In the complex and ever-shifting landscape of financial markets, one constant presence reigns supreme – central banks. These omnipotent institutions, with their power to set interest rates and control the money supply, hold the keys to the economic kingdom that investors and traders need to be aware of to optimize their asset allocation.
Whether you're a savvy investor aiming for long-term wealth or an active trader seeking rapid returns, understanding the intricate dance between central banks and your asset allocation is crucial. ActivTrades believes that this is the key to unlocking opportunities and mitigating risks. So, let's delve into the world of central banks and discover how you can make the most of their decisions to reach your financial goals.
What is a central bank?
At their core, central banks assume a pivotal role in any economy, entrusted with the vital tasks of overseeing a nation's money supply and ensuring the stability of its financial system.
The primary goal of a central bank is usually to establish and safeguard financial stability within a nation.
This involves the central banks' concerted efforts to keep inflation at a moderate and consistent level, often setting a target of approximately 2% in most developed nations. Through the regulation of inflation, central banks act as custodians of a nation's currency value, guaranteeing the relative constancy of prices over time.
In tandem, some central banks are committed to promoting full employment or sustaining a low and stable unemployment rate, such as the American and Australian central banks - the Fed and the RBA respectively. They achieve this by stimulating or tempering economic activity.
Understanding how central banks fulfill their mandates
Central banks use monetary policy as a strategic approach to oversee and adjust the quantity of money circulating within a given economy to reach their goals, through various tools such as interest rates, open market operations, reserve requirements, forward guidance, currency intervention, and unconventional tools.
These different tools serve as a critical set of instruments for central banks to navigate economic conditions effectively. Depending on the prevailing economic circumstances, monetary policy can take on one of two distinct forms: expansionary or contractionary.
An expansionary monetary policy aims to stimulate economic growth, particularly during periods of economic downturn or recession, such as the 2007 financial crisis, or more recently with the Covid-19 pandemic.
It's a strategy typically adopted when the central bank perceives the need to rejuvenate economic activity, curtail unemployment, and prevent the unsettling specter of deflation.
In that case, a central bank can decide to lower interest rates to render borrowing more accessible, engage in open market operations to infuse money into the economic bloodstream, and reduce reserve requirements for banks to stimulate increased lending.
In theory, these measures work together to increase the available money, lower borrowing expenses, and support individuals and businesses to spend more. This, in turn, becomes a catalyst for economic growth, gradually leading the economy out of the grip of a recession.
Conversely, a contractionary monetary policy comes into play when the central bank's objective is to put the brakes on an overheating economy and rein in inflation, all in the pursuit of maintaining economic stability.
This strategy is typically deployed during periods of rapid and unsustainable inflation pressures and economic overheating, much like the current scenario in various parts of the world, where inflation has surged in the wake of the conflict in Ukraine.
So under these circumstances, the central bank can decide to raise interest rates to elevate the expense of borrowing, orchestrate open market operations aimed at extracting money from the economic bloodstream, and increase reserve requirements for banks to curtail lending.
Theoretically, these measures collectively serve to curtail the money supply, heighten the costs linked to borrowing, and support savings rather than spending. This shift encourages the economy to cool off, reins in inflation, and ultimately safeguards economic stability.
How do central banks's actions influence the financial markets?
The bond market
In Times of Lower Interest Rates:
When central banks decide to lower interest rates, it results in newly issued bonds having reduced coupon payments due to the prevailing lower interest rates, which lowers the yield on these freshly issued bonds.
In this scenario, existing fixed-income investments become more appealing to investors because their yields appear relatively more enticing in a low-interest-rate environment. Consequently, investors can rush to acquire these existing bonds, causing their prices to rise.
This price appreciation provides investors with the potential for significant gains if they were to sell their bonds before maturity.
Keep in mind that there is an inverse relationship between bond yields and bond prices.
When bond yields decrease, the market values of existing bonds rise. Investors are willing to pay a premium for these bonds to take advantage of their relatively higher coupon payments compared to new bonds with lower yields.
In Times of Higher Interest Rates:
Conversely, when interest rates rise, the opposite situation occurs.
Investors who hold bonds with fixed interest rates expect a specific interest income over the bonds' lifetime. However, new bonds are issued with higher interest rates compared to those held by investors, making the new bonds more appealing due to their superior returns.
As a result, the value of existing bonds, offering lower interest rates, declines in the secondary market. This drop in bond prices occurs because investors are willing to pay less for bonds with lower yields when compared to newer, higher-yielding bonds.
In times of rising interest rates, investors seek better yields to maximize their returns. Consequently, there is reduced demand for existing bonds with fixed interest rates, as they become less competitive in a higher interest rate environment.
Bonds are often evaluated in comparison to other similar investment alternatives, such as savings accounts or newly issued bonds. When short-term interest rates increase, these alternatives become more attractive because they offer higher returns with lower price risk compared to existing bonds.
The impact of interest rate changes on bond prices also depends on several factors, including the bond's maturity, the magnitude of the interest rate shift, and the coupon rate.
Longer-term bonds are generally more sensitive to interest rate fluctuations because their cash flows are affected over a more extended period. Additionally, bonds with lower coupon rates are more sensitive to rate changes because the income component represents a larger portion of their total return.
👉 Discover our guide about bonds.
The stock market
In Times of Lower Interest Rates:
During periods of lower interest rates and quantitative easing programs, expansionary monetary policies aim to inject additional liquidity into the financial system, making borrowing more affordable for both businesses and individuals. This stimulates economic activity and influences various sectors of the economy.
Lower interest rates encourage businesses to invest in growth opportunities.
Companies find it more enticing to expand their operations, hire more people, or launch new projects because the cost of financing these endeavors is reduced. This (theoretically) results in increased economic growth and job creation.
For consumers, lower interest rates translate into reduced interest payments on loans, including mortgages, auto loans, and credit cards.
This reduces the financial burden of interest expenses, freeing up more disposable income to allocate it into discretionary spending, boosting sectors like entertainment, dining, travel, and home improvements. Consequently, companies in these areas may experience higher demand and potential stock price increases.
In the real estate market, declining mortgage rates make homeownership more affordable, leading to increased home purchases and refinancing. This benefits the housing market and related industries, such as furniture, decoration, and DIY shops.
However, lower interest rates present challenges for savers who rely on interest income from savings accounts or certificates of deposit. Their earnings may decrease, prompting some to explore alternative investments.
Investors, seeking higher returns, often turn to the stock market, as there may be a reallocation of assets away from fixed-income investments, such as bonds and savings accounts, towards equities and alternative high-yielding options.
Reduced interest rates also lead to a depreciation of the domestic currency, enhancing the competitiveness of a country's exports. This is because foreign buyers find products from this country more affordable due to the weakened currency exchange rate.
Consequently, companies based in this country may witness a surge in their export activity. This can bolster their sales, revenues, and overall profitability, potentially contributing to an uptrend in their stock prices.
In Times of Higher Interest Rates:
Conversely, higher interest rates lead to higher borrowing costs for both businesses and individuals. This increased cost of financing can have a direct impact on corporations, potentially affecting their profitability.
Higher expenses may indeed prompt businesses to scale back on investments in expansion, hiring, and new projects, which, in turn, can hinder overall economic growth.
Consumers also face the consequence of higher interest rates, as they result in increased borrowing costs. This, in turn, can curtail discretionary spending, as individuals allocate more of their income to interest payments on loans, leaving less available for other expenses.
The slowing pace of consumer spending can adversely affect companies' revenues and profits, reflecting in stock market performance.
Moreover, higher interest rates can exert pressure on stock valuations. As interest rates climb, companies may encounter higher discount rates applied to their future cash flows, potentially leading to lower stock valuations.
Investors may also adopt a more discerning approach when considering the price they are willing to pay for stocks, as fixed-income investments like bonds and savings accounts offer more attractive returns in comparison.
Additionally, the allure of fixed-income investments grows with rising interest rates due to their higher yields.
This shift in investor preferences can divert capital away from the stock market, as investors seek the safety and competitiveness of bonds and similar investments, potentially impacting equities.
Of course, the impact of rising interest rates isn't uniform across all sectors.
Some sectors, such as financials, may benefit from higher interest rates due to the potential for increased net interest margins. Conversely, sectors like utilities, technology, and real estate may suffer due to their sensitivity to borrowing costs.
Moreover, rising interest rates often means a stronger local currency.
As the domestic currency strengthens, the products and services from the country become relatively more expensive for foreign customers. This can result in a decline in export competitiveness, as foreign buyers may seek more affordable alternatives from countries with weaker currencies.
Heavily-oriented companies in the country may face challenges in maintaining or growing their export activities. With higher export prices, demand for their products may decrease, potentially impacting sales, revenues, and profitability.
These challenges can have implications for stock prices of such companies, as they can experience decreased investor confidence, potentially leading to pressure on their stock prices.
👉 Read our guide about dividend investing.
The Forex market
In Times of Lower Interest Rates:
When a central bank decides to lower interest rates, it essentially reduces the potential return on investments denominated in that particular currency.
Consequently, investors may opt to pursue higher yields available in alternative currencies.
This shift in investment preference can result in the depreciation of the currency associated with lower interest rates as traders move to exchange it for currencies offering more attractive returns.
In Times of Higher Interest Rates:
On the other hand, when a country's central bank raises interest rates, it typically attracts foreign capital seeking higher returns.
As a result, the demand for that country's currency increases, leading to its appreciation in the Forex market.
Higher interest rates can widen the interest rate differentials between two currencies.
This can make investments in the currency with higher rates more attractive to investors, encouraging them to exchange their holdings in lower-yielding currencies for those with higher yields.
What's the impact of central banks' decisions on investors?
When central banks decide to change their policies, it reflects the broader economic conditions and impacts the relative attractiveness of different asset classes because big players rethink their asset allocation strategies.
For long-term investors, understanding how central bank policies may impact future inflation, employment, and growth figures is crucial when making investment decisions to spot the best opportunities over time, because the dynamics are changing.
What's the impact of central banks' decisions on traders?
Central banks' decisions also exert a substantial influence on traders, shaping their trading strategies and decisions. This is primarily due to the potential for central bank policies and announcements to profoundly impact market sentiment and volatility.
Many traders closely monitor central bank statements and speeches, as these provide valuable insights into the future direction of monetary policies. These insights can be pivotal for traders seeking to exploit volatility and rapid price changes.
👉 Read our guide about news trading.
How to best balance risk and opportunity to take advantage of central banks' actions
Here are some tips about the best ways you can take advantage of central banks' actions and protect your positions:
● Know about the different central banks in the world, their objectives and how far/close they are to reaching them - especially the ones linked to the financial assets you're trading.
● Keep an eye on the growth, inflation, and employment figures in the economy you're trading in.
● Stay informed about the central banks' policy direction and their forward guidance to better anticipate their moves.
● Diversify your portfolio across different asset classes, countries, currencies, and activity sectors to avoid overexposure.
● Always adjust your asset allocation depending on the economic cycles and the expectations of monetary policies trajectories.
● Focus on the quality of the financial assets within your portfolio, as high-quality assets tend to be more resilient during economic and market turbulence.
● In an environment of rising rates to fight inflation, consider investments that offer protection against rising prices (inflation-linked bonds, gold, real estate…).
● Use hedging strategies with strong risk and money management methods in place to protect your investments against unexpected market events.
● Consider different economic scenarios and how central bank actions might impact your investments under each scenario.
● Take into account your investment horizon.
● Regularly review your positions.
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