Tight vs loose monetary policy: How to trade central bank shifts

Central bank policy shifts can have a significant impact on the markets. In this article, we explain the difference between tight and loose monetary policy and how you can trade these market conditions. Learn to trade with an understanding of how the decisions of central banks can affect the markets.

What is monetary policy and why is it important?

Monetary policy refers to the activity of central banks, such as the Federal Reserve (Fed) in the US and the Bank of England (BOE) in the UK, in managing the national economy. Central bank policies affect money supply and contribute towards achieving macroeconomic objectives, such as limiting inflation and encouraging economic growth.

These macroeconomic objectives and indicators have significant bearing on the performance of all sorts of securities. Markets often respond as soon as a policy is announced, or even suggested, so investors need to keep a close eye on central bank messaging.

The outcomes are often discussed by the Federal Open Market Committee (FOMC), which is the monetary policy-making branch of the Fed.

What monetary policy tools do central banks use?

Some of the tools central banks have at their disposal include:

Lowering/raising interest rates. Central banks determine the rate at which banks lend money, known in the US as the discount rate and in the UK as the base rate or bank rate.
Quantitative easing. As a form of monetary policy, central banks use this to inject money into an economy to encourage lending/investing by purchasing securities from the markets.
Yield curve control. Relatively short-term high bond yields typically indicate an upcoming recession, so central banks seek to keep bond yields low. Since bond yields are inversely related to price, central banks control bond yields by purchasing government or treasury bonds, increasing demand (price) and reducing yield.
Currency floors/ceilings. A currency band involves a price floor and a price ceiling, between which the currency can fluctuate freely. Beyond these limits the price switches to a fixed exchange rate.
Buying stocks/exchange traded funds (ETFs). Some central banks, notably the Bank of Japan (BOJ), have taken an active role in purchasing equities from the stock markets. The BOJ had used this novel policy tool in an effort to end deflationary pressures, which helped to contribute to a period of economic expansion following the Great Recession in Japan.
Macroprudential tools. The Reserve Bank of New Zealand is an example of a central bank that has deployed macroprudential policy tools “to reduce the likelihood of a financial crisis”. These include capital and liquidity instruments, such as countercyclical capital buffers, sectoral capital requirements, core funding ratios and transactional instruments including loan-to-value restrictions.
Reserve requirements. A conventional approach to monetary policy is to increase (tighten) or decrease (loosen) the reserves banks are required to hold to cover sudden demands on their liquidity.
Forward guidance. Central banks issue forward guidance about the state of the economy and expected interest rate targets. Verbal intervention & jawboning, such as the “whatever it takes” speech by European Central Bank (ECB) president Mario Draghi that effectively ended the Euro-zone crisis, can have a large impact on the markets.

What is tight monetary policy?

With tight (or contractionary) monetary policy, central banks adopt one or more measures aimed at slowing the money supply, usually in order to limit inflation. These measures can include raising interest rates and reserve requirements for banks, which discourages them from borrowing and incentivises them to lend less. This limits the supply of credit to individuals and businesses in the wider economy, meaning that businesses will invest less in equipment and hiring new staff.

This will typically reduce the price of securities, such as stocks, because investors will be less optimistic about companies’ future expansion prospects. There is, however, often a long lag time between contractionary policies being implemented and equities peaking. High interest rates have a strong negative impact on bond prices, as investors seek higher yields. Property and commodity markets tend to suffer under tight monetary policies, but a central bank’s national currency usually rises.

What is loose monetary policy?

Loose (or expansionary) monetary policy seeks to stimulate economic activity in order to deter economic downturns, such as recessions. Conventionally, it involves reducing factors such as short-term interest rates and reserve requirements for banks, encouraging bank lending to consumers and businesses. However, in exceptional circumstances it can also involve measures like quantitative easing, where new money is effectively created by the central bank and injected into the financial system by purchasing government bonds.

The extra cash in the system increases consumers’ spending and businesses’ expansion, as loans are cheaper. This has a beneficial impact on stock markets, as well as property markets (given the greater availability of mortgages) and commodities (as raw materials are in greater demand). Low interest rates decrease bond yields, discouraging cash and savings. Though the relationship is complex, national currencies will typically depreciate relative to their peers when the central bank adopts a looser approach.

Doves vs hawks

Monetary doves prioritise minimising unemployment and related indicators, therefore, favouring loose approaches. A dovish stance believes that stimulating economic growth has few negative effects.

Hawks, by contrast, believe monetary policy should focus on minimising economic indicators such as inflation, and therefore advocate restrictive policies. A hawkish view sees the risk of inflation as a threat to the overall economy, and believes stability is gained by keeping economies below maximum employment rates.

Many economists, for example Alan Greenspan, former chair of the Fed, have alternated between hawkish and dovish views. Investors can capitalise on these changes in central bank monetary policy by buying securities expected to benefit from new policies early.

What trading opportunities does changing monetary policy present?

Bonds and equities tend to be cheaper at the end of a period of contractionary policy. When a central bank announces a shift to more expansionary measures, the securities are highly likely to rise in the future. In this situation, investors may choose to take a long position in these asset classes.

The same holds true in reverse: investors or traders can go short on an equity if the expectation is that its value will fall, or invest in the national currency (i.e. increase savings), when central banks announce a policy of raising interest rates.

Trade on monetary policy changes

Examples of big market moves driven by changing monetary policy

Coronavirus pandemic 2020

The Covid-19 pandemic lockdowns crippled global economies. The US unemployment rate increased by 10.3% to a record 14.7% in April 2020. In response, the Fed began an aggressive $700bn round of quantitative easing to keep the economy from collapsing. This fuelled a bull market which saw the S&P 500 gain over 60% and the Nasdaq more than 80% in the 14 months following the programme’s announcement.

Taper tantrum 2013

Fed chair Ben Bernanke caused turmoil in 2013 when he announced that the central bank would at some point reduce its bond purchasing levels, and even sell bonds back to the market. This proposed slump in bond demand – despite the fact that it never materialised – crashed bond prices as holders pre-empted a price fall. This sent the US 10-year treasury bond yields up 36% between 3 May 2012 and 5 August 2013.

Draghi’s “whatever it takes” 2012

On 26 July 2012, ECB president Mario Draghi effectively reversed the Euro-zone crisis by asserting the bank would “do whatever it takes to preserve the euro”. A week later, Draghi proposed an outright monetary transactions scheme allowing the ECB to purchase unlimited amounts of distressed nations’ bonds. However, the scheme was never required thanks to the positive investor response to Draghi’s reassurance. From its bottom in July 2012 to the opening week of January 2013, the Stoxx Europe 600 Index gained 14%.

Abenomics 2012

Notorious dove Shinzo Abe’s return as prime minister of Japan in 2012 followed a prolonged period of stagflation, which was referred to as Japan’s “lost decade.” Abe implemented “three arrows” of monetary, fiscal and corporate governance policy aimed at reversing the decline. The monetary arrow involved printing ¥60-70trn to increase export competitiveness and to generate inflation of around 2%. The policies were partly successful, although faced setbacks because of factors such as Japan’s aging population. Between November 2012 and September 2018, the Nikkei 225 gained 155%.

Financial Crisis 2007-2008

The Fed’s previous quantitative easing programmes, also referred to as QE1, QE2 and QE3, prompted the longest bull market in US history. After the Financial Crisis of 2007-2008 crippled the US housing market, the Fed’s chairman, Ben Bernanke, triggered a programme of buying tens of billions of dollars monthly of mortgage-backed securities. The reduced debt and extra spending power this afforded US banks ushered in the longest bull market in US history. The S&P 500 gained 223.9% throughout the 11-year run from the end of March in 2009 to the same period in 2020.

Post-2000

Following the bursting of the dotcom bubble, Alan Greenspan, the Fed chair at the time, advocated for lower interest rates. The Fed funds rate was lowered from 3.5% to 1.13%. These loose monetary policies contributed to a bull run that lasted between October 2002 and October 2007, during which the S&P 500 gained 75%, but which also led to the global financial crisis.

Dotcom bubble 2000

Loose Fed policies, such as low interest rates, were a factor that drove up the value of technology stocks in the 1990s, leading to the dotcom bubble. The Fed’s Greenspan is said to have fuelled the economic bubble at the time by putting a positive spin on stock valuations. The Nasdaq Composite gained 228.5% between 1995 and 2000, when the bubble finally burst.

Reaganomics 1980s

President Ronald Reagan and Fed chair Paul Volcker responded to a period of stagflation (slow economic growth alongside rising inflation) in the 1980s with a mix of liberal economic and tight monetary policies which, combined, sent the S&P 500 on one of its most dramatic bull runs. Between the announcement of more restrictive monetary policy in February 1982 to “Black Monday” in October 1987, the S&P 500 gained over 180%.

Five key points for trading monetary policy shifts

By keeping a close eye on the tone and policy changes of central banks, a trader can try to make timely investments using the following guidelines:

Commodities typically respond positively to economic growth, making them potentially a good investment during, or just before, periods of loose monetary policy.
A nation’s currency tends to strengthen while its central bank pursues restrictive approaches and weaken when its central bank adopts more expansionary monetary policies.
Equities (stocks and shares) tend to rise at the beginning of a period of loose monetary policy, as low interest rates should see their value and dividends increase over time.
Cash or savings tend to better hold their value ahead of, or during periods of, tight monetary policy.
Real estate and related securities, such as real estate ETFs tend to be supported during or before periods of expansionary monetary policy, when low interest rates encourage mortgage lending and house buying.

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FAQ

What are the most influential central banks?

Perhaps the most well-known central bank in the world is the Federal Reserve, which involves FOMC meetings. Meanwhile, the European Central Bank is highly influential given its remit covers the entirety of the Euro-zone, as well as the Bank of England, which is the UK’s central bank and has been influential given London’s role as a financial centre. The Bank of Japan has also historically been one of the most innovative central banks.

Can you front run tightening/loosening monetary policy?

When central banks begin buying securities, such as equities or ETFs, it can be difficult for them to stop doing so without causing disruption to the markets. Investors can, therefore, invest in the same securities central banks are buying in the expectation that it will continue to buy these, and apply upward pressure on them, effectively front-running the bank. The same applies, theoretically, in reverse, although for the reasons above central banks don’t tend to completely scale back purchasing programs. Therefore, tightening monetary policy is harder to front run. Read more about market manipulation strategies.

What is the difference between monetary and fiscal policy?

Monetary policy refers to the actions of central banks, which are put in place to encourage economic growth and money supply and can have an effect on all financial markets. On the other hand, fiscal policy refers to governmental decisions, which are often concerning tax rates and government spending.

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