What are interest rates and how are they set?
Interest rates are basically the price of borrowing or lending money. They are expressed as a percentage of the amount of money involved. For example, if you borrow $1000 from a bank at an interest rate of 5% per year, you will have to pay back $1050 after one year. That extra $50 is the interest that the bank charges you for using its money.
Interest rates affect the cost of loans, mortgages, credit cards, savings accounts, and other financial products. They also influence the economy, inflation, and consumer spending. Generally speaking, higher interest rates make borrowing more expensive and saving more attractive, while lower interest rates make borrowing cheaper and saving less rewarding.
But who sets the interest rates and how? Well, there are different types of interest rates in the market, and they are determined by different factors. Some of the most common ones are:
- The base rate: This is the interest rate that the central bank (such as the Federal Reserve in the US or the Bank of England in the UK) charges commercial banks for short-term loans. The central bank uses the base rate as a tool to control the money supply and inflation in the economy. By raising or lowering the base rate, the central bank can influence the borrowing and lending behavior of banks and consumers.
- The prime rate: This is the interest rate that commercial banks charge their most creditworthy customers for loans. The prime rate is usually based on the base rate plus a margin that reflects the risk and profitability of lending to different customers.
- The LIBOR: This stands for London Interbank Offered Rate, and it is the average interest rate that major banks charge each other for short-term loans in different currencies. The LIBOR is used as a benchmark for many financial products, such as mortgages, bonds, derivatives, and student loans.
- The savings rate: This is the interest rate that banks pay their customers for depositing money in savings accounts or certificates of deposit (CDs). The savings rate is usually lower than the prime rate or the LIBOR, because banks can use the deposited money to lend to other customers at higher rates.
- The mortgage rate: This is the interest rate that banks charge their customers for taking out a loan to buy a property. The mortgage rate is usually higher than the prime rate or the LIBOR, because mortgages are long-term loans that involve more risk and cost for the lender.
As you can see, interest rates are not fixed or uniform across different products and markets. They vary depending on supply and demand, risk and reward, time and duration, currency and location, and other factors. Interest rates also change over time in response to economic conditions, market expectations, policy decisions, and global events.
Interest rates are important because they affect how much money we pay or earn when we borrow or lend money. They also affect our spending and saving decisions, our investment returns, our debt levels, and our financial well-being.
How do interest rates influence currency demand and supply?
Now, imagine that you are an investor who wants to invest your money in different countries. You have two options: Country A and Country B. Country A has a higher interest rate than Country B. Which country would you choose to invest in?
If you are a rational investor, you would choose Country A because you can earn more interest on your investment there. By investing in Country A, you are increasing the demand for its currency because you need to buy its currency to invest there. This will make its currency appreciate in value.
On the other hand, if you are an investor in Country A who wants to invest in another country, you would choose Country B because you can borrow money at a lower interest rate there. By borrowing money from Country B, you are increasing the supply of its currency because you need to sell its currency to borrow there. This will make its currency depreciate in value.
So, as you can see, higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country’s currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency’s relative value.
Of course, this is a simplified explanation and there are many other factors that affect currency demand and supply, such as inflation, trade balance, political stability, etc.
How to trade forex based on interest rate expectations?
Generally speaking, higher interest rates tend to attract more capital inflows and boost the demand for a currency, while lower interest rates tend to discourage capital inflows and reduce the demand for a currency. Therefore, if you expect a country to raise its interest rate in the future, you might want to buy its currency now and sell it later when the rate hike happens. Conversely, if you expect a country to cut its interest rate in the future, you might want to sell its currency now and buy it back later when the rate cut happens.
But how do you know what the market expects about interest rates? One way is to look at the forward rates, which are exchange rates that anticipate the rate at a future point in time. Forward rates are calculated based on the spot rate and the interest rate differential between two currencies. For example, if the spot rate of USD/CAD is 1.25 and the annual interest rate of USD is 2% and CAD is 1%, then the one-year forward rate of USD/CAD is:
Forward Rate = Spot Rate x (1 + IRO) / (1 + IRD)
Forward Rate = 1.25 x (1 + 0.02) / (1 + 0.01)
Forward Rate = 1.2575
This means that you can lock in an exchange rate of 1.2575 USD per CAD for one year from now. If you expect the USD to appreciate more than this rate, you might want to buy USD forward and sell CAD forward. If you expect the CAD to appreciate more than this rate, you might want to sell USD forward and buy CAD forward.
Another way to gauge interest rate expectations is to look at the yield curve, which is a graph that shows the relationship between the maturity and the yield of bonds issued by a country. The yield curve reflects how much investors are willing to lend money to a government for different periods of time. A normal yield curve is upward sloping, meaning that longer-term bonds have higher yields than shorter-term bonds. This is because investors demand more compensation for lending money for longer periods of time.
However, sometimes the yield curve can become inverted, meaning that shorter-term bonds have higher yields than longer-term bonds. This is usually a sign of an impending recession or a monetary policy easing by the central bank. An inverted yield curve indicates that investors expect lower interest rates in the future, which would make longer-term bonds more attractive than shorter-term bonds.
Therefore, if you see an inverted yield curve in a country, you might want to sell its currency and buy another currency with a normal or upward sloping yield curve. This way, you can benefit from both the exchange rate movement and the interest rate differential.
Of course, there are other factors that affect forex trading besides interest rates, such as inflation, trade balance, political risk, etc. But interest rates are definitely one of the most important ones that you should pay attention to. By using forward rates and yield curves, you can get a better idea of what the market expects about interest rates and how they will impact currencies.
