How Quantitative Easing Affects Your Forex Trades

How Quantitative Easing Affects Your Forex Trades

Quantitative easing (QE) is a powerful monetary policy tool used by central banks to stimulate the economy by increasing the money supply (yes, really!). While the main aim is to boost economic activity, QE also significantly impacts the Forex market. By better understanding the mechanics of QE, traders are empowered to make more informed decisions and optimise their strategies. Let’s unpack all the dynamics at play.

What is Quantitative Easing?
Quantitative Easing is when a central bank buys a lot of financial products, such as government loans and home loans, to put more money into the economy. This increases the amount of money available in banks, lowers interest rates, and encourages people and businesses to borrow and invest. By doing this, central banks aim to prevent falling prices (deflation) and support economic growth, especially during tough economic times.

In Africa, the use of QE depends on the country's economic structure, financial market development, and the specific challenges faced by the economy. For some African countries, QE can help address economic slowdowns and promote growth, but it requires careful management to avoid potential risks like inflation or currency depreciation.

Now, let’s explore the 4 main ways in which QE affects the Forex market.

1. QE is known to increase money supply and currency depreciation

When a central bank implements QE, it injects more money into the economy, effectively increasing the supply of the currency.

The impact
An increased money supply typically leads to the depreciation of the currency. As the currency's value drops, it becomes cheaper relative to other currencies, influencing Forex traders to adjust their positions.

2. QE can lower interest rates QE lowers long-term interest rates, making borrowing cheaper for businesses and consumers.

The impact
Lower interest rates reduce the return on investments denominated in that currency, leading to a decline in demand. Forex traders often move their capital to currencies with higher interest rates, resulting in further depreciation of the QE-affected currency.

3. QE could lead to higher inflation expectations

QE is designed to increase inflation to a healthy level, aligning with central bank targets.

The impact
Higher inflation expectations can lead to a weaker currency. Forex traders anticipate this and may sell off the currency in anticipation of future depreciation.

4. QE can influence investor sentiment and risk appetite

QE can boost investor confidence by signalling that the central bank is taking measures to support the economy.

The impact
Positive investor sentiment can lead to higher demand for riskier assets, including foreign currencies. Forex traders might engage in carry trades, borrowing in low- interest-rate currencies and investing in higher-yielding currencies.

What traders need to look for during periods of QE

Key Currency Pairs
During periods of QE, traders should keep an eye on currency pairs involving the currency of the country implementing QE. For instance, if the European Central Bank (ECB) announces QE, EUR/USD becomes a critical pair to watch.

It's also vital to monitor pairs where the counter-currency is from a country with relatively higher interest rates, as these pairs are likely to show significant movement.

Adjusting Trading Strategies
Traders might choose to adopt what we call ‘trend-following strategies’ to make the most of prolonged currency depreciation due to QE.

Also, through ‘carry trades’, traders can borrow money in a country with low interest rates (due to QE) and invest it in a country with higher interest rates to make a profit.

Risk Management
QE can lead to increased volatility in the Forex market. As always, it’s essential to manage risks to avoid big losses. This includes setting limits on how much to lose in a trade (stop-loss orders), not putting all your capital in one type of trade (diversifying), and keeping an eye on market news to stay informed about potential changes.

Keep your finger on the pulse
Staying informed about the latest central bank announcements and economic indicators is crucial for evert trader. Take care to follow news about QE policies, inflation data, and interest rate decisions to make timely and informed trading decisions.