A lot of factors determine the strength of a nation’s currency. While some affect its purchasing power directly others may affect it indirectly. Interest rates belong to the former and has a strong influence on the value of a nation’s currency. Interest rates are so important that there are trading strategies that rely on them. In this post I will be exploring interest rates and what significance it is to the forex market.
What Are Interest Rates
According to Wikipedia, an interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed. A lender/depositor receives interest on the amount lent/deposited (principal) while a borrower pays interest on the amount borrowed. The period for which the interest is charged can range from daily to monthly to yearly. The interest rate in most cases is set by the lender as it is the amount charged for leasing their asset (principal).
In normal day to day life, interest comes into play when people take out loans. The reason for taking loans can range from buying a car or house to studying or just shopping. Whatever the reason is, the borrower uses the money and pays back more than the amount borrowed. Just like individuals, businesses also obtain loans usually to fund their operations or carry out capital projects. The interest and the amount borrowed (principal) can be paid back in installments or once as a lump sum at a predetermined date. For the same interest rate over a specified period of time, the total amount of interest payable can vary depending on the type of interest that is applied. These types are simple and compound interest.
Simple interest is a linear form of charging interest. Once the rate is set, its amount does not change over the period. For example, if an annual rate of 20% is charged on a $10,000 loan with a period of 5 years. The amount of interest payable will be 20% (rate) of $10,000 (principal) multiplied by 5 (period). This will give $10,000 in interest. The total amount to be repaid will then be principal + total interest which is equal to $20,000. So for a $10,000 loan with an interest rate of 20% for 5 years the total amount to be repaid is $20,000.
From the above example, the formula for calculating simple interest can be seen.
Simple interest = Principal X Interest rate X Time
Compound interest is different in that the cash value of the rate changes because the interest of the previous period(s) is added to the principal and used to calculate the new value. This process is known as compounding and it leads to the incurring of much higher interest than in simple interest. For example, if compound interest is applied to a $10,000 loan with 20% annual interest rate for a period of 5 years it would look like this:
|Year||Starting Amount||Interest (20% of starting amount)||Ending Amount|
Using compound interest in comparison with simple interest resulted in a difference of $4,883.2 for the same interest rate and tenure. The longer the tenure the wider the gap will be.
The formula for calculating compound interest rate is:
Compound Interest = Principal × [(1+ interest rate)n−1]
Where n = the number of compounding periods.
Interest rates represent a major way through which banks make money. They borrow at a rate (interest paid on deposits) lower than at which they lend (interests received on loans). For example, if a bank pays 10% on savings and then charges borrowers 15%, then the banks make the difference (5%) as profit. While it may not seem like a big deal to everybody, interests play a very significant role in the financial sector as it affects the lenders, borrowers, and even neutral parties (that did not lend or borrow). This is because interest rates impact the economy that involves everyone.
Impact of interest rates on the economy
Banks are the primary deposit-taking and lending institutions and as such are at the center of interest rates. The position of banks (commercial) is such that they borrow money from the central banks or depositors (savings account holders) and then lend to borrowers. Thus for interest rates to affect the economy, banks have to be involved. The impact of interest rates on the economy will be discussed under different themes such as how interest rates affect consumer spending, business growth, inflation, and money supply. It is the culmination of all these that lead to the observed effect of interest rates on the economy.
A lot of people who have spare capital are encouraged to save it if interest rates are high. This is because they get a high return on investment. While if interest rates are low, people are less inclined to save. The problem with low interest rates is that it causes inflation as there is more demand than supply (demand-pull inflation). This particular phenomenon has the capacity to wipe out any perceived gain on deposits thus saving is discouraged in a low interest economy.
When interest rates are high, borrowing is reduced. This causes the economy to contract. This is because those who need loans to carry out business operations that put money in circulation are discouraged from borrowing due to the high rates. In contrast, when interest rates are low, the economy grows, borrowing is encouraged, and the cash in circulation increases. In a low interest economy, people spend more, demand is high and can cause inflation.
As highlighted in the two previous sections, interest rates are inversely related to cash supply – low interest rates = high cash supply, high interest rates = low cash supply. This causes business growth to be affected by interest rates. When interest rates are low, businesses have access to capital, consumer spending increases leading to economic expansion. And on the other hand, if interest rates are high, businesses do not have as much access to capital, consumer spending is reduced causing the economy to slow down.
During times of economic expansion, there is a tendency for inflation to occur. When this happens, banks raise interest rates to tighten the money supply and reduce inflation. To stimulate an economy, the interest rates can be lowered, this causes increased money supply, and inflation rises. Therefore, when interest rates are low, inflation increases, and when interest rates are high, inflation reduces.
Central Bank Monetary Policies and interest rates
Central banks are the apex banks in their countries and are responsible for a number of things such as regulating commercial banks, regulating cash supply, providing capital, and regulating the value of the nation’s currency. One of the ways central banks carry out their functions is through the use of monetary policies. A monetary policy as defined by Investopedia,
Central banks are the apex banks in their countries and are responsible for a number of things such as regulating commercial banks, regulating cash supply, providing capital, and regulating the value of the nation’s currency. One of the ways central banks carry out their functions is through the use of monetary policies. Monetary policy as defined by Investopedia refers to the actions undertaken by a nation’s central bank to control the money supply to achieve macroeconomic goals that promote sustainable economic growth. This policy can either be expansionary or contractionary. It is the regulation of the money supply and interest rates through the use of tools such as buying and selling government bonds, increasing bank reserve requirements, modifying interest rates, and regulating foreign exchange rates that help to carry out the macroeconomic objectives. These objectives include growth, inflation, liquidity, and consumption. Monetary policy can be used in tandem with fiscal policy to manage the economy.
Monetary policy announcements are usually met with high anticipation and can have significant effect on the value of a nation’s currency.
You can read more about central banks in this post.
Interest rates and the forex market
As stated in the previous sections, interest rates bear significant importance in determining the value of a nation’s currency. This is the reason why interest rates set by the central banks are watched closely by currency traders. Interest rate announcements alongside other economic indicators are tracked using an economic calendar by forex traders and economic analysts. The effects of interest rates on the value of a nation’s currency and how to trade this will be explored below.
Effects of high interest rates
Short-term: When interest rates are high people are more inclined to save money and there is a higher rate on loans therefore businesses are discouraged from taking out loans for capital projects. High interest rates in the short term causes a reduction in the value of the currency.
Medium-term: In the medium-term high interest rates also combat inflation by restricting money supply and reducing consumer spending. This effect on inflation would cause the value of the currency to rise.
Long-term: In the long-term high interest rates can also cause unemployment to rise and if not managed properly can result in recession. The onset of an economic recession will lead to the reduction of the value of a nation’s currency.
Effects of low interest rates
Short term: Low interest rates on the other hand when implemented boost consumer spending make capital easily available to businesses lower unemployment rates and generally causes the economy to expand this effect would cause the value of a nation’s currency to rise because the currency value rises when the economy is enjoying a boost.
Medium to Long-term: Low interest rates can lead to inflation if left unchecked this inflation would result in the loss of value of a nation’s currency this is because it would cost more to do things as there will be an increase in the cost of living and doing business.
How to trade with interest rates
Forex traders can take advantage of interest rates in two major ways:
- Trading news releases
- Carry trade
The first way is to track news releases. If the interest rate is set higher than expected, the value of the currency will most likely drop, and if the interest rates are set to lower than expected the value of the currency would most likely rise. The other possibility is if the interest rate is set to match the projections the currency would experience little to no movement.
The other way to trade news interest rates is the carry trade concept. To trade this concept, the different interest rates of countries are taken into account and the currency of a country with high interest rates is bought against the currency of a country with a low interest rate. Since the currency with the higher interest rate is bought, the trader would earn interest on it and then will pay interest on the second currency which is sold. The difference will be made by the trader just like the banks. This type of trading requires long to medium term and for the value of the currency to be relatively stable this is because if the currency moves opposite direction (against your position) for example, the value of the pair drops in the case of buying the base currency and selling the counter currency, it would most likely wipe out profits made from the carry trade but if the value of the price of the pair goes up then the profit would be added to that of the carry trade. Therefore, a carry trade is most ideal in a market trending sideways.
In conclusion, interest rates are important and bear significant influence on the value of a nation’s currency alongside its whole economic health. Interest rates are used by the central banks (monetary policy) with or without fiscal policy to achieve economic stability.
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