Understanding Central Bank Interest Rates

By | May 29, 2017
Understand Central Bank Interest Rates

Central bank interest rates decisions are one of the few economic developments that has an impact on a currency’s exchange rate. It affects not just the currency but also all other assets including equities and precious metals.

It is not surprising then that even the most stubborn of traders who swear by technical analysis do not take the risk of ignoring the central bank interest rate decision..

Further more, the implications of the central bank interest rates are far reaching and affects all asset classes; stocks, bonds, currencies and precious metals.

Once a month, central banks announce their monetary policy update. This event is watched with avid interest. If it is the United States Federal Reserve Bank (FRB) in the U.S., then it is the European Central Bank (ECB) in Europe, or the Bank of Japan (BoJ) in Japan.

Central bank’s monetary policy setting committee meets at least 10 times a year and decide on where interest rates should be.

In this article, well take a brief look at interest rates, what they mean and its implications for trading the respective currencies.

Central Bank Interest Rates – Getting the context

Interest rates are one of the many tools available at the Central banks’ disposal to monitor and to influence growth of an economy.

Broadly speaking, higher interest rates results in lower spending, thus indirectly slowing the economic growth and thus reducing inflation; while lower interest rates attract consumer spending resulting in higher economic growth and thus increases inflation.

Therefore, in a struggling economy, you can expect to see lower interest rates which is used by central banks to boost growth, while in strong economies you can expect interest rates to rise so that the economy does not overheat.

How do currencies react to interest rate decisions?

When interest rates a cut by central banks, the currency’s exchange rate tends to fall as investors pull out money and look for higher yielding currencies. This lower exchange rate has an impact on the exports of the economy, making the products cheaper.

On the other hand, when interest rates are hiked, the currency’s exchange rate tends to appreciate. Investors flood to park their money is the local currency to get higher yield. When rates are high and the exchange rate is also high, imports are cheaper and in a way, the importing country also imports inflation from overseas.

Jane Bryant Quinn, American financial journalist on bond markets and interest rates

Jane Bryant Quinn, American financial journalist on bond markets and interest rates

Of course, in both the cases you can expect to see some trade off as the exchange rate can also influence the nation’s trade balance as well.

How are interest rates decided by central banks?

The central bank’s monetary policy committee meets once a month to review the economic environment and take decisions in regards to whether interest rates should be reduced, increased or kept unchanged.

This decision is based on key economic markers such as Consumer Price index (inflation), GDP, Employment data, new/existing housing market data.

After the meeting is held, the central bank publishes a statement which is also referred to as Monetary Policy Statement. Here, the central bank gives more details on what member’s discussed and also justifies its monetary policy action.

(Ex: If interest rates were cut, then the monetary policy statement will explain what factors led to the cut in interest rates)

Why should you pay attention to central bank interest rate decisions?

As a currency futures trader, it is important to pay attention to the economic markers because they matter to the central bank policy makers.

In most cases, central bank decisions do not come out of the blue. Well ahead of the next central bank meeting, policy makers give their opinions on the economy and indirectly hint at what to expect from the upcoming meeting.

Central bank decisions are not made out of the blue, and are communicated ahead of time. This is done to ensure that there is minimal disruption to the markets.

The central bank policy makers are made up of board members and the chairman. Policy makers meet once a month to review the economy. Interest rates or forward guidance is given according to the assessment.

When considering a change to the interest rates, the policy makers look on a long term perspective. Thus, a month or two of weak growth wouldn’t necessarily indicate an interest rate cut.

On the other hand, if the policy makers decide to change the interest rates, then its done over a period of time. Because this announcement is watched by traders and investors alike, across retail and institutional sectors, a sudden and unexpected rate cut is never announced.

On the contrary, the policy makers drop hints towards a potential rate cut over a period of time so the markets factor in the sentiment.

Despite this, currencies tend to fluctuate wildly when the central bank announces a change in interest rates.

Understanding the Central Bank’s policy mandate

The first step is in understanding the central bank’s mandate. This mandate can be either inflation targeting or targeting the unemployment rate. The mandate is basically the central bank’s metrics that it follows. The mandates can change from one central bank to another.

Central banks have a mandate, which is inflation targeting or unemployment rate targeting. When these metrics change, the central bank responds with the appropriate policy decision.

For example, the U.S. Federal Reserve has a dual mandate, targeting both inflation and unemployment rate.

Our two goals of price stability and maximum sustainable employment are known collectively as the “dual mandate.

Whereas, the Bank of England has a single mandate, which is inflation.

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. The government defines the price stability target which is usually 2% inflation rate.

What this tells us is if you want to trade the U.S. interest rate decision, then you must keep a track of inflation and the unemployment rate. Or, if you were to trade the British pound currency futures, then you should keep a track on the BoE’s interest rate decisions by tracking how the UK inflation is evolving.

Example of inflation and unemployment affecting Federal Reserve Monetary policy

The chart below depicts the 10-year inflation and unemployment rate in the U.S.

U.S. Federal Reserve Dual mandate, targeting inflation and unemployment rate (Source: Fred.org)

U.S. Federal Reserve Dual mandate, targeting inflation and unemployment rate (Source: Fred.org)

Market pricing the event – Interest rate decisions

In most cases, the markets start to price the event ahead of time. This happens as market participants track inflation or unemployment (or both). Besides these two, GDP is another metric that can influence market participants and policy makers.

British pound futures reaction to BoE, August 2016

The speeches from various central bank officials  gives enough clues to the market participants. This helps them to speculate on the currency futures.

British pound futures reaction to Bank of England Interest Rate cut (August 2016)

British pound futures reaction to Bank of England Interest Rate cut (August 2016)

The above chart for the British pound futures contract shows how the somewhat surprise decision to cut interest rates by the Bank of England led to a sharp decline in the British pound futures market.

In some cases, markets get ahead of the event to become extremely biased.

If the event is as expected, there is hardly any movement in price. In most cases, the currency falls as traders book profits on a successful trade.

New Zealand dollar futures reaction to RBNZ statement, May 2017

When central banks do the opposite to what the markets were expecting, it results in a sharp decline in prices.

New Zealand dollar futures fall sharply on a surprise RBNZ policy decision

New Zealand dollar futures fall sharply on a surprise RBNZ policy decision

The above chart of the New Zealand dollar futures illustrates this point. On May 10, 2017 the Reserve Bank of New Zealand (RBNZ) was deciding on interest rates.

It was widely expected that interest rates would not be changed, but the RBNZ would signal a hawkish statement that rates could be hiked soon (on the back of improving economic data as inflation was back at 2.2%, sitting right in the middle of the RBNZ’s inflation band of 1% – 3%).

Ahead of RBNZ’s meeting, the NZD futures posted strong gains. This was because traders anticipated a hawkish central bank response.

However, it turned out that the RBNZ was very dovish, dismissing the rise in inflation saying it was only transitory.

This led to a sharp decline in the exchange rate as seen by the down gap in the price chart. It was indeed a big surprise for the markets which was betting on a hawkish statement instead.

Summary – Understanding central bank interest rate decisions

Understanding how the central bank interest rates decision works is essential for currency futures traders. Having a grip on the interest rates can help traders to understand which way the markets are moving. There are many ways to base one’s trading strategy that revolves around interest rate decisions.

There are a lot of trading opportunities that come around with interest rate decisions. Keeping a close watch on interest rate decisions and listening to what policy makers have to say is key.

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