banks require more interest for borrowing that out to other banks, which should increase the interest rate and of course lead to a stronger currency. So, from the more unconventional side of course, we also have something that is called QE or quantitative easing. Let me just quickly turn that squawk down, or quantitative easing. Now, quantitative easing is basically where the central bank buys and sells treasuries.
So you may ask, “What’s the difference between that “and open market operations?”
So QE is what they resort to when interest rates are already as low as they can go. So at zero percent or close to zero. So they can’t do open market operations to try and drop the interest rate that way. And they can actually not cut any further than zero, unless they want to go to negative interest rates. So when they’re at rock bottom, what do they do?
So the bank can then resort to quantitative easing, where they participate by buying sometimes longer dated securities, like think of 10 year treasury bonds for example, to synthetically increase the demand for those bonds, which will obviously send the yields of those bonds lower and thus keep the longer run interest rates lower across the curve.
So they’re still pumping money into the system. And that excess availability of all that money should obviously then also devalue the currency as it will keep interest rate expectations suppressed.
Now of course, the opposite is also true. You also get something called quantitative tightening, which is the exact opposite of quantitative easing. And that is of course when the central bank starts to taper their balance sheet, and that should obviously lead to higher interest rate expectations, and that can obviously lead to a higher currency as well.
So, Lauren, I hope that helps as a guide. Any other questions, please just let us know.