THE ESSENTIAL GUIDE TO UNDERSTANDING INTEREST RATES

Interest rates serve a number of purposes in the economy. They allow investors to lend capital to borrowers while earning a return to compensate them for the risk they are taking. They allow borrowers access to capital to finance assets and build businesses. And most importantly, they are used by central banks to balance growth and inflation in an economy.

Interest rates affect everyone – consumers, business leaders, and of course traders and investors. They also affect all asset classes, including currencies, bonds, and equities. It’s essential for anyone involved in the markets to understand what can influence the direction of interest rates, and what changing interest rates can mean for asset prices.

Interest rates and inflation

Policymakers have two sets of tools to help them steer an economy in the direction they want. Monetary policy is used to combat inflation when it rises too fast or too high, and to stimulate the economy during recessions. Fiscal policy uses tax revenues to fund certain parts of the economy and to provide stimulus.

The primary tools of monetary policies are interest rates. Rapid price inflation is bad for an economy as some businesses cannot increase their prices as fast as their costs increase. Inflation also makes it difficult for businesses to plan, and so they put off new projects – when this happens across an economy, it slows, and investors become nervous. 

If inflation gets out of control, the central bank can raise rates to slow borrowing and spending, which should slow inflation.  In practice, it does this by raising the interest rate it charges commercial banks when they borrow from the central bank. This, in turn, causes banks to adjust the rates they charge their clients, and so interest rates throughout the economy rise.

If economic growth is too slow, or if inflation is low, central banks can lower interest rates. This incentivises businesses to borrow more, spend more and employ more people. When central banks adjust rates, they affect short term interest rates in the economy.

Interest rates and the bond market

The other monetary policy tool the government has is the bond market. The government can borrow money by selling bonds, and then use that money to invest in infrastructure, thereby creating jobs and new spending in the economy. This also affects interest rates.

Bond prices are determined by supply and demand, so the more bonds a government sells, the lower the price will be. As bond prices fall, their yield, which is the interest rate they pay, rises. On the other hand, if there is strong demand for bonds or if the government decides to sell fewer bonds, bond prices rise, and interest rates fall. This activity affects long term rates.

Traders need to consider how much a government will need to borrow in the future, as this will affect the supply of bonds. If borrowing increases, the interest cost will also rise, which will have other effects on the economy and in turn affect interest rates.

These rates can be traded directly by trading in the bond market. However, interest rates trading is not the only way trading strategies can be based on interest rates, as they affect other markets too.

The yield curve

As mentioned, when central banks raise or lower the interest rate they charge banks, short term rates are affected. When supply and demand for bonds, causes the bond yield to change, this affects long term rates.

Interest rates for different time horizons can be plotted on a chart called a yield curve. Normally, long term rates should be higher, as the risk is higher if a loan is made over a longer time horizon. This means a normal yield curve slopes upward.

An inverted yield curve means short term rates are higher, which happens when the demand for short term loans suddenly rises. This is often a sign that a recession is about to occur as there is a shortage of credit in the market.

Interest rates and currencies

The relationship between interest rates and forex is at the core of fundamental analysis of the currency markets. This is because the interest rate differential between two countries is one of the main drivers of currency prices. If two countries have different interest rates, capital will flow from the country with the lower rate, to the country with the higher rate – unless there is too much risk. This will cause the currency with the higher rate to appreciate.

For currency traders, anything that may cause a country’s interest rates to rise or fall is of interest. Interest rate trading strategies can therefore also be applied to forex markets.

Interest rates and the stock market

Interest rates impact the stock market in a number of ways. For a start, higher rates make bonds more attractive relative to stocks. Higher rates also cause consumer spending to fall and business costs to rise, so company profits are impacted. In general, lower rates are good for the stock market, and higher rates cause stock prices to stop rising or to fall.

Conclusion

The relationship between interest rates and markets is not always linear. The impact of a change of rates is never certain because markets are all connected to one another, and other factors affect prices too. However, interest rates and the outlook for where they are headed always shape the market environment in some way – especially the forex market.

 

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