Why Do Interest Rates Matter?

Interest rates — and relative interest rates between countries, and expectations for changes in interest rates — are the single most important factor in trading Forex.

All fundamental data in Forex should be viewed with one eye on how that data will affect interest rates. To be more precise, you want to know how the central bank of that currency views each type of data. In the USA, for example, the Federal Reserve has a double mandate: to control inflation and to promote employment. Therefore, when we look at US data, we care about the monthly non-farm payrolls report as well as about CPI. In the eurozone, on the other hand, the ECB does not have an employment mandate. Unemployment can reach 30% or more in some countries, as it has done in 2012-2014, and yet we do not expect the ECB to respond to such terrible numbers.

Base-Case Model

At the most basic, the conventional model of a free-market economy assumes that there is an optimum interest rate that will promote equilibrium between growth and inflation. When growth is stagnating, and, therefore, prices are not rising by much due to lack of demand, central banks cut interest rates in order to stimulate production by enterprises that need to borrow and those that are sitting on a cash hoard alike — the lower rates help the borrowers and are a disincentive to the cash-rich. Lower rates, if successful in pushing up growth, may also push up inflation if growth is too high and excess capacity in the economy is used up.

You get a cut in rates under two conditions:

• Slow growth accompanied by a large or rising output gap (excess capacity)
• Low inflation

We may ask, since the eurozone was exhibiting slow growth and low inflation, why was the ECB not cutting rates or taking other stimulus measures in 2012-1014 despite the talks of stimulus as had been done in the USA and the UK? The answer is that the ECB did not accept that ultra-low inflation (0.5-0.7% vs. the preferred target of 2%) was a trend at that time. The ECB preferred to think of the low rates as an aberration that will be corrected — as history has taught us to fear.

You get a central bank hike in interest rates when an economy is showing

• Growth that is closing the output gap (high capacity utilization)
• Rising inflation

The rate hike is supposed to inhibit producers who need to borrow to continue to produce and also remove some spending power from both industrial and consumer pocketbooks. If you have an adjustable-rate mortgage and credit card debt, the immediate rise in interest rate charges reduces your ability to buy other goods and services.

Many analysts will say that because of this model, the fundamental data we should follow includes things like the health of the housing market, the degree of indebtedness of consumers, wages and productivity growth, unemployment and commodity prices, and the level of the equity markets (which heavily influences the wealth effect, whereby people with rising equity portfolios feel richer and go out to spend on consumer goods and services, including second homes). While it is possible to make the link between these economic variables and central bank changes in interest rates, as a practical matter, central banks make an effort not to be distracted by data like home price inflation or bubbles in commodity or equity markets. It is a minority of central bank policy board members who worry about ultra-low rates promoting bubbles. On the whole, central banks do not aim to manage markets, whether bubbling or not. They aim to manage monetary policy to herd industrial and consumer behavior. This is why most economists and central bankers missed the threat to the US and global economy of the housing market crash in 2007-2009.

Foreign Investment

Note that the base-case model does not entail any activity outside the borders of the country the central bank is managing. As long as we had fixed exchange rates and exchange controls limiting cross-border flows, the model worked fairly well.

But obviously, in the global free market without capital controls — which we have had for only a few decades (since about 1980) — foreign savers and investors will flock to the country with the higher real interest rate. You cannot look at raw interest rate differentials and deduce that money will always flow to the country with the very highest rates. Investors want the highest real rate, meaning after inflation and expected inflation are subtracted from the nominal rate, and they also want deep and liquid markets, a trustworthy government that will not freeze or expropriate their money, and as much variety as possible. So, the real global investment rule may be that money flows to the highest rate but should include the warning that the return has to be real and the risk of loss has to be small.

In order for a country and its currency to be in demand, investors want not only the highest rate of return but also the prospect that the central bank will take the right actions to keep growth percolating along and, therefore, rates at higher levels for the investing time horizon. Therefore, it is not just the rate differential today that counts but also the expected rate differential in the next time period.

Which Interest Rates?

Every central bank has a benchmark short-term rate that applies to the rate it charges commercial banks to borrow from the central bank and from one another for a time horizon of overnight. In the USA, it is the Fed funds rate, and in the eurozone, it is the repo rate. This is the rate we are watching when a central bank makes a policy change announcement. Every Forex trader needs to memorize the dates of the important central bank meetings.

The benchmark overnight rate is the base off which all other rates in the economy are determined. As a general rule, the longer the time involved in a lending/borrowing situation, the higher the rate off the base. When you chart interest rates of ever-longer maturities (named tenors), you start at the left-hand side with the overnight and draw a line through each maturity to the 20 or 30-year maturity. This is named the yield curve, and it almost always slopes upward to reflect that inflation uncertainty increases the longer you look out into the future.

During the 1980s there was a remarkable correlation between the 10-year rate differential between Germany and the USA and the USD/DM exchange rate. This correlation waxes and wanes, and during periods of turbulence in financial markets, analysts look to the 2-year differential to get a reading on the Forex market. The currency with the higher 2-year rate will be preferred. But you cannot look at the overnight rate alone or the 10-year alone to make a snap judgment on which currency should be higher — you also need to know the overall yield curve and how it can be expected to change given what we know about central banks’ current bias, either tightening or loosening monetary policy.

One of the enduring puzzles in the Forex market is that the dollar can have a yield advantage at every point along the yield curve, but still, the euro will be rising when the real rate differential rule would suggest it should be the dollar on the rise. We do not have a good solution to this puzzle, but one possible answer is that the ECB’s single focus on controlling inflation is the gold standard of monetary policy management among foreign investors, and they fear that the US, in seeking to promote growth and employment, will accept too much inflation.