Influence of Central Banks on the Capital Market
In the last blog posts we have reported on the topics of inflation, deflation and stagflation, which represent the different market phases. But there is another factor that strongly influences the markets, and that is the central banks. This is the topic we will cover in this article.
There is a well-known saying in the capital market
Never fight against the FED!
But what does this saying mean, what do central banks have to do with the capital market, and what is the Fed?
Let’s start from the beginning. A central bank is, so to speak, the state’s bank with the task of conducting monetary policy, which means printing money, taking money back from the market, monitoring inflation, and ensuring it does not get out of control.
We must understand the actions a central bank can take to understand why central banks influence the capital market.
Point number one: The key interest rate
The prime rate is the interest rate set by a central bank at which commercial banks can borrow or invest money with the central bank. And it is precisely this interest rate that strongly influences whether there is so-called cheap money or expensive money. We speak of cheap money when the prime rate is very low, and everyone pays very little interest for borrowing money.
Point number two: The quantitative easing
Quantitative easing means that central banks print money and buy government bonds with this money. As a result, money flows into the banking system and the state. This has the effect of lowering interest rates on loans, making it cheaper to borrow. This is intended to stimulate consumption and thus stimulate the economy.
The last point is Quantitative tightening
Quantitative tightening is the opposite of quantitative easing, so it is not intended to provide liquidity to the market but to withdraw liquidity. This is done by the central banks selling their bonds and thus taking the money out of the market. Quantitative tightening is a tool for central banks to reduce too high inflation.
And these are precisely the tools central banks can use to influence the capital market. When interest rates are low and quantitative easing is practiced, there is a lot of money in the market, which often flows into assets with higher risks such as shares, real estate, cryptocurrencies, and so on, which rise sharply in price. When central banks engage in quantitative tightening and raise the key interest rate, much money is taken out of the market, and most assets fall in price again. Here are other asset classes performing quite well like bonds. We will cover that topic in one of our next videos.
Every currency and/or country depends on a central bank. The Fed, or Federal Reserve, is the central bank of the United States of America. And due to the US as the main economy driver world wide, the Fed is the most important central bank worldwide. The European Central Bank or ECB is the central bank of the 19 European Union countries which have adopted the euro. And these are only two of many central banks.
As you can see, central banks significantly impact your investments and assets. That’s why it’s always important to generate a constant cash flow to be prepared for any market situation.