The forex market is mainly driven by interest rate changes by the eight major central banks in the world economy [US Federal Reserve Bank (USD), Swiss National Bank (CHF), Bank of England (GBP), European Central Bank (EUR), Reserve Bank of New Zealand (NZD), Bank of Canada (CAD), Bank of Japan (JPY), and Reserve Bank of Australia (AUD)].
That’s because decisions on lowering the rate, increasing it, or maintaining the status quo is linked to the country’s economic health. Whether anticipated or a surprise announcement, the impact is palpable, which makes it important for forex traders to have some plan/strategy up their sleeves to make the most of opportunities.
To be a successful in this game you must understand what drives the price in the global markets. If you don’t and you are not happy with your trading, fear not! After reading this article, you will know the most important facts about the subject!
This article discusses the five potential impacts of an interest rate hike on currencies and equities. It also factors in historical movements, which can help understand and contextualize the ‘then’ and ‘now’ scenarios, to make educated decision.
#1: FED Rate hike pushes the US Dollar up
A currency’s value is influenced mainly by two factors: economic growth and changes in interest rate. During times of robust growth, central banks feel encouraged to increase interest rates to avoid inflation. Rising interest rates increase the yield on assets available in the currency, and make them more sought-after than other securities.
With expectations that the Fed will end seven years of rock-bottom interest rates – which have hovered between 0 and 0.25 percent since the 2008 financial crisis – the US dollar will strengthen on the back of a demand for the higher-yielding currency.
At least this is the assumption.
This represents an opportunity for traders to buy the dollar against weaker currencies. You can now use the dollar to buy more of the other currency than you could previously. An increase in the value of the greenback always merits a purchase. You can invest in a broad basket of currency pairs to diversify any risk posed by the other currencies.
But note that a more aggressive rate hike than what the market expects has caused the dollar to fall on one occasion (see figure below).
Source: Bloomberg and FOREX.com
You must head about the old saying:
“Buy the rumors, sell the facts” This could be true in this situation too. The fact is the Dollar has been rallying for a very long time against other currencies. The “rumor” was – the FED raising interest rates some time in 2015. In anticipation of this, market bought Dollars bidding it up.
Next week can prove to be a “fact” where Dollar bulls decide to cash their profit on those long Dollar positions, causing Greenback to plunge despite the rate hike.
So be ready and don’t get surprised!
#2: Impact on the stock market
Changes in interest rates affect the stock market. Logically, a low interest environment allows companies to expand more quickly and borrow money without a high interest debt. It also allows customers to purchase more of a company’s products, and an increase in customer base will – in turn – offer the company impetus to expand.
However, owing to the weak economic climate following the recession, there has been a divergence in this typical feedback mechanism. A main reason for it is that, though companies and consumers can afford to borrow money, very few banks have been willing to lend it to them. So, while the buying power and ability to afford a loan exists, finding someone to lend the money is equally important. As a result, rising rates don’t necessarily cause the stock market to fall.
Historically, stocks don’t follow a straight downward path after the Fed hikes interest rates. The performance is mixed. Going by the trends observed in the past 35 years, the market tends to move up sharply – by almost 15 percent – as it heads into the rate hike, then stays pretty much flat for the 250 days after the hike, and then recovers after a period of 500 days.
In the last six cycles of rate hikes, dating back to 1983, S&P’s 500 stock index fell three times on the day of the Fed’s first rate hike, or 50 per cent of the time. February 1994 posted the biggest day one loss when the S&P 500 index declined 2.3 per cent. Following the first rate increase in January 1987, stocks moved up 2.3 per cent, and jumped 1.6 per cent after the initial increase in June 1999.
#3: How will other currencies be affected?
Anticipation of a rate hike has been around for a while now. That’s a reason why the dollar started the year with a bang, with the dollar index measuring this currency against a basket of its peers jumping to a 12-year high. But even as it surpassed emerging market currencies, the broad dollar has not sustained its strength, especially with the Euro and Yen regaining their footing. If a rate hike is announced in the December meeting, then the dollar will climb higher.
Now let’s look at the Euro. Though it may appear at first that a U.S rate rise will cause a fall in the Euro, at least versus the Dollar, Wall Street says that there is no definite way of predicting where the currency may be headed. One of the reasons for this is the Euro’s relationship with volatile assets like equity. The Euro has become a safe haven during times of market pressure; so if the rate hike negatively affects equity, it could be positive for the Euro.
On the flipside, inaction from the Feds may not bode well for the Euro if equities pick up. This rationale, along with a belief that the dollar has rallied as much as it could, has made investors less decided about the potential journey that the Euro could take.
#4: The price has already adjusted in anticipation of a hike
News of an impending interest rate hike always has an effect on the market. Therefore, traders must understand that currency prices are probably already adjusted. This lowers the likelihood of a drastic movement up or down. The hike is not a surprise and a s mentioned earlier can prove to be an opportunity for Dollar bulls to lock those profits.
#5: A rate hike could prompt carry trade closings
Already, an emerging dollar has damaged carry trade and liquidity in emerging countries’ capital markets. If the Fed raises the interest rate even by a small amount, it can adversely affect carry trades, which are speculations based on borrowing the USD and investing the money in higher-yielding emerging market currencies. As these currencies fall against the dollar, the carry trade’s gains are offset by foreign exchange (FX) losses.
Every serious trader must understand the above dynamics in order to profit from the market in the long run. Technical analysis is not enough to be fully in control. Fundamental market knowledge is essential to trading success in the long run.
But there are great opportunities in this market for those who are willing to learn and work hard.