Interest rates explained

This week I didn't published the Top Things to Watch because I'm in a kind'a holiday mood.

But anyway, last week was so huge in interest rate related events, with intense volatility moments, that I decided to write this article.

I will also publish a video in my YouTube channel (and share the link on my LinkedIn page), with an illustrated explanation that will go through some of the most relevant charts.

What is happening in the markets?

Last week, investors cheered as Jerome Powell reinforced that the Fed will cut interest rates in a near future, even though the inflation readings in the last two months were hotter than expected.

Main consequences of such statements:

• The Dow Jones 30 was up by almost 2%, registering its best week of 2024.
• The S&P 500 was higher by 2.3%.
• The Nasdaq 100 jumped 2.9%.

The 3 major US stock indexes are on track to positive gains for 5 months in a row, so if you invested on those indexes, or in ETF's that track those indexes, you should be rejoicing.

Some analysts argue, though, that this market euphoria is highly speculative and driven by the psychology traits of excitement that fuel bullish trends, specially amongst non-professional traders.

Facts: the Federal Reserve is keeping interest rate unchanged at the 5.25%-5.50% range, since July 2023. There are only 8 FOMC meetings left in 2024 but investors are pricing in at least 3 rate cuts untill the end of the year. According to the CME Group's FedWatch Tool, the probability of a 25-bp cut in June is 75.5%. Interest rates can lower to 4.50%-4.75% if the Fed decides additional 2 rate cuts.

The Dollar Index - which measures the USD against a basket of 6 major currencies - keeps on strengthening as markets believe other Central Banks won't make any interest rate cut before the Fed triggers the downward cycle.

The U.S. economy keeps on delivering signs of strength and resilience, whilst the eurozone's economy continues in a stagnation mode, China faces a deepening property crisis, and Japan unexpectedly slipped into recession at the end of 2023.

The key to understanding the USD strength are Fed policy decisions versus those of other central banks, and how high rates stay, as higher yields can bolster a currency.

In a financial perspective, relative currency values reflect the global flow of funds, meaning that the stronger the USD the higher the money flow into the U.S..

The FED monetary policy, which was the first Central Bank to rise interest rates, had a major effect over U.S. bond yields making them more attractive and consequently drawing more foreign investment to the U.S..

The demand for U.S. Treasury Bonds gave a major impulse on the demand for USD and, as you know, an increase in demand drives prices higher.

Nowadays, with inflation rates still at higher levels you are paying fees to keep your money sitting in a bank account. That being said, even if you are an unexperienced investors, with a low risk tolerance, its preferable for you to invest in Treasury Bonds or Certificates of Deposit (the equivalent to Certificados de Aforro in Portugal) to, at least, offset the impact of inflation.

A mature investor, will build a diversified portfolio to generate competitive returns over time.

If you are a forex a trader you should focus on monetary policy, if you are a day trader you must be watching the news by the second, but if you want to become a serious investor you should be considering a wider range of options.

To start with, invest in your knowledge and become proficient in the markets you wish to invest in.

Please, follow my trading lessons (in Portuguese) if you wish to know more about trading.