Quantitative Easing And The Effect On Forex Trading

Quantitative easing (QE) is a type of monetary policy adopted by central banks to stimulate a countries economy.

Central banks face the challenge of “balancing” economic growth (making sure the economy does not grow too fast or too slow) by influencing the forces of supply and demand.

Traditionally, this was achieved purely through interest rate decisions, however, central banks began facing the challenge of low economic growth with interest rates near zero… Quantitative easing was born to solve this problem.

This process involves central banks creating new money, known as “printing money”, through central bank reserves. The money is “new” because it has never been circulated in the system.

Central banks use this newly created money to purchase assets such as corporate and government bonds or to provide direct loans to commercial banks.

Injecting new money indirectly keeps the borrowing rate as low as possible and allows more money to circulate through the system. Increasing the money supply allows banks to continue lending money which is important because spending and investment are required for economic growth.   

How quantitative easing impacts the Forex market?

QE has a major influence on interest rates as well as supply and demand, making it rather important. To the point, what effect does it have on currencies?

As mentioned, QE introduces greater supply and keeps interest rates low- both of which are negative for currency valuation. Therefore, if a central bank implements an easing policy, market participants will usually put their money into higher-yielding currencies.

Say, for example, the ECB announces QE while the US maintains interest rates (without any easing policy). This is bearish for the EUR and neutral for the USD, the obvious result is EURUSD will decrease in value as investors move their money from the EUR into the USD to seek higher returns.

Here is a historical example

 

Effect of QE- USJPY Daily

In 2013 the BOJ began an easing program (QQE), the outcome was a significantly stronger USD vs. the Yen (as shown the exchange rate soared).

On a different note, central banks announcing new QE policies, or changes in these, leads to a significant amount of volatility in the market. Keep an eye on the economic calendar and always be aware of this risk when there is talk of a central bank announcing QE related information. 

Great places to gain an understanding of these events from economists are Bloomberg and CNBC, for economic calendars check out Daily FX, Forex Factory and FX Street.  

The other side of the coin - QE Tapering

QE cannot be implemented indefinitely as the rise in inflation would eventually be catastrophic, this is where tapering comes in. Tapering refers to the gradual reduction of asset purchases by the central bank.

Tapering has the opposite effect of QE, it pushes interest rates up and is inflationary (bullish) for the currency.

Summary of quantitative easing:

1. A central bank attempts to ignite an economy by lowering interest rates. If growth is low and rates are near zero, another method must be used.

2. Central bank begins QE and “prints money” to add supply.

3. The new money is used to purchase assets such as bonds and provide loans to commercial banks.

4. Lower interest rates facilitate borrowing and spending.

5. Allowing the economy to grow.

Summarizing the effect on Forex:

1. QE is generally bearish for a currency.

2. Tapering is usually bullish for a currency.

3. If a central bank announces a major decision involving QE, this will lead to high volatility.

 

Those who enjoy trading fundamentals can use QE related events to place trades based on the theories provided, though most traders must simply aware of the risk.

 

Now it’s time to stimulate your account and…

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