A tale of two central banks – what the latest interest rate decisions mean for investors
- Federal Reserve rate rise signals confidence in US economy
- Bank of England continues to hold rates in anticipation of Brexit
- Property, bonds and currency investments all impacted by latest decisions (easyMarkets)
It’s been decision time for two central banks this week. On Wednesday, the Federal Reserve decided to raise interest rates in the US to 1.00%, which didn’t surprise anyone as it was in line with expectations. Stocks rose and the dollar slid as a result. Now, the Bank of England hasn’t surprised anyone either, by keeping interest rates in the UK at 0.25%.
“It was the best of times, it was the worst of times.’ The opening line from Charles Dickens’ classic ‘A tale of two cities’ has always been a favorite of mine. Over the last 48 hours, we haven’t seen either the best or worst but we’ve certainly seen interesting times as we have had two very different decisions from two different central banks.”
James Trescothick, Reputation and Education Manager, easyMarkets
But our main protagonists haven’t always announced decisions which met expectations, and those kinds of surprises tend have a big effect on markets.
Just a couple of years ago, there was talk of a race to see whether the UK or the US would raise interest rates first. However, rapid political and economic change meant that though the US economy has carried on its revival after the 2008 financial crisis, the UK economy has stumbled into uncertainty as a result of the Brexit vote.
Interest rate decisions affect different types of investments in different ways, so the team at forex and CFD broker easyMarkets has put together a quick guide on how each type of investment correlates to interest rate decisions.
The easyMarkets guide to investment and interest rates
The currency market
One of the strongest influences that drives the forex markets is interest rate decisions, for two main reasons. First, the higher the interest rate, the higher the rate of return on the investment. Higher interest rates can attract foreign investment, which then increases demand and causes the value of that country’s currency to rise.
Second, for day traders, higher interest rates are often seen as an indication of the perceived strength of a country’s economy. This can mean that the country’s currency can gain strength against another country’s currency, if that economy isn’t considered as strong or as stable, hence the potential to make gains in the change of currency movements.
The aforementioned is why, when a nation’s economy is under pressure, a government or central bank can choose to implement a loose monetary policy, by either increasing the supply of money or decreasing interest rates to encourage borrowing. This tends to make credit cheaper and in turn potentially create more spending and economic growth.
The opposite course of action – a tight monetary policy – sees the central bank constrict spending in an economy either because it views the economy to be growing too quickly, or to slow down inflation. Central banks do this by raising interest rates.
Day traders look for hints for when these two different policies may occur to help them speculate on when a currency may decrease or increase against another.
There is an inverse relationship between bond prices and interest rates. Bond prices tend to fall when interest rates rise, and rise when interest rates fall.
The reason for this is simple. One way for corporations and governments to raise capital is by selling bonds. Higher interest rates make the cost of borrowing more expensive, which tends to lower the demand for lower-yield bonds. Hence their price tends to drop.
When interest rates fall, so does the cost of borrowing, which usually leads to more companies issuing new bonds for growth. This tends to increases demand for higher-yield bonds, which can then push bond prices to rise.
Generally speaking, a raise in interest rates means borrowing becomes more expensive, while an interest rate cut means borrowing becomes cheaper. When it comes to property investors, a change in interest rates can change the value of monthly mortgage repayments.
Logically, when interest rates are low and borrowing is cheaper, property investors are incentivized to purchase new properties. When interest rates are high, they will be less likely purchase, as mortgage payments would be higher.
“Interest changes influence different markets in different ways. Indeed, markets can sometimes be affected by the mere speculation of interest rate decisions, before the actual decisions have been made. A good percentage of market movements throughout the year can thus be attributed to interest rates. Thus, regardless of your investment choices or style, interest rates should be of interest to you.”
James Trescothick, easyMarkets
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