One of the major factors affecting financial markets is interest rate changes. The market would certainly be less exciting without them, not to mention less profitable. Any minor changes to these rates, even by as little as 0.25%, can result in significant price swings with good trade-placing gaps, especially in the forex trading market.
What exactly are interest rates – and who sets them?
Simply put, the interest rate is the rate at which a financial institution or another creditor borrows money. It is also the rate they will pay individuals who deposit money with them, although this rate is usually slightly less.
The rate we are referring to in financial markets is the key lending rate. This is the rate at which a central bank will lend money to commercial banks, who in turn lend money to individuals.
Monetary policy decisions to hike rates, leave them as they are, or decrease them are taken by members of the monetary policy committees of central banks around the world. Each country has a central bank. The Federal Reserve Bank, for example, is the central bank of the United States, while in the UK, it is the Bank of England (BoE).
Decisions are made in line with the goals of the economy. Decisions could be taken that will expand growth, contract it or keep it neutral. Each central bank has a mandate or objective it acts upon. In many cases, the mandate is inflation targeting. If inflation is seen to be creeping too high, this could lead to interest rate hikes to keep inflation under control. To stimulate growth, interest rates could be cut so people spend more.
It is essential that you pay attention to these meetings, along with any other data that may be of importance.
How these rates affect the market
Interest rates act as a barometer of how strong or weak a country is economically. If a country has high interest rates, it may attract more investors because they will get higher returns on their capital. As more investors flock to a currency, it could lead to the value of that currency appreciating. Consequently, as a forex investor, you could use a country’s interest rates as part of your analysis to see if a country’s currency will appreciate or depreciate.
The technique of comparing two countries’ interest rates is called finding the “interest rate differential”. It would allow you to buy a currency with a higher interest rate while selling a currency that has a lower one.
Watching out for interest rate announcements
These rate announcements are some of the most watched financial news stories by analysts because the market will often experience substantial price swings once an announcement has been made. It often offers lucrative trading opportunities.
Before a decision is made, analysts often express their predictions and expectations regarding which way a decision will go. This analysis is done based on the current financial outlook of a country, taking into account factors that could influence a decision, as well as a country’s economic outlook. If rates have been on the decline for some time, for example, the old adage that what goes up must come down and vice versa applies – the market will be expecting an upswing at some point. If the gap between what is announced versus what was expected is wide, this often leads to very big price gaps in the market. That’s why it is critical that you get to grips with rates cycles and their implications not just in a forex context but also when you learn CFDs, for example, because your underlying asset could be currency.
The hawk versus the dove
Central banks are seen as either hawkish or dovish when making these decisions. A hawk is often aggressive, while a dove is peaceful. If a bank is hawkish, it will raise interest rates to protect its goal, such as inflation targeting, even if other areas of economic development will be affected. Traders often look at whether a bank’s tone is hawkish or dovish in the days leading up to a decision to try to predict which way rates will go.
When a bank raises interest rates, the value of the associated financial instrument will usually rise and vice versa. However, as you study this more, you will realize that the opposite can and does happen from time to time.
The moral of the story is that before placing a trade on the strength of an interest rate decision only, pay careful attention to the entire statement released by a bank and anticipate the whole spectrum of consequences such a statement may have. Entire markets have hinged on a single word or phrase in a statement.