Why are central banks so important to financial markets?

Why are central banks so important to financial markets?

Central banks play a critical role in global financial markets because they determine how much it costs to borrow and lend money by regulating interest rates. They manage rates to ensure inflation stays within a predetermined range based on a country’s economic conditions.

This is one of a central bank’s most effective tools. Since the interest rate impacts the costs of lending and borrowing money, it has a direct impact on economic activity.

For example, if it costs more to borrow money, people who already have debt will have less money to spend on other items. Those who don’t might put off economic activities like buying a home until the interest rate comes down. With fewer people spending money, the price of goods and services tends to come down, slowing inflation.

When interest rates are low, it’s cheaper to borrow money. With more people spending, demand for goods and services increases while supply stays the same. This results in prices rising.

All central banks are responsible for the financial system's stability and supply of money in the country. Some, like the United States Federal Reserve (Fed), have additional economic goals such as increasing employment rates.

Central banks and volatility

Central banks can cause market volatility. Investors are attentively monitoring not only central bank decisions, but also all official statements made with regards to a region’s monetary policy. Often abrupt movements in financial markets are a direct result of a central banker’s statements, which create expectations among investors. Other times macroeconomic factors move the market in one direction or another, anticipating that the central bank will be forced to react.

One of the most well-known market occurrences in recent years is directly related to a central bank decision. The SNB startled the markets on 15 January 2015 with an announcement that shook up the foreign exchange market.

The SNB had been intervening in the market for months to keep the value of the euro above 1.20 Swiss francs. They did this by setting a floor on the euro-Swiss franc exchange rate (EUR/CHF) at 1.20. However, in January 2015, the SNB surprised markets by removing this floor. This caused the euro’s value against the Swiss franc to plunge dramatically from 1.20 to 0.80 almost instantly.

This was known as the Euro-Swisse Flash Crash, and it resulted in significant losses for everyone who held a long position in the EUR/CHF exchange. This unexpected decision resulted in many long positions closing simultaneously causing the value of open positions to fall rapidly. The number of people who benefited from this market movement was modest. Downside positions were essentially non-existent due to the SNB’s position not to allow its currency to fall below 1.20.

The European Central Bank (ECB) is another illustration of how banks can shift direction in the market. On 25 July 2012, as the European single currency was facing a severe credibility problem, ECB President Mario Draghi was making a public speech in London. His statements sent the public debt markets into an uproar. His speech, which would be remembered for his iconic use of ‘whatever it takes’, helped investors rebuild confidence in the eurozone and generated a strong movement in bond markets.

This time, it wasn’t a decision made by a central bank’s governing council that caused the market to react, but rather words of its president in a public statement unrelated to the organisation itself.

Central bank history

The first central banks were established in the 17th century. The Bank of Sweden (Sveriges Riksbank), which was founded in 1668, is one of the central banks whose origins can be traced back to this time.

Many of them began as private companies and gradually transitioned to public institutions, allowing them to achieve their current prominence.

Other banks, such as the US Fed, was founded in 1913 in response to a series of financial crises that erupted in the country around the turn of the century.

In the case of Europe, the ECB was founded on European countries’ commitment to the development of a shared economic region with a single currency. The eurozone states retain their respective national central banks, although their role has been diminished by integration into the ECB.

Major central banks

- The Fed: The United States’ central bank manages the world’s largest economy and keeps an eye on the dollar; the currency with the biggest impact on all worldwide trade transactions. The Federal Open Market Committee (FOMC), its governing body, meets eight times a year. The press conference held by its chairman following each meeting usually causes volatility in the markets. Investors and traders keep a close eye on the markets when these announcements are expected

- The ECB: Given the dominance of the euro as a reference currency, the ECB is another organisation with significant market weight. The ECB’s Governing Council, comprised of the central bankers of all eurozone member countries, meets every six weeks to set and announce the ECB’s monetary policy

- The Bank of Japan (BoJ): The Japanese bank of banks is among the top three major central banks. Its Monetary Policy Board meets once a month and is known around the world for its ultra-expansive policies, which inject a lot of money into the economy directly or indirectly

- Bank of England (BoE): This body oversees safeguarding the financial system’s efficiency throughout the United Kingdom. The BoE has a Monetary Policy Committee (MPC), and like the Fed’s FOMC, it meets eight times a year

- People’s Bank of China (PBoC): Even though this entity doesn’t meet on a regular basis, and China’s economy is closely regulated by the country’s government, the PBoC’s interest rate decision is becoming an increasingly important appointment on the investor’s agenda as the yuan gains international relevance

- In addition to the five mentioned above, other central banks include:

• Swiss National Bank (SNB)
• Reserve Bank of Australia (RBA)
• Bank of Canada (BOC)
• Reserve Bank of New Zealand (RBNZ)
• Central Bank of the Russian Federation (CBR)
• Reserve Bank of India (RBI)
• Central Bank of Brazil (BCB)
• Banco de México (Banxico)
• South African Reserve Bank (SARB)

How to respond to central bank announcements

Keeping an eye on interest rate announcements is critical for anyone participating in the economy. It’s particularly important for traders and investors who need to react quickly to market movements.

Central banks often have the most impact on currency and bond markets, but we frequently witness spillover effects in other markets such as stocks and commodities.

Maintain your agility and remain mindful of market conditions. Opinions and viewpoints change quickly, and the volatility around the central bank might be huge. Traders must stay well-informed, prioritise risk management, be ready to react swiftly and capitalise on all market changes. Remember that initial knee-jerk reactions frequently reverse once the dust settles, opening a new window of opportunity following the original market shift.