Interest rates from A to Z – a trader’s guide

Interest rates from A to Z – a trader’s guide

Global interest rates can make or break the Forex market. Learn how they work and why it is essential to stay informed about interest rate changes.

The three-way connection: interest rates - risks – inflation

By interest rates, we understand the costs of borrowing a loan charged by the lender to the borrower. Interest rates are displayed as a percentage of the loan amount (principle), and they are charged periodically depending on the borrowing contract.

Lenders (such as central banks) determine the interest rate value for their loans after assessing several risk factors. The riskier the loans are, the bigger the interest rates will be.

One of the most significant factors influencing interest rates is inflation (the steady increase in prices of goods and services).

High inflation can harm an economy. That is why central banks always keep a close eye on inflation-related economic indicators, such as the #CPI, GDP, employment, and many others.

How interest rates are calculated – keeping inflation in check and economies afloat.

Because they act as lenders of the national currency, central banks decide the minimum interest rates. It is essential to know that central banks make money for the national treasury by lending to commercial banks and charging interest.

Central banks also control the monetary policies and the short-term interest rate at which banks can borrow from one another. The central banks typically hike rates to reduce inflation and cut rates to encourage lending and pour money into the economy. No matter what they choose to do, currencies are affected, and that is one of the main reasons why the interest rate impacts the Forex market.

When central banks raise or cut the interest rates, the commercial banks’ borrowing costs are affected, and they are forced to apply higher or lower rates in their own commercial and retail financial services. The result is that customers pay the price.

As a trader, you can examine the most relevant economic indicators, such as the CPI (Consumer Price Index), as mentioned earlier, employment levels, the housing market, and others, to predict what central banks might do regarding interest rates.

A hawkish approach refers to an economic view promoting monetary policies that usually involve high-interest rates, while a dovish approach refers to an economic view promoting monetary policies that usually involve low-interest rates.

Let us get into more details to help you better understand context.

The hawkish approach vs the dovish approach.

Interest rate hikes are considered hawkish. When interest rates rise, the price of borrowing the national currency goes up as well. Lending might then become more profitable and loans more expensive. So, the national currency gains value.

Interest rate cuts are considered dovish. When interest rates fall, the price of borrowing the national currency also goes down. Loans then usually get cheaper, and lending becomes less profitable. As a direct result, the national currency loses value in the foreign exchange markets. Contrary to higher rates, the interest-paying investments lose their appeal when the central bank cuts the interest rates, and investors might become more prone to risks.

All eyes on interest rates - how traders keep themselves informed about interest rate changes.

As the indicators mentioned above improve, central banks might see it as positive signs, and they might not raise interest rates. On the same note, significant drops in these indicators can lead to rate cuts to encourage borrowing.

However, it might not be enough to closely monitor data such as #CPI or employment reports. Outside of economic indicators, it is also possible to predict a rate decision by following major announcements from central banks and analyzing forecasts.

Major Announcements

Major announcements from central bank leaders (see Fed’s interest rate decision or Bank of England’s MPC Announcements) can play a vital role in interest rate moves. Whenever a board of directors from any world’s top central banks goes public, it will most likely provide insights into how the bank views current inflation and where interest rates might head.

The interest rates decisions rely on past data analysis of other economic reports. By identifying recent economic trends, the central banks make projections and decide to make changes to interest rates where they see fit.

Interest rate decisions are usually announced monthly or at six-week intervals. Sometimes, a press conference follows, explaining the interest rate decision and other monetary policy decisions taken. Also, emergency interest rate changes can occur from time to time, meaning #central #banks could alter the interest rate level between the scheduled meetings.

No matter how well you do your homework before a significant announcement, central banks can always deliver a surprise rate hike or cut. When that occurs, you should get ready to trade according to the market's new direction:

  • If there is a rate hike, the currency will most likely appreciate, meaning that traders might take the buy approach.
  • In case of a cut, traders will probably sell and purchase currencies that boast higher interest rates.

Once you are fully aware of the market movement, it is vital to act promptly because most of the action tends to happen quickly. At the same time, experts advise keeping an eye on a possible trend reversal, meaning the markets might revert to their original direction soon after news hit the wire.

Forecast Analysis

Market participants often anticipate interest rates moves. Brokerages, banks, and professional traders generally have a consensus estimate of the new rate, potentially offering you valuable insights.

You can always check some of these forecasts and average them for a more accurate prediction.

Key Interest Rate Decisions Around the World

US Federal Fund Rates

Region: The US

Date of release: 8 times a year

Issuer: Federal Open Market Committee (FOMC) of the Federal Reserve (Fed)

Affected Instruments: the USD, USA30, TECH100, USA500, U.S Bonds.

EU Official Interest Rates

Region: Europe

Date of release: 8 times a year

Issuing Agency: European Central Bank (ECB)

Affected Instruments: EUR-related currencies; government bonds.

UK Base Rate

Region: Europe

Date of release: 8 times a year

Issuer: Monetary Policy Committee (MPC) of the Bank of England (BoE)

Affected Assets: GBP, EUR; UK100; UK Bonds

Japan Interest Rates

Region: Asia

Date of release: 8 times a year

Issuer: Bank of Japan (BoJ)

Affected Instruments: JPY; Japanese stocks; Japan government bonds, Japan225.

Closing Words – why interest rates matter to traders.

Interest rates provide opportunities to trade based on the rise or fall of a currency and invest based on forecasts and general market sentiment. However, there are dangers for traders as well due to the increase in market volatility.

Many things surrounding interest rates could be worthy of attention. Knowing how to read & interpret economic releases (GDP, CPI, unemployment) could prove crucial for developing sound news-based trading approached and improving your existing strategies and systems of investing.

Here at CAPEX.com, we offer you a complete suite of tools & resources to help you make informed trading decisions, together with unrestricted access to the latest market news, articles, and financial commentary.

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Sources: investopedia.com, thebalance.com, babypips.com.

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