Brief Summary: An interest rate is the amount charged, expressed as a percentage of the principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, and large assets such as a vehicle or building.
What is an Interest Rate?
Interest rates are one of the most important tools available to fundamental traders. Trends in interest rates can form new price-trends or reverse them, attract capital flows, and increase demand for or supply of certain financial instruments.
That’s why every trader needs to know what interest rates are and how they can affect markets. Also, we’ll cover how Forex traders use interest rate differentials to make trading decisions and how carry trades work.
Interest Rates Explained
Interest is a payment that the borrower of funds pays to the lender above the sum that is given as a payment for the borrowed funds. Therefore, the interest rate is the amount of interest paid for a specific period for which the funds are borrowed.
Alternatively, it is the interest earned per specific period for the money that you lend or deposit. It is usually expressed as an annual percentage rate (APR), however, other periods such as monthly or daily interest rates are also common.
Effects of Interest Rates on the Economy
Interest rates directly influence economic growth as well as inflation. Therefore, this is carefully monitored by government agencies in order to set the right rate according to the current economic situation.
Low interest rates encourage individuals and companies to borrow more, which in return boosts economic activity and produces growth. Companies can borrow more “cheap” money to expand their assets, increase the number of workers while individuals can get mortgages, car loans and general consumer loans much cheaper.
Alternatively, higher interest rates discourage individuals, companies, and consumers from buying and investing. This is done during times of economic overheating, which can result in high inflation and economic instability.
What Influences Interest Rates?
High demand for loans usually results in higher interest rates while the opposite is true during times of low demand with the interest rates being lowered in order to increase borrowing, therefore, stimulating the economy. Additionally, an economy that has high inflation will have higher interest rates to adjust for the factor that money will lose its purchasing power over time.
Further, the rates are controlled by retail banks as they are the ones who give out the loans and accept deposits. Different interest rates are applied to the customer based on several risk factors. This is called a risk premium. Therefore, the interest rate you get always have a spread that the bank takes for providing the funding.
Political goals can also influence interest rate decisions. Lowering the interest rate can give a short-term boost to the economy. Therefore, central banks operate the best when there is no political pressure on their decision.
Central Banks Around the World
For most of the developed world, interest rates are set by the central bank. They are an independent authority of every country, or as in the case of the European Union for the whole Eurozone area, that sets monetary policy in addition to bank regulations and economic research.
The interest rate is determined by the monetary policy that the central bank aims to achieve to ensure price stability and liquidity in the market on a macro level. In addition to managing interest rates, the central bank also sets capital and reserve requirements for banks. This further influences the stability of the economy and work together with interest rate decisions.
Some of the most important central banks around the world are:
- U.S. Federal Reserve System.
- European Central Bank – ECB.
- Bank of England – BoE.
- Bank of Japan – BoJ.
- Swiss National Bank – SNB.
Each of them operates with its local specifics, however, the main goal is the same – to ensure the stability of the economy by setting interest rates independently.
Therefore, the interest rate can vary around the world dramatically as the economic situation varies from country to country. Emerging market economies usually have higher interest rates compared to developed economies in order to accommodate for the higher investing risk.
How to Trade Monetary Policy Meetings?
Forex, bond, and equity traders are especially interested in the monetary policy meetings of central banks that determine the direction of interest rates. Those meetings are widely followed around the world and can lead to significant volatility in the markets.
The US Federal Reserve is perhaps one of the most important central banks. As the highest instance of monetary policy in the largest world economy, traders closely follow each meeting of the Fed.
The branch of the Federal Reserve Board that determines the changes in monetary policy is called the Federal Open Market Committee, or FOMC for short. The FOMC has eight meetings each year when members of the board vote whether to change the direction of monetary policy, specifically open market operations. Open market operations are a tool of the FOMC that results in buying or selling of US government securities on the open market, which in turn impacts liquidity in the market and promotes economic growth.
The FOMC consists of 13 members. Seven members form the board of governors, and five members represent Federal Reserve Bank presidents. Traders usually categorise members of the FOMC as “hawks”, i.e members who favour tighter monetary policy and higher interest rates, and “doves”, i.e. members who favour looser policy and lower interest rates.
Traders are primarily focused on changes in interest rates after each meeting. If the actual interest rate missed market expectations to the downside, this will usually lead to a sharp sell-off in the US dollar and a rise in the stock market, because companies typically benefit from lower interest rates. On the other hand, if the actual interest rate comes in higher than expected, the US dollar will usually rise and the stock market will fall as a result.
It’s not unusual for the US dollar to move hundreds of pips against other major currencies if an FOMC meeting surprises the market with an unexpected rate cut or rate hike.
A popular trading strategy that involves changes in interest rates is the carry trade. A carry trade involves borrowing funds at a low interest rate and investing those funds in a currency that provides a high interest rate. Carry trades are typically performed with currencies, but the proceeds can also be invested into assets that are denominated in a higher-yielding currency, such as commodities, bonds, or even real estate.
While carry trade has become less popular with the trend of lowering interest rates around the world, it was a popular trading strategy back in the 2000s with the Japanese yen acting as a borrowing currency and the Australian dollar and New Zealand dollar acting as high-yielding currencies.
Besides interest rate risks, carry trade can also be affected by changes in the exchange rate between the two involved currencies or by a sharp decline in prices of the invested assets.
Interest Rate Differentials in Forex
Forex traders often follow interest rate differentials of currencies to make their trading decisions. For example, traders can follow the 2-year yields of US and German government bonds to decide whether to buy or sell the EUR/USD pair. The pair has a tendency to rise when German interest rates rise relative to US interest rates, and to fall when the opposite is true.
This works with other currency pairs as well. Traders who follow the GBP/USD pair can analyse interest rate differentials between the UK bonds and US bonds, for example. Higher yields usually attract capital flows from around the world, which leads to an appreciation of the domestic currency.
Real Interest Rate
Real Interest Rate is the rate that is adjusted by including the cost of inflation.
Therefore the formula is simple:
Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)
This, however, is an estimate as precise inflation rates are never constant and fluctuate over time.
Real Interest Rate is important to keep in mind when borrowing as it is not advertised, however, crucial as it allows to identify the real cost of either borrowing or lending funds. If both Nominal interest rate and Inflation are the same, you are essentially borrowing the funds for free since the purchasing power of borrowed money decreases at the same speed as the cost that you pay to borrow it.
Alternatively, when depositing during times when inflation is much higher than inflation, high results in a negative real interest rate. For example, a deposit with a 2% annual interest rate yields -1% if the inflation rate in the economy is 3%.
Negative Interest Rate Policy (NIRP)
Negative rates have been a recent development as various Central Banks look to stimulate the economy even further after reaching a 0% interest rate. This means that depositors are paying money to hold at the bank instead of receiving interest rate payments. Therefore, they are much more likely to invest money and spend in the economy.
Additionally, this makes banks more willing to give out loans. Therefore, overall economic activity increases. Switzerland and Japan are recent examples of using negative interest rate policy.
Overall, interest rates are an important factor for the economy as they directly influence the ability and willingness to borrow and lend funds.
High interest rates are intended to slow down the economy in order to protect it from overheating or high inflation. The opposite is true with low interest rates as it creates an environment where banks are more willing to lend while companies and individuals are more inclined to borrow funds for investment and spending, therefore stimulating the overall economic activity.
The decision for increasing or decreasing interest rate is made by a Central Bank in most countries. Preferably this is done without political intervention as it can influence economic developments short-term.
The FOMC meets regularly every few months to discuss the direction of monetary policy. Traders follow those meetings closely as they often create significant volatility in the market.
Carry trades involve borrowing low-yielding assets and investing them into high-yielding assets. Carry trades mostly include currencies, but the strategy can also be used with other assets, such as bonds, stocks, or real estate.
Real interest rate is something to always keep in mind as holding deposits with low interest rates can have a negative real interest rate during times of high inflation. Additionally, a negative interest rate has been seen recently as a means to stimulate the economy even further after the interest rates reached record-lows around the globe.
Interest rates are a key tool used by policymakers to stimulate a weakening economy or to cool-down an overheating economy. Interest rates affect capital inflows and outflows and can have a significant effect on financial markets.
Higher interest rates attract capital inflows, while lower interest rates usually lead to capital outflows as investors look for other higher-yielding investments.