How Interest Rate Announcements Are Priced Into Currency Values
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How Interest Rate Announcements Are Priced Into Currency Values
When trading any financial market, it is imperative that one understand what drives price over the long-term. What makes the underlying asset tick? In stocks, it is earnings and growth, in commodities it is supply and demand, and in currencies it is interest rates. Interest rates are the primary driver of a currency pair over the long-term. The reason is simple. Every fund manager and investor in the world has one primary goal each year—to make money. The most logical way to make money in financial markets is to find an asset with positive yield. Thus, capital tends to flow into currencies that offer a high yield, and capital tends to flow out of currencies that offer a low yield.
Each currency that is traded in the foreign-exchange market carries a short-term interest rate that is set by its Central Bank. This short-term interest rate carries extreme importance relative to economic growth and activity in a country. A Central Bank’s primary goal is to help foster an economic environment that promotes full employment, contained inflation, and steady economic growth. In order to create this positive economic environment, a Central Bank manipulates the short-term interest rate.
A Central Bank will lower the interest rate in order to increase the money supply, which should in turn loosen credit markets and stimulate economic growth. Likewise, a CB will raise the interest rate in order to decrease the money supply, tighten credit markets, and slow-down economic growth. Remember, if an economy is growing too fast, inflation will kick in and erode economic strength. Thus, the economy must not be moving too slowly, but it also must not be moving too fast. A Central Bank’s job is to make sure an economy is moving forward at just the right pace, and its primary weapon of controlling economic growth is its power to raise and lower short-term interest rates.
How Interest Rate Movement Affects Currency Prices
Since currencies tend to increase in value as interest rates are raised and decrease in value as interest rates are lowered, the market is constantly monitoring Central Banks around the world for clues on future monetary policy decisions. In currency trading, if the market becomes convinced that a particular Central Bank is going to raise interest rates in the near-term, then it will begin to bid up the value of that currency. Likewise, if the market becomes convinced that a particular Central Bank is going to lower interest rates, then it will sell that currency.
Thus, when a Central Bank finally makes an interest rate announcement, it oftentimes won’t move the market significantly because the Central Bank’s interest rate decision has already been priced into the market. It gets very interesting, however, when the market is expecting one decision and the Central Bank comes out with another. Let’s break down an example.
The Bank of England is facing inflationary pressures. In several consecutive press conferences, BOE Board Members and the Mervyn King himself (BOE President) have communicated that the BOE is seriously considering a rate hike at next month’s meeting. If the market takes all of this into account and believes a rate hike is in order next month, then the British Pound will be bid up in value weeks before the actual interest rate announcement. This action is the market pricing in an interest rate hike and determining what the pound will be worth with an X% interest rate.
Now, a few weeks later the day finally comes for the Bank of England to release its interest rate announcement. The Bank of England announces an interest rate hike that was exactly what the market had expected. This will not cause much movement in the FX Market because this rate hike has already been priced in. However, if the BOE comes out and decides to leave rates unchanged, that’s when it get very interesting!
If the market has priced in an interest rate hike or interest rate decrease and the Central Bank does not actually follow through as the market has predicted, then that currency pair will react violently. In our pound example, if the BOE did not raise interest rates, we would see the pound drop significantly within seconds. In fact, it is not uncommon to see 100+ pip movements in just a few minutes after an interest rate announcement if the announcement diverges from market expectations. Remember to keep a close eye on Central Bank as major market movers.