forex market: 5/1/07

Are you a forex newbie? Well here is where you begin your illustrious forex trading career.
Our Quickstart guide is a series of Forex lessons created to quickly familiarize the clueless forex newbie or kinda-clueless forex newbie.

Every industry has its own collection of jargon, and Forex is no exception. You have to grasp Forex gobbledygook before you can start trading. The lessons are designed to help you gain a better understanding of what the Forex market actually is, who participates in this foxy market, and how you can make money trading Forex.

By the time you finish reading this guide, the slang of currency trading will have become second nature to you.

What is FOREX ?
The Foreign Exchange, also referred to as the "FOREX" or "Forex" or “FX” or "Spot FX" market is the largest financial market in the world, with a volume over $1.95 trillion a day. If you compare that to the $25 billion a day volume that the New York Stock Exchange trades, you see how giant the Foreign Exchange really is. It's actually more than three times the total amount of the stocks and futures markets combined!
What is traded on the Foreign Exchange ?

The answer is money. Forex trading is the simultaneous buying of one currency and selling of another. Currencies are traded through a broker or dealer and are traded in pairs; for example the Euro dollar and the US dollar (EUR/USD) or the British pound and the Japanese Yen (GBP/JPY).

This kind of trading is often very confusing to people because they are not buying anything physical. Think of buying a currency as buying a share in a particular country. When you buy, say, Japanese Yen, you are in effect buying a share in the Japanese economy, as the price of the currency is a direct reflection of what the market thinks about the current and future health of the country's economy.

In general, the exchange rate of a currency versus other currencies is a reflection of the condition of that country's economy compared to the other countries' economies.

Unlike other financial markets like the New York Stock Exchange, the Forex spot market has neither a physical location nor a central exchange. The Forex market is considered an Over-the-Counter (OTC) or 'Interbank' market, due to the fact that the entire market is run electronically, within a network of banks, continuously over a 24-hour period.

Which Currencies Are Traded?
Any currency backed by an existing nation can be traded at the larger brokers. The most popular currencies along with their symbols are show below:

Symbol Country Currency
USD United States Dollar
EUR Euro members Euro
JPY Japan Yen
GBP Great Britain Pound
CHF Switzerland Franc
CAD Canada Dollar
AUD Australia Dollar

Forex currency symbols are always three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country’s currency.

The Forex market (OTC)
The Forex OTC market is by far the biggest and most popular financial market in the world, traded globally by a large number of individuals and organizations. In the OTC market, participants determine who they want to trade with depending on trading conditions, attractiveness of prices and reputation of the trading counterparty.

In comparison, while the total daily trading volume worldwide was estimated at about US$1.5 trillion, only about 12 billion dollars was estimated for currency futures - less than a tenth of one percent!

The one factor that is sure to move the currency markets is interest rates. Interest rates give international investors a reason to shift money from one country to another in search of the highest and safest yields. For years now, growing interest rate spreads between countries have been the main focus of professional investors, but what most individual traders do not know is that the absolute value of interest rates is not what's important - what really matters are the expectations of where interest rates are headed in the future. Familiarizing yourself with what makes the central banks tick will give you a leg up when it comes to predicting their next moves, as well as the future direction of a given currency pair. In this article, we look at the structure and primary focus of each of the major central banks, and give you the scoop on the major players within these banks. We also explain how to combine the relative monetary policies of each central bank to predict where the interest rate spread between a currency pair is headed.

Examples
Take the performance of the NZD/JPY currency pair between 2002 and 2005, for example. During that time, the central bank of New Zealand increased interest rates from 4.75% to 7.25%. Japan, on the other hand, kept its interest rates at 0%, which meant that the interest rate spread between the New Zealand dollar and the Japanese yen widened a full 250 basis points. This contributed to the NZD/JPY's 58% rally during the same period.

On the flip side, we see that throughout 2005, the British pound fell more than 8% against the U.S. dollar. Even though the United Kingdom had higher interest rates than the United States throughout those 12 months, the pound suffered as the interest rate spread narrowed from 250 basis points in the pound's favor to a premium of a mere 25 basis points. This confirms that it is the future direction of interest rates that matters most, not which country has a higher interest rate.

The Eight Major Central Banks
Editor's note: Information on central banks and key officials is accurate as of the time of writing (April 2006).

U.S. Federal Reserve System (The Fed)

Structure - The Federal Reserve is probably the most influential central bank in the world. With the U.S. dollar being on the other side of approximately 90% of all currency transactions, the Fed's sway has a sweeping effect on the valuation of many currencies. The group within the Fed that decides on interest rates is the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board plus five presidents of the 12 district reserve banks.

Mandate - Long-term price stability and sustainable growth

Frequency of Meeting - Eight times a year

Key Policy Official - Ben Bernanke, Chairman of the Federal Reserve. Following former chairman Alan Greenspan's retirement in January 2006, U.S. President George W. Bush tapped Bernanke to head the Federal Reserve, given his four years of experience on the Fed Board of Governors. His views differ from Greenspan's in that he believes in inflation targeting and printing money to avoid deflation. The historic change of power at the U.S. central bank marks the first time in two decades that an academic, who may focus more on mathematical and econometric models, is chairing the Fed.

European Central Bank (ECB)

Structure - The European Central Bank was established in 1999. The Governing Council of the ECB is the group that decides on changes to monetary policy. The council consists of the six members of the executive board of the ECB, plus the governors of all the national central banks from the 12 euro area countries. As a central bank, the ECB does not like surprises. Therefore, whenever it plans on making a change to interest rates, it will generally give the market ample notice by warning of an impending move through comments to the press.

Mandate - Price stability and sustainable growth. However, unlike the Fed, the ECB strives to maintain the annual growth in consumer prices below 2%. As an export dependent economy, the ECB also has a vested interest in preventing against excess strength in its currency because this poses a risk to its export market.

Frequency of Meeting - Bi-weekly, but policy decisions are generally only made at meetings where there is an accompanying press conference, and those happen 11 times a year.

Key Policy Official - Jean-Claude Trichet, President of European Central Bank. Prior to succeeding Wim Duisenberg as ECB president in November 2003, Trichet was the president of Bank of France. He has a reputation for being a cautious and forthright banker, though many criticize his slow response to European economic stagnation and high unemployment. Typically seen as a hawk with a bias toward making preemptive moves to ward off inflation, Trichet has the huge responsibility of managing the monetary policy of 12 nations.

Bank of England (BoE)

Structure - The Monetary Policy Committee of the Bank of England is a nine-member committee consisting of a governor, two deputy governors, two executive directors and four outside experts. The BoE, under the leadership of Mervyn King, is frequently touted as one of the most effective central banks.

Mandate - To maintain monetary and financial stability. The BoE's monetary policy mandate is to keep prices stable and to maintain confidence in the currency. To accomplish this, the central bank has an inflation target of 2%. If prices breach that level, the central bank will look to curb inflation, while a level far below 2% will prompt the central bank to take measures to boost inflation.

Frequency of Meeting - Monthly

Key Policy Official - Mervyn A. King, Governor of the Bank of England. Prior to assuming the role of BoE governor on June 30, 2003, King was a professor at the London School of Economics. Initially joining the BoE in 1990, he became an executive director and chief economist in March 1991 and was promoted to deputy governor in 1997. King's "Goldilocks" monetary policy, which is neither too restrictive nor too accommodative, has propelled the U.K.'s economy into its longest streak of uninterrupted growth in 200 years.

Bank of Japan (BoJ)

Structure - The Bank of Japan's monetary policy committee consists of the BoJ governor, two deputy governors and six other members. Because Japan is very dependent on exports, the BoJ has an even more active interest than the ECB does in preventing an excessively strong currency. The central bank has been known to come into the open market to artificially weaken its currency by selling it against U.S. dollars and euros. The BoJ is also extremely vocal when it feels concerned about excess currency volatility and strength.

Mandate - To maintain price stability and to ensure stability of the financial system, which makes inflation the central bank's top focus.

Frequency of Meeting - Once or twice a month

Key Policy Official - Toshihiko Fukui, Governor of Bank of Japan. A lifelong bureaucrat, Fukui joined the bank of Japan in 1958 and held various posts before succeeding Masaru Hayami as governor on March 19, 2003. Although Fukui has a reputation for being conservative, he has implemented new policies geared toward greater transparency, such as publishing BoJ economic outlooks and detailed minutes of policy meetings. On March 9, 2006, he ended the five-year-old ultra-loose monetary policy and prepared for a return to conventional rate targeting.

Swiss National Bank (SNB)

Structure - The Swiss National Bank has a three-person committee that makes decisions on interest rates. Unlike most other central banks, the SNB determines the interest rate band rather than a specific target rate. Like Japan and the euro zone, Switzerland is also very export dependent, which means that the SNB also does not have an interest in seeing its currency become too strong. Therefore, its general bias is to be more conservative with rate hikes.

Mandate - To ensure price stability while taking the economic situation into account

Frequency of Meeting - Quarterly

Key Policy Official - Jean-Pierre Roth, Chairman of the Swiss National Bank. Roth has spent most of his professional career at the SNB, starting in 1979; he assumed the role of chairman of the governing board in 2001. Roth is also a member of the board of directors of the Bank for International Settlements and is governor of the International Monetary Fund.

Bank of Canada (BoC)

Structure - Monetary policy decisions within the Bank of Canada are made by a consensus vote by Governing Council, which consists of the Bank of Canada governor, the senior deputy governor and four deputy governors.

Mandate - Maintaining the integrity and value of the currency. The central bank has an inflation target that is currently set at 1-3%, and it has done a good job of keeping inflation within that band since 1998.

Frequency of Meeting - Eight times a year

Key Policy Official - David Dodge, Governor of the Bank of Canada. Princeton-educated Dodge held various public offices and taught at a few universities throughout the U.S. and Canada before taking office as the central bank governor in 2001. He is known for being frank and open about his beliefs, and has also been credited for carefully balancing inflation with currency appreciation.

Reserve Bank of Australia (RBA)

Structure - The Reserve Bank of Australia's monetary policy committee consists of the central bank governor, the deputy governor, the secretary to the treasurer and six independent members appointed by the government.

Mandate - To ensure stability of currency, maintenance of full employment and economic prosperity and welfare of the people of Australia. The central bank has an inflation target of 2-3% per year.

Frequency of Meeting - Eleven times a year, usually on the first Tuesday of each month (with the exception of January)

Key Policy Official - Ian Macfarlane, Governor of the Reserve Bank of Australia. Macfarlane has been with the RBA from 1979. Before becoming governor in 1996, he occupied a variety of positions at the RBA, from head of research to deputy governor. Considered to be an inflation hawk, Macfarlane has raised lending rates several times during his tenure, as the Australian economy - spurred by seemingly insatiable demand from China for a variety of commodities - is experiencing strong wage growth and a boom in capital spending that is creating capacity constraints throughout the economy.

Reserve Bank of New Zealand (RBNZ)

Structure - Unlike other central banks, decision-making power on monetary policy ultimately rests with the central bank governor.

Mandate - To maintain price stability and to avoid instability in output, interest rates and exchange rates. The RBNZ has an inflation target of 1.5%. It focuses hard on this target, because failure to meet it could result in the dismissal of the governor of the RBNZ.

Frequency of Meeting - Eight times a year

Key Policy Official - Alan Bollard, Governor of the Reserve Bank of New Zealand. Before his appointment as governor of the RBNZ in September 2002, Bollard served as secretary of the treasury, chairman of the NZ Commerce Commission and director of the NZ Institute of Economic Research. Known as a strong inflation hawk with extensive economic training, Bollard has condemned large current account deficits and raised New Zealand interest rates to a high level of 7.25%. (For further reading, see Current Account Deficits and Understanding The Current Account In The Balance Of Payments.)

Putting It All Together
Now that you know a little more about the structure, mandate and power players behind each of the major central banks, you are on your way to being able to better predict the moves these central banks may make. For many central banks, the inflation target is key. If inflation, which is generally measured by the consumer price index, is above the central bank's target, then you know that it will have a bias toward tighter monetary policy. By the same token, if inflation is far below the target, the central bank will be looking to loosen monetary policy. Combining the relative monetary policies of two central banks is a solid way to predict where a currency pair may be headed. If one central bank is raising interest rates while another is sticking to the status quo, the currency pair is expected to move in the direction of the interest rate spread (barring any unforeseen circumstances).

A perfect example is EUR/GBP in 2006. The euro broke out of its traditional range-trading mode to accelerate against the British pound. With consumer prices above the European Central Bank's 2% target, the ECB was clearly looking to raise rates a few more times. The Bank of England, on the other hand, had inflation slightly below its own target and its economy was just beginning to show signs of recovery, preventing it from making any changes to interest rates. In fact, throughout the first three months of 2006, the BoE was leaning more toward lowering interest rates than raising them. This led to a 200-pip rally in EUR/GBP, which is pretty big for a currency pair that rarely moves.

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