Central banks and interest rates

This lesson explains why a central bank decision moves currencies, bonds and equity valuations, and how to tell new information apart from what the market had already priced in. It is for a trader who wants a rule for decision days and wants to understand the bank’s statement, not for someone looking for a rate forecast for the coming year.

The policy rate as a reference point

The policy rate is the price of money at the central bank. It does not act on the market directly, only through linked rates: money market rates, loan pricing, bond yields and the cost of corporate funding all stem from it. When that reference point moves, every valuation that contains a discount rate moves with it — including equity valuations, especially for companies whose profits lie far in the future.

Two practical consequences follow. First, today’s decision is only one element of a longer story. Second, the market trades expectations about the future path of rates, not their current value. I discuss that difference in the lesson Macro data and the economic calendar as well — there the focus is macro surprises, here it is specific institutions.

Which central banks are worth following

It is worth separating two layers. The first is the rate decision — usually in line with expectations and not very informative on its own. The second is the statement and the press conference, where the assessment of inflation and growth prospects appears. In practice the second layer moves valuations harder than the rate change itself, because it changes the expected path, and the reaction shows up first in the spread and in the cost of entry. Bank projections and the distribution of members’ expectations are useful supporting material, but treat them as a statement about today, not a commitment.

The priced-in move versus the surprise

This is the most important distinction in the lesson. A priced-in move is the rate change the market has already reflected in prices before the decision. The surprise is the part of the decision the market did not expect. If the bank does exactly what was priced in, the information is already in the price — and often nothing happens beyond noise.

Supporting definitions. All parameters are illustrative figures:

expected_change_bp = base_rate − market_implied_rate   (in basis points)
surprise_bp        = actual_change − expected_change_bp
relative_surprise  = surprise_bp / |expected_change_bp|
curve_slope        = long_term_yield − short_term_yield

The first formula shows where to get the pricing: not from a headline, but from instruments whose price reflects market expectations — interest rate futures or short-dated bond yields. The second tells you how much of the decision is new. The third brings the surprise onto a common scale so you can compare a decision where a move was expected with one where nothing was expected.

Record rate changes in basis points, because two languages circulate around decisions: the bank quotes basis points while the media describe the change as a percentage. One basis point is 0.01 of a percentage point — mixing the units up changes the meaning of a sentence.

What the yield curve says

The yield curve is a chart of bond yields for increasing maturities from the same issuer. Its shape describes the market’s expectations for rates and growth:

An inverted curve is a widely watched signal, but it is neither a precise clock nor a guarantee of recession. Read it as a warning that the distribution of probabilities has shifted, not as an announcement of an event on a specific date.

Protocol for analysing a central bank decision

1. Write down the date and the institution in your local time. The decision date is in the bank’s calendar, not in a comment. Check it at the source before the week in which you plan a position.
2. Establish what is priced in. Find the rate implied by the market from futures or short-dated bond yields. Record the result in basis points, with the date and time of the reading — pricing changes from hour to hour.
3. Write down the consensus for the decision. Compare it with the market pricing. If they differ, the market itself is not agreed on direction — in that case the surprise can be large regardless of what the bank decides.
4. Prepare two scenarios before the decision. One for a decision in line with pricing and one for a surprise. For each, write down what happens to your position: do you stay in, or exit before publication. The rule is written before the session, not during it.
5. Calculate the surprise after the decision. Apply the basis point formula and record the result. That is the new information you will later compare with the price reaction.
6. Check the statement and the curve, not just the headline. A move at the short end of the curve speaks about the rate itself, while a move at the long end speaks about expectations for the future. The difference between the two is often larger than the rate change.

Steps one to four happen before the decision and steps five and six after it. Without the second stage you do not know whether a surprise actually occurred.

A worked example with illustrative numbers

Before the decision the market prices the base rate at 4.50 per cent, and the bank delivers 4.75 per cent. The actual change is 25 basis points and the expected change is 0. So the surprise is 25 − 0 = 25 basis points. In this case, when the expected move is zero, do not calculate a relative surprise — dividing by zero makes no sense. Relate the size of the surprise to the typical range of surprises from recent decisions and record only that ratio in your journal.

A second variant: the market prices a cut of 25 basis points and the bank cuts by 25. The surprise in basis points is zero, and yet the statement can move the long end of the curve by a dozen or so basis points if it changes the assessment of the future path. That is exactly the case where the headline “in line with expectations” does not describe what is happening to valuations.

All figures in this paragraph are illustrative. Check current rates, market pricing and statements on the institutions’ websites and in a calendar at the source, because they change from month to month.

A decision sheet: fill it in with your own data

You fill in the columns from “Market pricing” to “Position plan” before the decision, and the surprise, curve change and result columns after it. After a dozen rows you will see which combination of pricing and surprise actually means your rules protect capital. The next step is the market mood context, described in the lesson Risk-on and risk-off.

When a central bank decision says “do not trade”

Four conditions. Meeting any one of them means skipping the trade or postponing entry until the condition no longer applies.

1. You do not know what the market has priced in. Without pricing you cannot separate new information from what is already in the price. If you cannot point to the source of the pricing, do not trade around the decision.
2. You plan to trade the decision headline without reading the statement. The headline describes the rate, while the statement and the press conference move valuations. Entering in that second is a bet on direction, not on the value of information.
3. Your stop only fits inside your risk limit if it is set tight. Around a decision the typical range of movement is wider than in an ordinary session, so a tight stop will be taken out by noise. Reduce size or stay out.
4. Market pricing and the consensus disagree, and you have no scenario for both cases. A disagreement means the market itself does not know what to expect — volatility will be high in both directions.

The practical order is the reverse of intuition: first you reject, then you plan. You write the rejections down too, because without them you cannot tell discipline from fear.

Common mistakes around central bank decisions

• Trading the rate headline alone. The biggest moves around a decision concern the expected path, not the level for today.
• A tight stop just before the press conference. The release of the statement and the Q&A regularly widen the range of movement.
• Assuming that a “priced-in” decision means a quiet session. Pricing concerns the rate, not the statement — and the statement can change the picture for future decisions and reprice longer-horizon assets.
• Increasing leverage before a decision “because the rate is surely unchanged”. Getting the rate right does not describe your loss if the range of movement turns out wider than planned.
• Copying rules from the dollar market onto the local one. Liquidity, hours and the impact on your position are different; you carry rules across only after checking the costs described in the lesson on round-trip costs.
• Treating bank forecasts as a commitment. Projections are an assessment for today; the market revises them after every new data point.

Measurable exercise

List the dates of the next three central bank decisions whose currencies or equities you actually trade. For each, complete a row of the decision sheet before publication: the market pricing in basis points, the consensus and the position plan. After the decision, add the actual rate and calculate the surprise plus the change at the short and long ends of the curve.

After three decisions, compare two sets: how many times the surprise was larger than the typical range, and how often the change at the long end of the curve was larger than the rate change. This is a test of the consistency of your measurement, not a test of how well the strategy works — if after three decisions you calculate pricing differently than you did on day one, fix the definition before it enters your playbook.

Check yourself

Common questions

Do I have to read the full transcript of the bank's conference?

Not to begin with. The decision date, the market pricing, the direction of the surprise and the tone of the statement are enough. Deeper reading comes with time, once you start comparing consecutive decisions with each other.

Why follow the NBP if I only trade a US index?

With pure exposure to the US market an NBP decision is background. But if you settle your result in PLN, the currency rate comes in as well, and the local rate affects credit and companies on the Warsaw exchange. Always map a central bank onto what you actually hold in your portfolio.

Does a decision in line with pricing mean a quiet session?

No. Pricing concerns the rate itself, while the statement can change expectations for the next decisions. That is why you calculate the surprise for the rate separately and watch the reaction of the longer end of the curve separately.

Why measure the priced-in move and the surprise when the reaction is visible on the chart?

Because the chart shows the effect, not the size of the new information. Separating pricing from surprise lets you compare decisions with each other and across banks: with a move fully priced in, no reaction does not mean the statement was empty, and a large reaction does not mean the surprise was large. Only from recorded numbers can you check whether your rule for decision days rests on measurement or just on belief. Check current rates and pricing at the source, because they change with every session.