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Fundamental analysis guide

Monetary Policy

Understanding a currency's strength extends beyond inflation and interest rates. While these metrics are crucial for assessing asset strength, they are influenced by a larger factor—the actions of central banks such as the Federal Reserve in the US, the European Central Bank in Europe, or the Bank of Japan in Japan, and others globally. Central banks play a pivotal role in shaping investors' perceptions of the present and future value of currency, both domestically and in comparison to other nations. By the end of this lesson, you'll gain insight into monetary policy and comprehend the underlying motives driving central bank actions.

What is Monetary Policy?

To put simply, monetary policy is the way a federal bank directs money supply, demand, debt, and reserve ratios. Monetary policy is planned through a series of meetings throughout the year. At every meeting, members of these committees discuss the overall state of the economy and what they plan to do going forward. Depending on the economy, the committee will determine to either be more or less focused on a currency’s strength or the economy’s strength.

Money Supply



Reserve Ratios

What does it mean if the fed is “hawkish” or “dovish”?

Here are the key differences between a hawkish and dovish central bank:

What is "Hawkishness"?

Hawkishness is when a central bank becomes more focused on strengthening their country’s tender. In periods of expansion, a central bank will be more encouraged to take a hawkish stance on their currency. This is done through the manipulation of interest rates and money supply. Although money supply is done by the treasury system in the US, the Fed can still influence the printing of money to help stimulate the economy. If a central bank wanted to raise interest rates, this would make borrowing costs higher, mortgage rates higher, decrease consumer spending, and cause what is called an economic contraction. Although this might seem counterintuitive on the surface, it’s meant to help the economy in the long term as it brings more value to the nation’s dollar by bringing inflation down. In the US, the Federal Reserve is in the middle of an unwinding process which entails bringing interest rates higher to battle an concerningly high inflation rate caused by economic stimulus during the 2020 pandemic. In the short term, hiking interest rates will cause some sort of economic slowdown, but it is intended to keep the economy from collapsing in the long run. After all, high inflation is one thing that will destroy a nation’s domestic GDP and hurt international trade. There are times for both expansion and contraction which is why monetary policy is a countercyclical process. It’s all a balancing act to maintain a healthy equilibrium between a nation’s economic strength and dollar demand.
Figure 1: The Monetary Policy Cycle

What is "Dovishness"?

On the other end of the cycle, expansionary policy is when a central bank becomes more dovish. In a dovish environment, interest rates are low or in the process of lowering to help the economy grow. Companies will usually thrive in dovish periods, overall spending will increase, mortgage rates will be lower, and more money will flow through the economy. In 2020, interest rates were near zero percent, and the economy/stock market flourished on bounteous tender fueled by the Fed. During this period, there were low rates of interest and mortgage, consumer spending was higher, and the economy experienced a period of expansion. This was done to prevent a temporary economic collapse. In other words, the US experienced an unprecedented contraction which prompted the Fed to act in a dovish manner.

Monetary Policy Key Takeaways

Central banks influence the strength of a nation’s currency
Monetary policy is a countercyclical process
Hawkishness is when a central bank becomes more focused on currency strength
Dovishness is when a central bank becomes more focused on economic strength
Central bank projections of interest rates and inflation are essential in fundamental trading
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    Sentiment analysis is fundamental in trading analytics. Most investors look to others to see what they’re investing in before they start investing.

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    Geopolitical Events
    Geopolitical risks are factors that can affect the way nations interact with each other. These sorts of conflicts influence market sentiment or even a nation’s GDP. Depending on the type of conflict, certain markets can either suffer or prosper.

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    Seasonality Trends
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There is a significant degree of risk involved in trading securities. With respect to foreign exchange trading, there is considerable risk exposure, including but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or currency pair. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when trading in CFDs. You should consider whether you can afford to take the high risk of losing your money.
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