Monetary policy has played an increasingly important role in moving financial markets, whether directly or indirectly. Here are the fundamentals for you to build your expertise upon.
Starting with the basics; what is interest?
Interest is the cost of borrowing. At country level, it is set by central banks and sets the base rate of interest and rate at which banks lend to one another. For consumers, it is the annual rate of interest on a loan, mortgage or credit card. Interest is generally expressed as a percentage.
Why do interest rates move up or down?
The setting of interest rates is one of the 'tools' central bankers have in order to control monetary policy. When an economy is healthy, inflation might spiral, in which case interest rates can be hiked to dampen spending levels.
Conversely, when people are not spending and the economy is weak, an interest rate cut might encourage borrowing in order to spend, injecting life into a struggling economy.
How does that translate into the markets?
Interest rate moves can have a direct and indirect impact on markets, as well as influencing inflation and hampering or boosting economies. If the base rate is lowered, people are more inclined to borrow for 'big ticket' items, such as houses, cars or white goods. If their savings are earning less, they might be inclined to spend more on a discretionary basis, filtering into many sectors of the economy and driving up stock prices.
Further, if farms or businesses borrow at lower rates of interest, they may invest in their operations, improving productivity or streamlining to make their businesses more profitable. On the flip side, if interest rates go up, this can restrict borrowing, slowing investment and resulting in lower productivity. Their share prices may fall accordingly.
European Central Bank president Mario Draghi is thought to have single-handedly preserved the future of the single currency following his now infamous pledge to "save the euro" in July 2012. Image: iStock
Where does foreign exchange come in?
Currency appreciation or depreciation is based on a number of factors, including interest rates, geopolitics, economic health, supply and demand and trade flows, all of which can all affect a currency's relative strength or weakness.
Fundamental and technical analysis is used to predict price movement, with various academic models and approaches cited. It is also worth noting many currency shifts are based on expectations of what might happen, with real events having a subsequent different impact.
High interest rates, for example, attract foreign investment into a country, which might appreciate the currency of that country due to greater demand. Political activity can also have an impact either positively or negatively.
Purchasing Power Parity (PPP) is one common method of forecasting currency movement, which suggests if goods or services are being traded in different countries their respective exchange rates will adjust to offset price inflation.
What about fixed income?
Interest rates are closely correlated to government bond yields, having a direct influence on the rate of return investors will receive. Bond prices have an inverse correlation, with bond prices falling as interest rates rise and vice versa.
As interest rates fall, borrowing is cheaper, so companies may issue new bonds to finance expansion, for example. This drives up demand for higher-yielding bonds, pushing bond prices higher.
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