Interest Rates

Interest rates are regarded as probably the biggest mover of currencies in the Forex markets. The interest rate represents the level of yield paid in return for holding a particular currency.

Rates are set by Central Banks and are used both to control the pace of economic expansion and to maintain control over inflation. Lower interest rates encourage the economy to expand as the credit required to fund economic growth becomes cheaper. Higher interest rates make credit relatively more expensive to acquire and consequently the pace of economic expansion is slowed.

Not only is it vitally important for the Forex trader to be aware of the current interest rate, it is perhaps more important that they have an idea of its likely future direction.

When interest rates rise, the yield offered for holding the underlying currency increases. This makes the currency more attractive to hold in relation to its peers. Similarly if an interest rate is lowered, then there is less incentive for traders or investors to hold it.

A consensus view of what an interest rate decision is likely to be is made prior to the actual rate announcement. Therefore when the decision is released and is in line with expectations, there may be only a muted reaction from the market. This is because the change has largely already been factored into the price. However If the decision is different from the consensus view then this can cause huge swings in the currency as traders frantically attempt to re balance their portfolios.

The accompanying ‘minutes’ released by the Central bank will also be scrutinized. Crucially these may reveal intentions for future rate decisions. As markets are ‘forward looking’ the interpretation of these minutes by traders can often move prices more than the actual rate decision itself.

Interest rates are fundamental to the analysis of a currency as they used as a measure of the underlying economy’s strength or weakness. As an economy grows prices tend to rise. This is due to the increased income available, allowing a greater amount of services and goods to be purchased. Quite simply, there is an increased amount of money supply available to chase the same amount of goods. This in turn leads to higher prices being charged for these goods. This effect is called ‘inflation.’

Central banks keep a watchful eye on inflation and use the level of interest rates to stem inflationary pressures and keep the economy in check. By raising interest rates, borrowing becomes more expensive which dissuades both businesses and the consumer from spending. This is turn slows down economic growth and expansion, stemming price inflation. At some point this will impact growth and a point will be reached when interest rates are likely to need to be lowered again to re-stimulate the economy.  The whole process is cyclical and a delicate path along which each Central bank treads, in an effort to maintain economic growth while keeping the economy in check.

Central Banks review interest rates every four to six weeks dependant on the Bank in question. They can however call ad hoc meetings to implement emergency rate decisions in times of economic crisis. Central Banks have specific economic goals and will seek to regulate both money supply and interest rates to support their local economy.

Key Central Banks of note are:

• The Bank of Canada
• The Bank of England
• The European Central Bank
• The Swiss National Bank (Switzerland)
• The Federal Reserve (United States)
• The Bank of Japan
• The Reserve Bank of Australia
• The Reserve Bank of New Zealand

Capital flows are a further area worth mentioning here. Higher interest rates not only keep inflation in check, they also increase the attraction of investing in a country. They are indicative of economic strength in the economy. This economic strength coupled with a high yield helps to attract foreign capital flows into the country.

Capital flows are classed as either positive or negative. A positive capital flow is when foreign investment into a country exceeds foreign investment leaving the country. A negative capital flow is when foreign investment is lower than that leaving the country for foreign sources.

A positive capital flow also allows for a natural appreciation in the local currency as a result of this process. This is because foreign investment is exchanged for the local currency. This works in the reverse for negative capital flows where the domestic currency is exchanged for foreign investment.

The key point to learn from this lesson is the importance that both current and future projections for interest rates have in determining both the short, medium and long term direction of a currency’s price.

Next: Inflation and CPI