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A Beginner’s Guide to Understanding the European Central Bank

By , Forex Trading Instructor
13 January 2014 18:38 GMT

Talking Points

  • Understanding Any Central Bank
  • Key Economic Mandates of the ECB
  • Pivotal Moves By The ECB
  • Future Challenges
  • 2014 Meetings

As a Forex trader it’s a good idea to get comfortable with major Central Banks and familiarize yourself with their Monetary Policy which can help you develop trade ideas. If you’re new to Forex, but are familiar with the Stock Markets, you can think of a Central Bank Meeting as the Forex equivalent of the Earnings Announcement. When a company announces their earnings, they’ll also get investors excited about upcoming opportunities that the company is looking to capitalize from.

Conversely, if you remember 2008-2013, it’s also an ideal time to let investors know that they shouldn’t plan their retirement just yet as the company is facing a few headwinds that will have to be addressed before they can hit their targets as a company. When a Central bank has a monetary policy announcement, they’ll likely discuss what opportunities lie ahead like, how the economy as a whole is looking to capitalize on. For example, such as improving the employment picture or a healthy showing of inflation, or when there are challenges ahead like inflation getting out of hand, that the Central Bank is hoping to keep it contained.

Understanding a Central Bank

To get a good grasp of any central bank, it’s helpful to know three things. First, you need to know what economic measure they find important and worth managing as a central bank, also referred to as key mandates. Second, it’s important to know when they are meeting next so that you can manage your trades accordingly. Third, it’s important to know what major undertakings the central bank is involved in which has dramatically affected their currencies value and at some point they may soon unwind which will also have extreme importance to the future value of the currency you’re looking to trade.

Background on the ECB

A unique aspect of the Eurozone is that they are in charge of managing the monetary policy that is meant to support the economic needs of 18 different member states. However, it’s important to know everyone who is in the European Union does not use the Euro currency.

Map of Eurozone (Latvia was added January 1st, 2014)

ECB_body_Picture_4.png, A Beginner’s Guide to Understanding the European Central Bank

Courtesy of ECB

Key Economic Mandates of the ECB

The European Central Bank or ECB is a single mandate central bank. That single mandate is inflation. Therefore when a poor Consumer Price Index or CPI reading comes out like one did in late October 2013 the market may begin to sell Euros because the ECB more likely to act which will likely have the effect of weakening the Euro.

Inflation Readings 2006-2014 with 2015 Expectations

ECB_body_Picture_5.png, A Beginner’s Guide to Understanding the European Central Bank

Courtesy of Bloomberg

Going back to 2006, you can see how inflation has oscillated around 2%. In referencing the ECB website, you can see they price stability or inflation is their focus: The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. Therefore, to understand inflation in the Eurozone is to understand the core of the ECB’s policy decisions.

Pivotal Moves by the ECB

To understand the single mandate that the ECB is operating under is to

understand the major actions taken on by the ECB over the last few years. As you can see above, there was an uptick from 2009 to 2011 in inflation. As a Central Bank that focuses solely on inflation, this inflation reading encouraged then ECB head, Claude Trichet to raise rates as you can see below in 2011.

However, the ECB had to unwind this procedure and continue to bring rates lower due to the Sovereign Debt Crisis continued to linger on. The Sovereign Debt Crisis was a time after the 2008 credit crisis when many European Countries (specifically Portugal, Italy, Ireland, Greece & Spain) were facing uncontrollable debts and the bond yields made it very tough for them to renew their debt which almost brought the Euro Union to its knees.

ECB Raised Rates in 2011 While Global Economy Was Still Forming a Bottom

ECB_body_Picture_7.png, A Beginner’s Guide to Understanding the European Central Bank

Courtesy of Bloomberg

ECB_body_Picture_9.png, A Beginner’s Guide to Understanding the European Central Bank

Presented by FXCM’s Marketscope Charts

Looking above, you can see that the raising of interest rates boosted the Euro but in times of global economic duress, central banks rather not have the strongest currency. As you can imagine, this is exactly was the Bank of Japan has been dealing with as a strong currency makes the export sector relatively expensive. If a key portion of your GDP is unattractive to global buyers, then you’re going to have a hard time seeing year over year growth in your economy.

Referencing the top graphic again, you can see that the ECB retracted their rate increase in the following quarters. This helped to increase their global competitiveness for their export sector.

Future Challenges

Most central banks will look at 2014 as a time where they hope to join the global recovery without having to worry about too strong of a currency. In risk of repetition, a stronger currency relative to other trade partners could significantly impact the demand of products which in turn can affect price stability or inflation which is the key mandate of the ECB.

Also of concern for the ECB is the fact that they manage a reserve currency to many central banks around the globe which is referenced in the chart above when you see knee-jerk buying in EURUSD. What’s more is that their Balance Sheet continues to show a strong surplus which makes the Euro even more attractive as a reserve currency and if too many banks act on the attractive balance sheet of the EBC through debt markets, that could continue to bid up the Euro to uncomfortable levels from an export and manufacturing point of view. Therefore, if that picture plays out and the Euro begins to approach 1.40+ against the USD, you could see the ECB take action with the hope of a weaker currency boosting exports and thus inflation.

2014 Meetings

ECB_body_Picture_1.png, A Beginner’s Guide to Understanding the European Central Bank

Happy Trading!

---Written by Tyler Yell, Trading Instructor

To contact Tyler, email tyell@dailyfx.com

To be added to Tyler’s e-mail distribution list, please click here.

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13 January 2014 18:38 GMT