Understanding the Effects of Quantitative Easing on Currency Markets

Quantitative easing (QE) is an approach taken by central banks such as the Federal Reserve and the European Central Bank during economic slowdown or during times of financial crisis in stimulating the economy. Here, it involves the act of a central bank buying long-term securities like government bonds to add liquidity into the financial system. Although the major objective of QE is to stimulate lending and investment within the domestic economy, it does spill out, and Forex trading is at its core.

In simple words, QE aims to lower interest rates and increase money supply. Whenever the central bank buys assets like government bonds, it enhances the floating money in the market. The long term interest rates go low which encourages borrowing and investment. These actions from the central banks often affect the Forex traders’ accounts immediately as currency values start fluctuating.

Image Source: Pixabay

When a central bank is implementing QE in a country, the currency often goes down. This is due to the reason that increased money supply might debase a currency. If the traders feel that a central bank is proactively devaluing its currency to fuel economic activity, they would shift away from that currency, and therefore, its exchange rate might decline. For instance, if the Fed is practicing QE, then the US dollar is likely to decline with the other currencies. This causes it to be cheaper or more attractive to exportation. As a result, the trade balance of such a country will improve; however, for Forex traders, this is a depreciated currency, which again entails risk and opportunity.

One of the direct consequences of QE in the Forex market is that it could be very volatile. With a central bank’s intention or decision to expand a QE program, traders have traditionally reacted by shifting their positions depending on their expectations regarding the future monetary policy of a country. This reaction causes a quick shift in currency prices as traders try to guess the next move of central banks. For example, when the European Central Bank rolled out QE in 2015, it simply made the euro drop sharply against other currencies, therefore becoming a challenge and, at the same time, an opportunity in Forex trading.

While, on the other hand, QE effects are not at all simple. It always seems that a currency is going to fall when it announces QE, but then it doesn’t happen sometimes. The general strength of the world economy or any other geopolitical event can be a determinant of how the currency reacts. Sometimes, if a country is viewed as doing QE while other large economies are not, the currency of that country even appreciates.

The most important lesson for Forex traders would be that QE adds another dimension of complexity to the markets. Decisions made by the central banks are not limited to their domestic economies alone but also affect the landscape of global currencies. Forecasts of the likely reactions of the markets to these policy changes can help the Forex traders navigate the uncertainty of such policy shifts more effectively. Whether in crisis or recovery times, the impact of QE is something traders must always be aware of in their strategies.