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Instead of Japan, the G7 focused its attention on everyone's favorite easy target, China, calling on that country to increase the flexibility of its currency. This only serves to highlight the impotence of the G7; China manipulates its currency, and everyone knows it, yet the G7 is powerless to stop it.

China and Japan are in completely different situations. The Bank of Japan hasn't directly intervened in the currency markets since early 2004, as it does on occasions when it believes the Yen is too strong. Sure, the Europeans and others are crying about the weak Yen, but what do they expect Japan to do about it? Do they want Japan to interfere with free and open markets? Unlike the Chinese Yuan, the Yen is not weak because of a government policy. The Japanese Yen is weak because the market says it should be weak. Perhaps Trichet and other officials would disagree, but good traders know better than to argue with the currency market. The market is always right, only we have the capacity to be wrong.

A Tale of Two Banks
On Thursday, February 8th, two major central banks decided to hold the line on interest rates. The two underlying currencies reacted in very different ways; the currency of one country fell, while the other rose. Why did this happen, and how could Forex traders benefit from this information?

First, at 7:00 am New York time, the Bank of England (BoE), which determines the interest rate policy for the United Kingdom, held rates steady at 5.25%. The British Pound responded by falling nearly 100 pips vs. the U.S. Dollar over the next hour (see figure 3).

Figure 3: GBP/USD tumbles after Bank of England rate decision. Source: Saxobank.com

When the European Central Bank also decided not to raise rates just forty-five minutes later, the Euro strengthened anyway. Euro climbed to the upper end of its recent range vs. the U.S. dollar, to the area near 1.3040 (see figure 4).

Figure 4: EUR/USD rallies after Trichet speech. Source: Saxobank.com.

Why did two similar decisions result in two very different reactions? The answer lies in the expectations of traders. The Bank of England offers little forward guidance regarding its decision making process, and last month the central bank shocked the currency markets by unexpectedly raising rates to 5.25%. Since the BoE speaks softly and carries a big stick, some traders undoubtedly had placed bets that the U.K. central bank would raise rates once again last week. When these expectations were not met, the British currency suffered.

While some traders clearly anticipated another move from the Bank of England, no such expectation existed for the European Central Bank. This is because of Jean-Claude Trichet's skillful management of expectations; Trichet sends clear signals regarding future rate hikes. While the Euro didn't rise immediately after the decision, it rocketed higher when Trichet gave a speech less than an hour later.

What did the European Central Bank (ECB) President say to excite the markets and propel the Euro? Trichet's comment that the ECB would remain "strongly vigilant" against inflation was taken as a clear signal that a rate hike would come soon, probably at the next policy meeting in March. "Vigilant" has become a sort of code word that is used to signal the ECB's intention to raise rates, and if that word had not appeared in Trichet's speech, the Euro most likely would not have rallied.

Now that Trichet has given the signal, a rate hike at next month's meeting is considered a done deal. The focus will now shift to the speech that will follow that decision – a speech that will signal the ECB's next move. At that time, the Euro will move based not just on the rate decision itself, but on the future expectations as signaled by Trichet during his subsequent speech.