How to profit from central bank shenanigans

It's a race to the bottom for the world's central banks, with the European Central Bank cutting its main interest rate, following more monetary easing from the Bank of England and a rate cut from the People's Bank of China.

The most interesting bit from a spread better's point of view is the effect this has on a currency. Grasping that is one of the absolute basics of playing the currency markets.

Interest rates affect currencies perhaps more directly than any other factor. And the short-term impact is usually entirely predictable. If a bank such as the ECB lowers the main euro interest rate, the currency falls against other currencies or in forex parlance, it "weakens".

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Sure enough after this morning's interest rate cut to 0.75%, the euro fell around 0.5% against the US dollar. It also dropped against other currencies such as the Australian and New Zealand dollars. So anyone who was short say EUR/USD in anticipation would have made money.

Equally, moves to create more liquidity such as quantitative easing (QE) will tend to weaken a currency as, very broadly speaking, QE creates more of the currency in question which, as in any market, will tend to lower the price of it against other currencies.

The flipside of this is that other currencies strengthen. This can simply be by default currency markets are zero sum in the sense that one currency has to weaken or strengthen against another. But it can also be because a central bank has chosen to raise rates, albeit this isn't an obvious prospect for any of the major currencies at the moment.

Watch out for the indirect moves that can occur sometimes. For example the Aussie dollar got an extra fillip from the move by China as the forex markets decided that anything that might help the Chinese economy would also help the Aussies who sell a lot of commodities such as metals there.

What is slightly more difficult to call is what will happen to the euro next. There are two views (as there usually are in financial markets!). Some analysts see this move actually causing the euro to strengthen against other currencies such as the pound, as markets perceive that at last the Europeans are doing something to restore faith in Europe's battered economy. After weeks of largely fruitless summits, anything concrete may restore confidence is the logic.

However I don't buy that argument. Yes the ECB has "done something" but then again it needed to, and fast given the paralysis that seems to be infecting the politicians as well as the European economy.