After the latest round of monetary policy statements, the forex scene was abuzz with the term forward guidance and what it implies for forex trading. Simply put, this is all about the public announcement of what the central bank plans to do with monetary policy and interest rates for the foreseeable future.
In this week’s Bank of England monetary policy statement, new BOE Governor Mark Carney stated that the markets shouldn’t expect an interest rate hike until the middle of 2015. Meanwhile, European Central Bank Chairman Mario Draghi said that interest rates in the euro zone will remain low for an extended period.
This kind of communication strategy isn’t exactly a brand-new phenomenon among central bank leaders. In fact, the US Federal Reserve has been practicing this kind of announcement for a few years already. Recall that Fed Chairman Ben Bernanke was often quoted saying that interest rates will remain at record lows for an extended period of time back when the US economy was having difficulty recovering. Recently, Bernanke gave a timeline for the stimulus taper plan, as he announced that the Fed is looking to reduce bond purchases towards the last quarter of the year and possibly ending the easing program by the middle of next year.
For central bank officials, they are able to accomplish two objectives with forward guidance. First, they are able to keep a lid on bond market volatility by preventing interest rate expectations from causing sudden spikes in bond yields. In effect, they induce stability in borrowing costs, as these will no longer be driven by differing speculations but by actual forecasts from the central bank. Second, they are able to make the most of their current monetary policies by extending the effect of their rate cuts or asset purchases. Remember that several central banks already have record low interest rates and are running out of ideas when it comes to implementing more stimulus. By announcing that rates are likely to stay low for a number of years, they are able to influence lenders into keeping interest rates lower for longer-term loans without needing to slash rates lower or print more money.
Because of that, forex traders are now more conscious of which central banks are dovish and which ones are leaning towards tightening monetary policy. To be specific, the ECB and BOE are clearly more dovish compared to other major central banks while the US Fed is relatively more hawkish. As a result, GBP/USD and EUR/USD could be in for stronger and longer trends moving forward.