How Interest Rates Work and Why They’re Important to Forex Traders

Interest rates are one of the fundamental factors that influence the currency markets. All else being equal, the differing interest rates set by central banks make holding one currency more attractive than holding another.

Why should this be? Because holding Currency A when it pays 2% interest is more attractive than holding Currency B when it only pays 1%. Why all else being equal? Because there’s a lot more to currency values than just interest rates, but they’re always there under the surface, exerting a pull on the flow of capital.

If all things were indeed equal and interest rates were the only factor governing the rise and fall of currency values, then the best strategy for a forex trader to employ would be to buy currencies with high-interest rates by selling currencies with lower interest rates. In our previous example, you would sell Currency B in order to purchase Currency A. In reality, of course, things aren’t as simple.

What do central banks do?

If we take the Federal Reserve Bank of the United States as an example, its stated mandate since the late 1970s has been as follows:

“To promote the goals of maximum employment, stable prices, and moderate long term interest rates effectively.”

The goals of other central banks come worded differently, but they are also generally geared towards price stability and currency confidence.

Monetary policy is the primary way in which central banks work towards their stated objectives, which involves influencing the cost of money as well as its availability. 

The primary way Federal Reserve execute this is to increase or decrease the supply of money (in other words, how much is in circulation at any given moment) and to influence the interest rates at which banks lend to oneanother.

How do central banks affect the cost of money? 

Taking the Federal Reserve as our example, it has three main tools with which to fulfill its mandate. 

1. It sets the reserve requirements of banks, i.e., how much capital they must have on deposit with the Federal Reserve to be able to do business. 

2. It sets the Discount Rate, which is the interest rate banks pay to access loans from their regional Federal Reserve bank. 

3. It conducts “Open Market Operations,” in which it buys and sells US government bonds. 

The Federal Reserve uses open market operations to add or remove US dollar liquidity from the market. By buying or selling government bonds to and from banking institutions in return for US dollars, it effectively expands or contracts the money supply as it sees fit.

What is the Federal Funds Rate? 

The Fed Funds Rate is the US interest rate that gets the most attention. When you hear about Fed rate hikes or rate cuts, it’s this Federal Funds rate that the financial media are referring to. The Fed Funds Rate is the interest rate at which banks are prepared to lend their excess reserves out overnight to other banks. 

While the Fed doesn’t explicitly “set” this rate, it influences it by setting a “target rate.” It uses the above mentioned monetary tools to nudge interest rates towards that target rate. The simplest way it can do this is by increasing or decreasing the supply of money. 

If it decides to repurchase government bonds from banks, it increases the excess cash they hold on reserve, thus making them more willing to lend it out, which causes interest rates to fall. 

On the other hand, when it sells government bonds in return for cash, it takes money out of circulation, thus decreasing the amount of excess cash the banks hold on reserve, which means less to lend out, which causes interest rates to rise. 

Why do central banks raise and lower interest rates?

They are bringing us on to doves and hawks. You have almost certainly heard about it that central banker referred to as a dove or a hawk by the financial media. While traders get described as either bulls or bears depending on their market behavior, central bankers and economic policy advisers get described as either being doves or hawks depending on their financial outlook. 

A dove is a central banker or policymaker who believes in keeping interest rates low to stimulate economic growth. 

A hawk is a central banker or policymaker who believes that rates should be high to combat the effects of inflation. 

When central banks lower the cost of money by increasing its supply and reducing interest rates, they are often attempting to soften the effects of a slowing economy or to stimulate one that is in contraction. Lower interest rates make it cheaper to take out loans to start new businesses or to refinance existing debts. The effect is to stimulate economic activity. In Fed-speak, this is called “easing.”

When central banks increase the cost of money by reducing their supply and raising interest rates, they are often attempting to rein-in an economy so that it doesn’t spiral out of control and become inflationary. In Fed-speak, this is called tightening.

The above always represents a delicate balance between the fed data coming from the economy and monetary tools that it has at its disposal. 

How do central banks decide whatinterest rates should be?

FX traders are very familiar with the economic indicators that the Federal Reserve and other central banks use to monitor the economy. After all, theyare the same economic indicators that Forex traders like to daytrade around. 

They’re the weekly and monthly data reports tracking various sectors of the economy, such as retail sales, employment, industrial production, and GDP. They also include several highly-valued sentiment indexes that get collected by surveying the mood of certain vital groups in the economy. Such as purchasing managers (Purchasing Managers’ Index) and consumers (Consumer Price Index).

This constant flow of incoming economic data allows the Federal Reserve to keep track of the US economy to form a view of how well or poorly it’s performing, which helps the Fed to decide on the measures, if any, that it is required to take. 

How do central banks guide market expectations?

Anyone who has ever traded around an interest rate announcement will tell you that very often; it’s not the announcement itself that generates the volatility. Instead, it’s the press conference that follows. In which every word uttered by the Fed chair gets scrutinized down to the syllable. For evidence of a change in sentiment. 

That the market usually knows what to expect when it comes to interest rate decisions isn’t a fact of life and hasn’t always been this way. It’s a conscious decision on the part of central banks not to surprise markets. 

This practice is known as forwarding guidance, and it’s a tool that is used by central bankers across the world, particularly since the Great Recession of 2008. It mainly involves telling markets what the central bank plans to do and outlining the conditions that will cause it to carry on doing so or to change its course. 

In the wake of the 2008 crisis, when US interest rates were effectively at 0%, the Federal Reserve was open about its intentions to maintain rates at this zero bound until conditions had significantly improved in the US economy. 

In fact, not only did it do this, but it also outlined the specific metrics that would have to change and the levels that they would have to reach before the Fed would consider raising interest rates again. These were 2% annual inflation and an unemployment rate of 6.5%.

The Bank of England’s Mark Carney also issued similar statements at thetime, when in 2013, he announced that the BoE wouldn’t consider raising rates until UK unemployment had fallen below 7%.

Forwarding guidance aims to communicate what a central bank’s policy is and the conditions under which it will get implemented. The logic being that such openness avoids the creation of unnecessary volatility around interest rate decisions. Forward guidance helps the market to theoretically price-in policy changes in advance of them getting announced. 

Why do central banks intervene in “free” markets?

A thorny topic that is guaranteed to cause a great deal of disagreement. Many accuse central banks like the Federal Reserve of artificially trying to interfere with what are otherwise natural cycles. Economics, as a discipline, has no issue with the idea of cycles. We have accepted mainly the related notions of the business cycle, credit cycles, and market cycles. 

However, the way central banks behaved since the last crisis almost to deny the existence of such cycles. As is the unconventional tools that were used in the wake of the previous crisis to prevent the global financial system from collapsing (see QE) have given central bankers a false sense of their power.

In its most basic form, the idea of a cycle can get expressed in a six-word phrase: what goes up, must come down. Non-economists accept this principle as a matter of course. We all, almost innately, have an understanding that lean years follow fat years and that the ups and downs we go through more or less resemble the image below.

However, you will be amazed at what many commentators take issue with, since at least the crisis of 2008, central bankers across the globe seem to have convinced themselves they can use monetary policy to eliminate cycles. 

When you see a zoomed-out chart of the S&P 500 going more or less straight up for more than a decade, with no correction insight, while conditions on the ground haven’t significantly improved for most people since 2008, you have a disconnect. And it is this disconnect that many are starting to criticize.

Like forest fires in the natural world, many hold that these natural phenomena are a form of creative destruction that allows for a new life. As we have found in the areas of conservation, trying to micromanage ecosystems often leads to unforeseen problems that can often be more serious than the first issue itself.

If you extinguish every inkling of a forest fire before it can take hold, you’re effectively saving up all that old brush and deadwood that would ordinarily get burned in smaller, controlled fires. Then, one day, when a fire does take hold, there’s so much flammable material around that you get an uncontrollable inferno that decimates large areas of woodland. 

Many claim this is what central bankers have been doing in some shape or form since the Federal Reserve started overtly intervening in markets in the wake of the 1987 Stock Market Crash. 

By artificially trying to extend the expansion phase of a cycle or attemptingto avert or reduce the contraction phase, many feel that central banks are just prolonging an inevitable correction that will be all the worse for our trying to prevent it. 

How do central banks get things wrong?

You’ve probably had the experience of trying to balance the hot and cold water on an old mixer tap to achieve the right temperature. You add hot, it burns your skin, you compensate with chilly, and it suddenly turns cold. In many ways, this is the sort of game that central banks like the Federal Reserve are playing. Only where monetary policy is concerned, it’s not about balancing hot and cold, but rather balancing tightness (hawkishness) and ease (dovishness). 

When the cycle looks like it’s swinging down towards contraction and recession, central bankers tend to find themselves in a more easing mode, which, as we saw above, is characterized by low-interest rates and an expansion of the money supply (typical dovish behavior). The aim is to encourage economic activity by making money cheaper and more available.

On the other hand, when the cycle is in full expansion mode, central bankers, seeking to reduce the possibility of rising inflation, tend to find themselves in a tightening way, which is characterized by rising interest rates and contraction of the monetary supply (typical hawkish behavior). The aim here is to bring expectations back down to earth and to discourage exuberant risk-taking by making money scarcer and costlier to access.

The problem is similar to the case of the mixer tap. There’s a lag between the adjustment you make and the temperature change of the water. The reason why you don’t get the balance right immediately is that the delay causes you to overcompensate with the hot tap when it’s too cold and toovercompensate with the cold tap when it’s too hot.

The data that central banks have at their disposal lag a great deal longer than the water coming out of your taps. Meaning that, while the indicators may be saying that the economy is booming, it may be slipping into recession, only to have the indicators catch up some months later. 

It is making the job of central banks incredibly tricky. Try convincing a country that hard times lie ahead when the indicators are still pointing towards a growing economy. And to over-tighten or over-ease when this is not warranted can have catastrophic effects further on down the line.

During and after the Great Recession of 2008, the Federal reserve reduced and kept interest rates at the 0 bound from 2008 to 2015. After the crisis, with some evidence that the US economy was improving, the Fed raised interest rates a total of 9 times between December of 2015 and December of 2018. 

Many now believe that the last two rate hikes the Fed performed (in September and December of 2018) were two too many. By over-tightening it has inadvertently caused the liquidity shortages we have been witnessing lately in the repo market. Some believe that a consequence of this over-tightening is that the US is now likely to enter a recession.

How to use interest rates in your trading

As I’ve tried to show throughout, interest rates are a tool. They shouldn’t get considered an end in their own right; they are a means used by central banks to the end of keeping the economies they oversee from veering off track. As such, you shouldn’t just blindly trade them on face value.

In other words, an interest rate rise isn’t a guarantee that a currency will appreciate, nor is an interest rate cut a guarantee that a currency will fall in value. To make the most of interest rate decisions in your trading, you will have to follow the broader story of the hows and the whys.

How did we get here?

What conclusions got previously taken, and why?

What effects did these decisions have?

Where is the central bank trying to go now?

In this way, you can start to determine the economic health of the countries whose currencies you are trading and take appropriate decisions with your capital.