Central banks continue to sustain their big role in modern day's Forex market, even after losing absolute control to trading ranges in late 1980s. Here are a few hints that every Forex trader must know. Since the dark days of the Bretton Woods Accord, a time when currencies were bound to each other at a 1% range, foreign exchange markets have gone through a big change. In the past 30 odd years, the globalization of the economies, the technological breakthroughs and the staggering growth in investment funds and commodity trading advisers have expanded the daily trading volume in Forex to trillions of dollars.
Central banks make use of Forex for a number of reasons; one of which is making payments. On the contrary, when Forex exchange is involved, the trader's focal point goes to market interventions. People usually wonder if central banks are involved in profiteering at all, because of the way they manipulate specific currencies when foreign exchange is at the summit and lowest point. However, even if major central banks are often successful with long term because they never speculate in Forex, they typically lose in the short and medium terms. Their actions are often for keeping exchange rates from getting dangerously low, which has a negative effect on exporters, and restoring orderly conditions in the market.
Only foreign exchange is involved with unsterilized, or naked, interventions. The Fed, for example, only conducts Forex with countries with external currencies like Japan and Europe. However, in addition to the effect on foreign exchange rates, an intervention has a rather unpopular side effect to major central bankers, as seen on monetary supplies. Because of this, economic levels often require significant changes to pricing and interest rates. A naked intervention always leads to long term effects.
A sterilized intervention, however, promptly reflects on the monetary supply, making it a tool of choice for traders. Sterilized interventions are known for short to medium term effect, but that is more than enough in foreign exchange.
If not done wisely, interventions can also affect traders negatively. Interventions can be both damaging and beneficial at the same time, so understanding the concept behind it is very important. Central banks may reverse the trends, slow it down, or intervene with the market to provide liquidity and protect specific levels from variation. Because central banks prompt answer to compromising trends, traders are restricted from expecting a mechanical approach.
In case of a crisis, a currency pair or several currency pairs may be affected, thereby throwing off the market either in terms of pure havoc or imbalance between the pairs. In case one side of the pair goes astray, central banks are there to supply it and keep the market running. However, there is no guarantee the bank will operate this way. In case it does, do not expect the bank to cover the entire market losses, as they will only be there to provide a minuscule backdoor for traders.
Actually, central banks do not have total control of where the market may lead; they are only capable of making interventions so as to influence the pace of the trend. Volatility acceleration has a rather reflexive effect on momentum funds; as it increases, so does the other one. In turn, central banks will aim for the speed of movement, and not its particular direction. To slow down a plummeting trend, for example, a bank may purchase stocks in minute amounts sequentially. In which case, traders are going to take advantage of the bank's intervention by selling now, and buying back their stocks when the trend recovers.