Central banks have a big impact on global markets, including currency markets.
Their decisions directly impact how investors approach global markets and risk.
In this article we’ll look at how central bank decisions impact investment strategies and why you should stay up to date with what they do.
Central Banks and Financial Markets
Central banks are responsible for the monetary system of the country.
Their major targets include; rates of interest, inflation and the volume of money, particularly money in circulation.
They influence expenditure by consumers, behavior of investors in the international markets among others.
For instance if a central bank decides to increase interest rates it is expected that the currency of the country will appreciate because investors will want to get richer.
When interest rates are lowered the currency too often depreciates to master trading basics, because there is less demand for the currency as an asset by overseas investors.
Central Bank Decisions and Currency Moves
Central bank action may lead to a large shift in the currency which in turn affects investment plan around the world.
This shows that flows in currency can affect investment returns across borders.
Currency Value
This can use interest rates as one of its main tools. Usually, a central bank raises interest rates and the currency strengthens.
That’s because foreign investors looking to get better returns will always be attracted to higher rates.
U.S. Federal Reserve increased interest rate several times in 2022 and U.S. dollar strengthened for example.
Demand for the dollar rose as investors hunt for higher returns in the U.S.
Monetary Policy
They set inflation targets also affects investment decisions.
It may raise interest rates to slow the economy and their currency will strengthen if inflation is too high.
When the central banks decide that the economy (and currency) need some boost, rates can be cut to stimulate the economy and the currency can weaken.
Central banks right an economy, however, during high inflation they sometimes take action to economy, making it affect investments in international markets.
Deciding to invest in international assets means that you need to factor in inflation.
What Investors Do
Investors watch central bank decisions because they know they impact their investments. Here’s what they do:
- Rebalancing
Investors can move their investments based on central bank policies. For example if a central bank is tightening by raising rates, investors may move their investments into assets that benefit from higher rates like government bonds.
- Diversification
Since central bank policies can affect currencies and markets differently, investors diversify their portfolios to reduce risk. For example if the US dollar is strong, investors with international investments may want to hedge against losses in other currencies.
- Risk Assessment
The level of risk investors are willing to take changes based on the central bank’s stance. If a central bank is raising rates aggressively, some investors may see it as a sign of economic instability and reduce risk in their portfolios.
Central Bank Coordination
Sometimes central banks in different countries will coordinate with each other. This can make the global market more stable but can also cause changes in investment strategies.
During Financial Crises
During financial crises central banks may work together to calm the market.
A classic example of this is the 2008 global financial crisis when central banks around the world cut rates and injected liquidity into the market to prevent a deeper recession.
When central banks coordinate, it usually means less volatility and a more stable environment for investors.
But these actions can have unintended consequences like inflation or asset bubbles which investors need to watch out for.
Interest Rate Differentials Between Countries
When central banks in different countries set rates at different levels, it creates a differential that can move investment flows.
For example if the European Central Bank (ECB) sets rates lower than the Fed, it could mean a stronger dollar and weaker euro.
This differential can impact global investment strategies as investors seek higher returns in countries with higher rates.
Conclusion
Investors should bear in mind that central bank policies are not laid down in set rules and regulations.
Such disturbances are those movements of the policy rate or any other policy factor that is contrary to the market expectation.
It is for this reason that the potential investor should follow central bank news and the state of the global economy in order to make proper investments.
Thus, I believe that anyone who wants to succeed in today’s world must know something about central banks and global markets.
Knowledge of these impacts enables learners to fine-tune their investors strategies in a way that prepares them for the shocks resulting from monetary-policy changes.
