By Louis H-P on October 2, 2019Reading Time: 4 minutes
Ask anyone what interest rates are and you will usually be told it is the % they earn on a saving account. To a retail Forex trader they are the rate set by a central bank. Yet for all of us who are financially minded, they are important. They influence the rate on our mortgage or the potential yield (and prospective profit) on a currency.
They are the rate of interest paid on an amount of money you borrow. They are important as many financial instruments are priced off them. For retail Forex traders they are important as a currency yielding more than another, will often appreciate at the expense of others. This has the effect of creating a return from both yield and capital appreciation.
Interest rates are set within the western world by central banks. Central banks monetary policies use interest rates to control the flow of money. These central banks are independent from government, and so their rate setting decisions are not directly influenced by politics. Indirectly politics do play a part: the Bank of England has acknowledged that the on-going Brexit impasse is influencing their rate setting. Independence of action is important, as otherwise rates could be set by a politician who has short-term priorities, such as getting re-elected.
Trump has been recently been very critical of the Fed not cutting interest rates more radically. This is because he has calculated (probably correctly) that an interest rate cut will drive the economy and stock market upwards, making him more popular with voters. The downside is this may not be what is required for the long-term stability of an economy.
Both the Bank of England through the Monetary Policy Committee and the New York Federal Reserve through the Federal Open Market Committee, have formal meetings where the rate is voted on. These meetings occur regularly throughout the year and are closely watched by market participants. Speeches by members of these committees in between these meetings are also closely scrutinized to see which way each member is leaning. Will they vote to raise, cut or hold interest rates?
As a result, before most meetings, many investment banks will try to predict which member will vote which way, based on that individual member’s economic standpoint. The minutes released after the meetings, are also analysed closely for clues in the change of the tone of language regarding rates, so traders can position themselves accordingly.
Central to interest rates are inflation expectations. If the New York Fed or Bank of England are worried about inflation increasing or decreasing, they will adjust interest rates. If inflation is increasing, spurred by price increases, they will often raise rates. This makes money more expensive, which leads people to borrow less and spend less. On the flip side, if there is no or little inflation, then rates are usually cut. Cutting rates promotes growth. Growth usually creates price and wage increases which in turn produces inflation.
Institutional traders are there to make money. Therefore anything which can help or hinder them will be watched closely. Such is the importance of interest rates, that even the language used by central banks is pored over. A change in language in the minutes of central bank meetings can move markets. Central banks are aware of this, and therefore try and pre-empt this prospective volatility by communicating with markets what they think the path of interest rates will be.
Although there are many market participants who trade on emotion, there are many who trade using technical or fundamental approaches. The Lazy Trader is there to help with teaching technical trading. For fundamental traders, everything has a price. As interest rates affect the price of so many securities, whenever rates change, everything needs to be re-priced. If a rate change is unexpected, this creates sudden volatile moves which often lead to mis-pricings. This gives opportunities to profit. If a rate change has been telegraphed in advance, you will see the pricing adjust gently over time, which still gives some opportunities to profit.
A return from Forex trading is earnt from a combination of yield, (if available!) and capital appreciation of that currency versus another. This means that in Currency pairs one currency is appreciating, whilst another is falling. If a currency is backed by a strong economy and has an attractive stable government and yields more than others, then it will become attractive. This will often make it appreciate.
An example is the USD, which has appreciated over the recent years. This gives a chance for relatively steady profits. Yet there is always the risk that a black swan event changes everything. Anyone who was short the CHF in 2015 will have nurtured big losses when the Swiss National Bank removed their peg to the Euro.
Like many financial terms, interest rates can proving confusing to the layman. It does not have to be so. Everything has a price, a mortgage, a Mars bar and a currency. If the key ingredient to that price changes, then the price will change. Learning to understand how much importance the market places on interest rates is critical if you want to be a successful Forex trader.