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Interest rates, interest rates. This seems to be everything everyone with any skin in today’s financial market ever cares about. With the whole world shifting uncomfortably in their seat whenever a rate hike review is due from the Federal Reserve, this almost obsessive focus on this seemingly arbitrary number feels a little crazy for the uninitiated.
After all, what can one little percentage point really do?
The concept of interest rates dates back to ancient Mesopotamia around 3,000 BC, where loans were made and interest was charged in the form of a commodity, like grain or silver. However, it was the ancient Greek philosopher Aristotle who first noted the idea of interest, albeit with skepticism, considering it unnatural.
Fast forward to the Renaissance, when financial minds like the Italian mathematician Leonardo Fibonacci began to formalise the mathematics behind interest rates, setting the stage for modern economic theories. We still use the Fibonacci retracement as a technical analysis tool today.
In the modern economy, interest rates are treated as the “cost” of borrowing money. They influence consumer spending, business investments, and overall economic growth. The power of interest rates lies in their ability to steer the economy. Whether it’s cooling down an overheating market or stimulating a sluggish one, this little number wields immense influence.
So how profound is the influence of interest rates on the value of any currency? We can observe how interest rates fluctuate, almost in tandem to market movement. Why then, one might wonder, is it necessary for central banks review interest rates periodically?
And why should you as a forex trader care?
The role of central banks in managing the economy
Central banks change interest rates primarily to manage economic stability. Changes in interest rates can determine if the economy growth of a country is sustainable, as this in turns control inflation and achieves a stable financial environment.
In the context of monetary policy, central banks can have varying attitudes in approaching inflation and economic growth. When describing the tone and content of speeches by central bank, two terms are commonly used:
Being hawkish cools down the economy
Hawkish policymakers prioritise keeping inflation low, often advocating for higher interest rates and tighter monetary policy.
Their main concern is that high inflation could destabilise the economy, so they tend to act quickly and decisively to raise rates or otherwise restrict the supply of money.
Being dovish heats up the economy
Dovish policymakers are more concerned with unemployment and supporting economic growth. It is common to see lower interest rates and a looser monetary policy to stimulate borrowing and spending.
Dovish policymakers are more willing to accept higher inflation if it means encouraging job creation and economic growth.
When hawkish and when dovish?
To put it simply, a sensible central bank may start taking a hawkish stance when it perceives that the economy is overheating. Common signs that an economy is overheating would include rising inflation and asset price bubbles. As raising interest rates can make borrowing more expensive, a hawkish stance can potentially cool off speculative investments and reducing the risk of a market bubble.
On the other hand, central banks tend to adopt a dovish stance when it felt the need to stimulate the economy. Recession periods, high unemployment rates and financial crises are the usual triggers. For instance, during the COVID-19 pandemic in 2020, central banks like the US Federal Reserve and the European Central Bank (ECB) slashed interest rates to near-zero levels and implementing quantitative easing to support their economies.
A game of tug-of-war
Whichever stance taken by a central bank, change is the only constant in any economy. This is the reason why central banks cannot go with a one-way street approach as it pleases, but rather review its approach periodically to tighten and loosen the monetary policy like a game of tug-of-war depending on the economy status at the given material time.
Can interest rate solve all economic problems?
It depends. While interest rates are key drivers in forex markets, the impact isn’t always straightforward. Delays in economic response, high existing debt and global economic conditions can lessen the effectiveness of rate changes.
Also, when rates are near zero, traditional rate cuts become less effective. Interest rates are also closely tied to other economic indicators like employment rates, inflation and GDP growth.
As such, understanding how interest rates relate to these factors can provide deeper insights into potential currency movements. For forex traders, understanding and anticipating interest rate changes is essential for those who would like to trade on news, which can be very swift and lucrative.
Trading opportunities arising from changing interest rates
Interest rates are closely tied to other economic indicators like employment rates, inflation and GDP growth. Understanding how interest rates relate to these factors can provide deeper insights into potential currency movements.
Further, announcements regarding interest rate changes are typically times of high volatility in forex markets, quite like the nature of news trading. Traders can capitalise on this volatility if they can predict the direction of the market movement following an interest rate change.
What if the central bank makes a poor decision?
In short, it can turn into a situation of adding oil to fire. Not only there would be long-term economic challenges for the country, but everything from the stability of the currency to general living standards would be impacted.
One of the classic examples would be Turkey and one of the biggest losers in the currency market, the Turkish Lira (TRY).
Under the administration of President Recep Tayyip Erdoğan’s, the Central Bank of the Republic of Turkey (CBRT) has lowered interest rates despite soaring inflation. President Erdoğan has publicly advocated for lower interest rates, arguing that it helps to foster economic growth.
The Turkish lira (TRY) has seen a sharp fall since 2018, depreciating between 80% to 90% against major currencies such as the US Dollar (USD), the Euros (EUR), Pound Sterling (GBP) and Japanese Yen (JPY). Foreign investors are spooked, and the purchasing power of Turkish people practically just evaporated into thin air.
Opportunities for forex traders
With an obvious trend from the CRBT, USDTRY and EURTRY are the most traded exotic currency pairs as traders can simply choose to short TRY.
Combined with the right trading strategy, technical analysis and risk management, both pairs can present a good trade setup for traders to seize some profits.
