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We have a quick question here from a new subscriber saying that they just want some more information on why we focus so much on interest rates, and wants to know how interest rates really affect currency prices. Now when it comes to influences on currencies, there are many things that we need to consider as traders.
We actually did a video on this in the terminal, so if we quickly jump to the Video Library for a second, and if we just scroll down, we did a video called “What Moves Currency Prices?”, so I would highly advise you to just watch that one as well. There we go, “What Moves Currency Prices?” That’ll be a good video that I’ll highly recommend you watch as well.
Now, apart from all the other various factors that can affect the currency markets in the short term, by far, interest rates is gonna be the biggest one. Now whether it’s short-term interest rates affected by the central bank lowering rates or longer-term interest rates affected by central banks performing things like QE, the implications for these things have, by far, the biggest impact on currency prices.
So to start things off very simply, the most common way that interest rates affect currency prices is that lower interest rates usually leads to a weaker currency, and higher interest rates usually leads to a stronger currency.
But the biggest and most important thing to remember about interest rates are that it’s not only the current interest rates that are important, right? Or the central bank, what they’re gonna do today or what they did yesterday, but rather, what the market thinks the central bank will most likely do next.
So as the markets are always forward-looking, we as traders, we always need to be forward-looking as well. So always thinking about how new information and new data, how it changes what the market thinks will happen to interest rates next.
Now to make it very simple, you always need to view everything that happens through the lens of monetary policy. So how will this event likely change interest rates going forward? Does this drastically increase the probability or decrease the probability for rate cuts or rate hikes, or just stay neutral? And this also comes down to market expectations once again.
So knowing that the central bank will cut rates will only have a major impact if the news is fresh or very recent. So let’s think of an example, right? So imagine that a central bank has been holding rates neutral for the last 18 months, and the economic data has been improving consistently over the past few months.
Now that will eventually lead the market to think that the bank might need to think about tying to monetary policy as inflation starts to creep up towards the target. So coming from a holding cycle, and basically transitioning to a hiking cycle, will have a massive impact on the currency, as it’s fresh, and it will basically change the market’s expectations of what happens next.
In the same way, imagine another scenario where we have a bank that has already been hiking, they’re currently in a hiking cycle and they’ve already been hiking for 12 months.
Now let’s say they’ve already had, you know, five rate hikes behind them. Another rate hike from the central bank might not be such a big deal, right, because the market’s already expecting it to happen.
Now imagine that the markets are expecting that central bank to hike once, or let’s say twice more, and suddenly the bank comes out and says, “You know what? “The data has been so much better than expected, “we think inflation is going to overshoot our target “by quite a bit, so we are probly looking “at maybe three or four “more hikes.”
Now that will obviously be a massive change in expectations because the market was only expecting one or two more hikes, and now they suddenly change that to four or five. So that’ll see lots of upside for the currency.
Now it is true, however, that we do need to keep things like interest rate differentials also in mind, so even if a central bank has been hiking for 12 months, and they have done five hikes already, if we compare that currency to a currency, for example, that has been, or a central bank that has been neutral for 12 months, and their rates are much lower than the other bank that has been hiking, of course that interest rate differential between the two alone can be enough to keep the currency with the higher interest rate in demand compared to the other one.
But once again, expectations of what happens next are crucial to keep in mind, both for the currency and also how it might impact monetary policy, and of course interest rates going forward.