A New Era of Central Banking

A New Era of Central Banking explained by professional Forex trading experts the “ForexSQ” FX trading team.

A New Era of Central Banking

From “Whatever It Takes” to “What Will It Take”

2016 was supposed to be a year of policy normalization. The Federal Reserve had raised interest rates December 2015, and according to their infamous Dot Plot, it appeared we would see anywhere from 2 to 4 hikes in 2016 as the world economy began to form in a more non-crisis fashion.

Now, after the September meeting of the Federal Reserve and the Bank of Japan, markets appear as uncertain as ever is where the global market is heading and what it means to foreign-exchange market.

On September 20, the Bank of Japan announced that they would target the yield curve to diminish inflation. To get a full appreciation of this act, it is helpful to remember that the Bank of Japan introduced negative interest rates in January which depressed the yield curve. Eight months later, it looks like they are putting the car into reverse by steepening the yield curve above the Bank of Japan’s presumed neutral rate, the rate that will not lead to acceleration or deceleration in growth or inflation, at around -.2% for two-year maturities and 0% for ten-year maturities.

What Will It Take

Markets love confidence. Few statements by a central bank were as confident as those of European Central Bank (ECB) President Mario Draghi in the depths of the sovereign debt crisis in Europe in 2012. Mr. Draghi told the market in no uncertain terms that the central bank of Europe would do “whatever it takes” to help Europe through this crisis and back to the state of price stability.

However, the ECB failed to give the market what they wanted for nearly two years after the ‘whatever it takes’ comment before announcing quantitative easing through bond buying officially in January 2015.

The Federal Reserve has threatened traders that are not taking them seriously about rate hikes that a rate hike is soon to come.

However, the September Federal Open Market Committee brought about another central bank meeting where they seem to find an excuse not to raise rates. Now, many are looking at the actions of the Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England after they reacted to the UK referendum that resulted in a Brexit to see whether or not they have a valid plan to get the economy back on the track. They are seeking price stability, also known as inflation.

What We Learned in September

In September, we learned that central bankers are still searching for the right amount of confidence to inspire the market to bid up prices so that inflation can get going and that employment slack is reduced. As many have noticed, there seem to be larger issues at hand that is preventing employment from picking up, such as a structural mismatch of the new demand for quantitative skill sets and the undereducated worker markets supply. While the Federal Reserve discussed the possibility of a rate hike still to come, the most informative aspect likely came from the Dot plot which once again showed a drop in expected longer-term rates. Such a drop shows their view of the neutral rate that has larger forces pushing it down and indicates there is less the Federal Reserve needs to do to provide restrictive monetary policy.

Naturally, the Federal Reserve could be in a tight spot depending on how the US election pans out, as market uncertainty, and volatility could easily rise making it all the more likely that there is no rate hike in 2016.

Where We Stand

As we head into the last quarter of the year, we have seen the Bank of England engage in new easing, the Bank of Japan change course; the European Central Bank fail to extend anticipated quantitative easing, and the Federal Reserve fail to extend anticipated monetary policy tightening.

Many thought the theme of 2016 would be policy divergence. Instead, 2016 looks to be the year policy delusion or indecision is the best path forward. This type of market naturally favors shorter-term traders or those in the realm of mean reversion to look for extreme moves to reverse when a central bank fails to meet market expectations.

While mean reversion could still play out in particular pairs, there appears to be more pain to come from currencies whose economy is export-dependent and that seek a weak currency. The growing account surplus is making the currencies of Europe and Japan surprisingly resilient while the US Dollar has failed to launch as many hoped it would. 2016 is not over yet, but it is likely safe to say that 2017 will not be as confusing to FX traders as 2016 was.