Just a few days ago, the FOMC meeting minutes rocked the markets as Fed officials hinted that they might taper off their ongoing asset purchases. A week before that, BOE Governor Mervyn King's speech about the British central bank's willingness to implement further asset purchases resulted in a massive pound selloff. Why are asset purchases such a big deal?
When central banks conduct asset purchases, they are simply buying government bonds from banks in exchange for cash. In effect, banks end up with more money to lend to businesses and consumers. This results to easier lending conditions and increased money supply in the economy.
Asset purchases are also referred to as quantitative easing efforts or bond buyback programs. In buying back bonds from the market, the central bank is also able to reduce the supply of government bonds in the economy.
According to the Law of Supply and Demand, decreasing asset supply translates to an increase in that asset's price. Bond prices are inversely correlated to bond yields, as discussed in the 411 on Bonds lesson in our School of Pipsology, so rising bond prices leads to lower bond yields. With declining bond yields, banks and creditors are able to demand less returns on the funds they lend, eventually driving overall interest rates down.
Central banks usually implement asset purchases or increase their ongoing asset purchase programs when economic performance is weak. The combination of increased money supply and lower interest rates encourages borrowing and spending, which stimulates economic activity.
On the other hand, central banks decide to reduce or end their asset purchases when they think that the economy is already performing well. In this case, policymakers believe that economic growth will continue even without stimulus.
Central bank officials can also reverse their asset purchase programs by selling government bonds back to the market. By doing so, they are able to reduce money supply as banks will have to pay cash in exchange for holding these bonds. On top of that, overall interest rates climb as the increased supply of bonds in the economy drives bond yields up. Higher interest rates lead to tighter lending conditions, which dampen borrowing and spending.
Since asset purchases pretty much dictate money supply and interest rates, currencies usually react strongly when their respective central banks announce an expansion or withdrawal of these quantitative easing programs.
Increasing asset purchases or expectations of such typically result in a weaker currency as more money in circulation and lower interest rates reduce its value. Meanwhile, decreasing asset purchases or the central bank's intention to do so can lead to a stronger currency since less money in the economy and higher returns boost its value.
Now that you know how asset purchases affect economies and currencies, you should have an easier time figuring out how to make pips from interest rate decisions, policymakers' speeches, central banks' monetary policy meeting minutes. Do you plan on trading these events?