FOMC Example Continued

Let's continue examining how the market reacts to changes in the US interest rate outlook. We turn to 2006.

Euro Uptrend Continues

1. On March 28th the Federal Open Market Committee (FOMC) continued their campaign to hike rates by increasing the base rate for the 15th consecutive time by .25% to 4.75%.

Even though the FOMC raised rates, which would favor the currency, the Euro continued climbing against the Dollar. Investors and traders kept up the speculation that the Federal Reserve was ready to end their campaign. The only question was how much further further they would go.

EUR/USD - December 2005 - May 2006

2. On April 14th, Greg Ip, a prominent Wall Street Journal reporter that follows the Federal Reserve closely, wrote that its officials were divided regarding the need for further tightening, fueling investors’ expectations that the base rate would stop at 5%. This news along with other Dollar negative factors (a standoff with Iran over their nuclear ambitions) accelerated Dollar losses for the next four weeks.

The EUR/USD pair went from trading at 1.2100 to 1.2900 which is a significant 800 pip move that translates to a change of $8,000 dollars for a 1 Lot position. Whether the position gained or lost the 800 pips depends on whether the open position was a buy or sell of the pair.

3. On May 10th, the FOMC met and raised the rate to 5%. In the announcement that accompanied the rate hike the Federal Reserve officials said that “further tightening would depend on incoming economic data”. This statement clouded the intentions of the FOMC for their next meeting, which was scheduled for June 29th. A couple of days later when the pair closed in on 1.3000, it stopped trending and entered a ranging market as investors analyzed what the Federal Reserve would do next.

Federal Reserve Chairman Moves Markets with Hawkish Talk on Interest Rates

The start of June brought some clarification to investors and traders. The still new Federal Reserve chairman Ben Bernanke, at a speech, said that “recent inflation measures were higher than his comfort zone”. These comments were regarded as highly “hawkish” a term to mean an official that favors higher interest rates. “Dovish” statements are those that favor cutting rates. Bernanke's comments caused the Dollar to immediately strengthen as it seemed that the base rate would not stop at 5%, contradicting the earlier speculation that had built up following the Wall Street Journal news report and analysts predictions.

In the next 7 trading sessions, the EUR/USD moved from 1.2950 down to 1.2550 a change of 400 pips (or $4,000 for a 1 Lot position). We have already explained what role inflation plays in the considerations of central bank officials.

The Dollar strengthened on the changing US interest rate outlook, touching the older upper (green) trendline we had drawn previously in March/April. From this point, the pair enters another, larger ranging market with price bouncing between 1.2900 and 1.2500. The ranging market developed because investors and traders were unsure about what would happen next since higher inflation readings meant that the FOMC could continue raising rates. If inflation did not pose a problem then the FOMC could pause in their rate hiking campaign.

Now that we have taken you through an example of how central banks impact the Forex market let’s take a closer look at the main central banks.