ECB Rate Decision - How does it impact the market?
The ECB interest rate decision is among the most keenly watched economic publications. Each year, it has the attention of investors, forex and index traders, and has opportunities for day traders, swing traders, or long-term traders. As the image above shows, current ECB rates are historically low, and some are even negative at the moment.
But how can we analyse, and trade, the rate decision's impact on the market?
In this article, we are going to look at what is the ECB rate, when it is announced, what is its impact on the financial markets and trading strategies with the key ECB rate
What is the ECB interest rate?
The ECB decision referred to here concerns the interest rates of the European Central Bank. These are the rates at which the Central Bank grants short-term credit to commercial banks within the European Union.
How does the ECB rate decision impact the market?
During most major economic announcements, such as the ECB rate decision, there are several significant ways that financial markets create opportunities to trade:
- Volatility is elevated: the EUR/USD can easily move by 100 points, and the DAX 30 can vary up to 300 points
- The spreads are wider: forex and index spreads are generally wider at the time of the of the ECB interest rate announcement
- Increased speculation: When economic events take place, the volume of trades increase, and are more volatile during the days leading up to the announcement from the European Central Bank
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What are the individual ECB rates?
The Central Bank has three key interest rates:
- ECB refinancing rate - The refinancing rate is the most important rate relevant to commercial banks. Generally, commercial bank refinancing options occur on a weekly basis. During these, the Central Bank determines the cost of the credit it makes available to commercial banks, based on the loan volumes.
- The discount rate, also called the marginal lending rate. This has a higher rate than refinancing, because it is intended for emergency cases. If a commercial bank needs to borrow capital quickly, the ECB discount rate comes into play.
- The rate of return on deposits. This rate represents the remuneration of the reserves that commercial banks deposit with the ECB.
These rates are a part of the instruments which central banks have for the regulation of the economy, and applying European monetary policy. The monetary policy of the ECB always pursues the same objectives, namely:
- Limit inflation
- Stimulate economic growth in the European Union
How does the ECB decide the rates?
In the case where a commercial bank obtains refinancing from the European Central Bank as mentioned above, this commercial bank can then, thanks to the low refinancing rate, lend money in the form of credit to businesses and individuals.
The intended effect of this is to promote growth within the eurozone, and in the economic activity of the nations of the European Union.
It is also possible that the European Central Bank may decide to raise the rates in order to limit demand for liquidity from banks, and keep inflation under control. If the demand for liquidity from commercial banks is too high, it can increase inflation. The central bank therefore uses cuts and increases in the ECB rates to maintain a satisfactory level of inflation, and allow the growth of the various economies of the European Union.
A fall in key rates very often gives rise to violent movements in forex and stock markets.
Any change in the ECB interest rates bring in a large number of investors. The goal in lowering key interest rates is to revive economic activity.
The subprime loan crisis in the United States gave way to a fall in the Fed's interest rates in the United States, and also the ECB in Europe. These declines resulted in a sharp rise in the euro/dollar pair. The ECB refinancing rate fell from 4.25% in October 2008 to 1.25% in April 2009.
When is the ECB rate decision announced?
For fundamental and swing traders, ECB announcements are closely followed. The ECB has a huge influence on the direction of both forex and stock markets.
The ECB rate decisions are published once a month, on the first Thursday of the month at 1:45 p.m., Paris time. The publication of the key rate is always followed by a press conference at the end of the meeting. This conference also brings great interest for investors, forex traders, and index traders. In addition to the outcome of the ECB decision, the president of the European central bank, Mario Draghi, speaks on the evolution of ECB interest rates.
It's influence is so significant that some traders only trade during ECB announcements or major economic publications. This type of strategy is used only by traders who have a lot of experience and a well-developed trading plan, as well as a very well established strategy.
Effect of ECB and Fed announcements
We would all be very wealthy if the effect of raising or lowering rates was predictable every time. In reality, there are many factors which determine the way that the market shifts after the ECB announces its rate decision.
If the announcement is in agreement with the consensus, as being in line with the expectations and projections of market participants, there is a moderate swing in the expected direction. Some markets can revive, or completely change trends within Forex instruments upon the confirmation of the expectations of traders.
If the announcement is at odds with the consensus, strong reactions generally occur, and involves large and sometimes rapid movements in the stock markets. The strength of the reaction depends on the gravity of the difference between the results of the ECB announcement, and previously held expectations.
The ECB announcement effect can be fast and confusing, and it is not unusual to observe large price swings occurring very quickly before seeing an stabilisation in the direction that the currency will likely settle on for the next few hours or days.
How the ECB rate announcement impacts the Forex market
The forex market is very reactive to major economic events. The publication of the ECB rate decision is one of these is one of the most significant of these. Thus, it is necessary to understand the forces at play between the ECB rates and the movement of currency market present on the forex market.
In a growing economy, interest rates tend to go up because rising rates favor the country's currency. The logic behind this mechanism is that if the country is growing, investors import their capital there, which influences the rise of the local currency.
On the other hand, if there is too much inflation, investors tend to withdraw to find a better investment because they fear a fall in the interest rate. This happening would influence the exchange rate of the Euro through any of the forex currency pairs that involve the subject currency.
The purpose of keeping rates low, done by lowering the ECB's rates, is to stimulate and revive the growth of a country's economy. This is exactly what happened following the 2008 financial crisis in the United States, as another example.
Effect of the ECB rate announcement on the stock market
The volatility that stock market indices feel during major economic announcements is significant, and gives rise to numerous trading opportunities. The effect of the publication of the ECB rates directly influences the choices of the investors involved in the companies which make up the stock indexes. We should also not forget that the European central bank's rate decisions reflect the state of the eurozone's economy, which is taken into account by foreign investors when making decisions on significant investments in Europe.
Thus, the indices are very reactive to the ECB rates, and make it possible for traders to take advantage of opportunities following their announcement.
Whether in the very short term, short term, medium, or long term, it is possible to trade stock indexes in the context of changes in key rates in order to diversify your portfolio and take advantage of their unique opportunities. Admiral Markets has some of the smallest spreads on the stock market indices, as well as having no commission on this asset class.
Carry trade strategy for the ECB interest rate decision
The carry trade strategy is used by professional as well as individual traders, because it is such a simple and effective trading strategy.
This strategy is based on the market conditions which link an ECB interest rate to a currency.
If the ECB interest rate associated with a currency is low, investing in the currency in question is not very profitable. If the interest rate associated with a currency is high, investing in the currency in question becomes attractive.
Let's take an example:
A trader buys a currency that has a high interest rate. At the same time, they short sell a currency which has a very low interest rate, and which yields almost nothing.
Imagine that the Australian dollar carries a rate of 5%, while the Japanese yen carries a rate of 0%. In this case, the trader who uses the carry trade strategy decides to buy the Australian dollar against the Japanese yen, in order to benefit from its appreciation. The rise of the Australian dollar is facilitated by the remuneration associated with each currency of the trade.
There is a famous example that occurred with the NZD/JPY pair. In 2005, New Zealand had a strong demand for raw materials from China, and the interest rate was 7.5% at this time. Carry traders could therefore buy the NZD/JPY at this precise moment, since the Japanese interest rate is 0%.
The operation theoretically yields 7.5% per year under these conditions, if the exchange rate remains stable over time.
One of the reasons to close a position within a carry trade strategy, is when the spread between the respective interest rates of the two currencies included in the trade begins to narrow.
Swing traders, and traders who employ a fundamental style of trading, scrutinize opportunities such as the publication of the ECB rates. Each major economic publication allows these kinds of traders to adjust their strategy in response to events which influence the forex and stock markets. Thus, they take a position for several days, or weeks in the case of the swing trader, or up to several months or even years for the fundamental trader.
Day trading strategy for ECB rate announcement
This strategy is used by traders who have some experience in the forex market. The quick reaction time necessary, as well as the capital with which a trader requires in order to trade this type of economic event, are important.
The concept behind day trading the ECB interest rate decision is to benefit from large movements in the forex market in a very short time. This strategy requires waiting a few minutes after the publication of the rates, in order to let the forex market fluctuate violently, before identifying the trend that the instrument is to follow.
Having to wait a short time after publication is essential, in order to minimise the risk involved in the trade. During major publications such as the ECB interest rate announcement, the forex market often faces substantial volatility, which can have serious consequences not just for your risk management, but also for your underlying capital. Also remember that spreads tend to widen at the time of these announcements.
All these factors must be kept in mind in order to benefit from the strategy in the long-term.
Finally, it should be kept in mind that volatile markets tend to show many false signals, so patience pays off when taking advantage of the movement following the publication.
Here are some examples:
Euro dollar in a 15 minute time frame: The red arrow locates the exact time of the publication of the ECB rate decision of June 08, 2017. As you can see, the candlestick representing the ECB announcement has a very large wick towards the high, against the trend of the previous one, as represented by the moving average 20 and 50 downwards. Several traders have taken an upward position here, without any success. Shortly after the ECB meeting (magenta arrow), the previous trend continued for the rest of the day.
DAX 30 in a 1 minute time frame: The first vertical line identifies the exact time of publication of the ECB interest rates of April 27, 2017. As you can see, just after the ECB announcement, traders had to wait a few minutes to be able to see an upward push in the German index followed by a period of consolidation pending the ECB press conference 45 minutes later.
Trading the ECB rate decision - Conclusion
By the end of this article, we hope you better understand how significant the ECB rate decision is, as well as how traders take advantage of the trading opportunities derived from this important economic event.
Whatever your trading style, and if you want to try your hand at trading economic news and the ECB rate decisions, Admiral Markets provides you with free and unlimited demo accounts in order to trade risk-free, discover for yourself if trading the key ECB rate is for you.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.