Interest rates are key influencers for the financial markets and the world of investing in general. Trading would be less exciting without them. The reason is simple: interest rates decisions impact the value of currencies in the Forex market, as they are indicators of a country's economic strength.
High-interest rates attract foreign investors and the flow of global capital due to high returns potential, so currencies are the first to benefit. Low-interest rates generate less buzz, so currencies cannot receive any boost. Almost any shifts in interest rates cause price swings and volatility, offering interesting trading opportunities for investors not only in the Forex market but also for stocks, indices, and even commodities tied with different currencies.
Stay with us, and you'll learn more about how interest rate predictions and decisions impact the world of investing and, most importantly, how you can make the most out of them!
But first things first. Let’s start by taking…
…a closer look into interest rates
For the average person, an interest rate is a tax he or she pays to a financial institution for borrowing some of its money. This might be the standard mortgage rate, personal loan interest, or any other interest a bank charges its clients.
For the financial markets, things are a little different. Here, interest rates are the rates that commercial banks and other institutions pay the central banks when borrowing money – Key Rates. Also, commercial banks can choose to deposit their funds with the central bank for safety, receiving an interest in return.
Since the Key Rates drive the financial markets the most, we will be focusing on them. But we cannot go any further without explaining some essential terms.
Monetary policy, inflation, and interest rate decisions
Central banks are responsible for setting up interest rates values. They achieve their goals of controlling economic growth and price stability by using monetary policy* tools. If everything goes according to plan, inflation targets can reach comfortable and safe levels. Moderate inflation is usually beneficial for the economy, and uncontrolled inflation can be very harmful.
By hiking interest rates, the banks ensure inflation does not affect the country’s growth. But higher inflation levels can affect interest rates, impacting currencies, stocks and indices. Lower inflation levels can lead to higher consumer demand, stronger currencies, and higher share prices for companies in the respective countries.
*Monetary policy involves managing the money supply and interest rates.
Interest Rate Announcements
Usually, the central banks' board members release economic reports and give speeches after the interest rate decisions. Before these official announcements, analysts give interest rate predictions on the expected values, based on factors such as an economic situation or performance outlook.
When making interest rates announcements, central banks can be either hawkish or dovish. A hawkish direction supports interest rates hikes, and dovish guidance supports lower interest rates for stimulating economic growth.
Traders often try to estimate whether a central bank is hawkish or dovish during the interest rate announcements to try and take advantage of the following market movements. For example, the Federal Reserve (U.S. Central Bank) increased the federal funds rate* from 0,25% to 0,5% for the first time in ten years. This move boosted the US Dollar strength, causing the popular EUR/USD pair to drop, as the euro was losing in value compared to the US Dollar. Market analysts say that buying the EUR/USD currency pair was the natural thing to do, since selling it at a later stage for higher profit chances was very attractive.
* The federal funds rate is the interest rate that banks charge each other for overnight loans. This reflects the base interest rate for the U.S. economy.
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Major Central Banks Interest Rate Decisions
Some of the most crucial interest rate decision announcements worldwide are the Bank of England Interest Rate Decision (BOE), FED Interest Rate Decision, the European Central Bank (ECB) Interest Rate Decision, and Bank of Japan (BoJ) Interest Rate Decision.
Let’s take them one by one and see how each of them opts to set the interest rates.
Fed Interest Rate Decision
During the FOMC Meetings, the Federal Reserve, through Chairman Jerome Powell, can announce rate hikes or cuts, impacting the financial markets, starting with the USD. Since the U.S. Dollar is connected with the world's biggest currencies, you can imagine how significant the impact can potentially be.
Another instrument that investors prefer to trade based on Fed interest rate decision is the US dollar index, as it measures the performance of the USD against many foreign currencies.
When trading the stock market, interest rate hikes are generally interpreted as negative signs because companies cannot borrow as much money from banks as they would want. Loans also become more expensive, and companies are unable to accelerate their growth and might experience earnings decrease too. Still, banks, mortgage, or insurance companies thrive from interest rate hikes from charging more for lending.
On the other hand, rate cuts have a reversed effect. Lower interest rates are positive signs for economic growth.
When a lot of companies face declines in their share prices, indexes also go down. In the U.S. market, popular indexes such as Dow Jones, S&P 500 or Nasdaq can feel the effects, as companies like Facebook, Intel or Apple are in trouble. Of course, the opposite is true.
Bank of England Interest Rate Decision
The Bank of England Base Rate is the official bank rate in the UK charged by the central bank to commercial banks for overnight loans. As it impacts both short and long-term interest rates, it has a significant effect on the economy, for the overall monetary policy, and for achieving inflation targets.
When the base rate is low, banks can borrow more money from the central bank and employ lower interest rates, reducing the cost of borrowing for businesses and consumers and allowing them to borrow and spend more. The other way around: when the base rate goes up, it is harder for banks to borrow funds from the BoE, and their interest rates increase, increasing costs for both businesses and consumers.
Increasing or reducing the base rate affects the financial markets, starting with the Pound Sterling and the GBP/USD pair, but also unemployment and inflation. These impact stocks, indices, and even bonds, as they are correlated with the GBP strength.
U.K. Monetary Policy Committee (MPC)
The MPC meets eight times a year, each meeting lasting three days. The final vote for increasing or lowering the base rate takes place on the third day, and the subsequent decision is published the following Thursday.
Traders and investors usually keep a close eye on these MPC meetings and for relevant Bank of England news, for spotting trading opportunities on various financial instruments. For example, they look for indicators of possible monetary policy directions. Rate hikes usually boost the Pound Sterling but can affect stocks or indices such as FTSE 100. Rate cuts have the opposite effect.
European Central Bank Interest Rate Decision
The European Central Bank (ECB) uses three key interest rates:
● the minimum bid rate, used for one-week loans (also called the interest rate for primary refinancing operations)
● the rate for the deposit facility (used by commercial banks for making overnight deposits)
● the marginal lending rate (for overnight loans)
The ECB holds monetary policy meetings to make interest rate decisions every six weeks, planning to keep inflation rates under 2% in the Euro Area. Their decision is announced on the day of the meeting, with an ECB press conference taking place shortly after.
Additionally, the Governing Council of ECB might use quantitative easing programs to inject money into the economy and boost spending, when the situation is needed.
Just like for the other major Interest rate decision, traders look closely into this meeting too. ECB news, speeches, and press conferences offer valuable info into the Eurozone Area status. Any shift in the value of rates might impact the Euro, currency pairs tied to it, such as EUR/USD or even stocks. Rate increases help the Euro, but are bad for stocks, for while rate cuts have the opposite effect.
Usually, investors monitor factors like distribution of votes during member countries, and red-hot economic factors (Brexit).
Bank of Japan Interest Rate Decision
The Bank of Japan (BOJ) aims to regulate the potency of its currency and keep inflation on the right track by using interest rates decisions. A growing economy signals higher interest rates, and a weaker economy gives room for interest rate cuts. Also, people should note that Japanese banks use long-term monetary easing programs because of the last major recession called “the lost 20 years”.
The short-term interest rate that the Central Bank of Japan sets is highly important to traders, as these rates impact the Japanese Yen and the USD/JPY directly. Also, the BOJ can use both quantitative and qualitative easing policies, also impacting trading in the financial markets and especially ETFs, stocks, or indices.
Through its eight meetings/year, the BOJ aims to achieve a year-on-year increase in the consumer price index of 2%.
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Source: boj.or.jp, fxstreet.com, ecb.europa.eu, investopedia.com, thebalance.com, babypips.com
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