What Makes Interest Rates Interesting

I’m sure you already know that the interest rate is the rate a borrower pays for holding a lender’s money. Now what does that have to do with the central bank and the overall economy? Tasked with setting the nation’s monetary policy, a central bank has three main tools in its arsenal: money supply, reserve requirements, and the (in)famous interest rate. Also known as the benchmark rate or overnight rate, a central bank’s interest rate is used to indirectly influence variables such as investment, inflation, and employment. In general, when interest rates are raised, the effects on the economy could be good and bad at the same time.

Let’s start with the bad side – hiking rates up makes borrowing more expensive. When interest rates are high, businesses and consumers are discouraged to take out loans. This in turn causes investments to fall or to at least taper off. Note that most firms use borrowed funds from banks for their investment projects. Consumers use mortgages for their homes and vehicles. They even use credit for their retail spending – anybody heard of a credit card? As borrowing costs become heavier, saving suddenly becomes a more attractive alternative to spending! Because economic activity declines, the profitability of firms also falls which, in turn, subdues economic growth.

“Why the heck would central banks want this to happen?!?” you’re probably asking yourself. Enter the good stuff… You see, raising interest rates is the primary weapon of central banks to combat inflation. By making borrowing money more expensive, the rate of increase of money supply in the economy slows down.

Now look at it from a different angle… Lowering interest rates would essentially make borrowing costs cheaper. Consumers and businesses alike would be prompted to borrow more and would consequently spend and invest more. Output would therefore increase as the spending goes higher. And as businesses prosper, more jobs would be needed and more investments would flow into equities.

But too much of anything can be bad. In this case, too much economic activity would cause inflation to rise. The higher the inflation rate gets, the more expensive goods and services become. The more expensive things grow, the more your money loses its purchasing power. That means if prices rise faster than you generate income, in time, you’d be in trouble. Another negative aspect of having a low interest rate is that it makes safe investments such as treasuries and bonds less attractive to investors given their relatively low yields. Bonds issuers would have a harder time borrowing from the market given the low interest rates.

Okay, enough about that. As currency traders, you’re probably more interested with the effects of interest rate changes on currencies. Let’s take a look at the major currencies, shall we?

Given that the entire world is feeling the effects of this recession, each of the major currencies’ respective central bank has acted on its own to help combat it. Basically, the 8 major currencies and their central banks can be classified into 3 major groups based on their interest rates: the high-yielders aka “the kings of the carry trade” (AUD, NZD), the middle of the pack “in-betweens” (EUR, CHF, GBP, CAD) and the low-yielders aka “safe havens” (USD, JPY).

The RBA and RBNZ currently hold the highest interest rates amongst the majors, at a whopping (relatively speaking, of course) 3.00% and 2.50%, respectively. In fact, there has been speculation already that the RBA could be one of the first to raise interest rates. In its last two rate decisions, however, RBA Governor Glenn Stevens has decided to keep its current rate despite Australia’s strong economic performance. RBNZ Governor Alan Bollard and his team of wizards did the same this week, saying that they would keep rates steady well into 2010.

I suspect that, even though their part of the world is showing signs of recovery, they are still waiting to see whether their particular economy will be able to stand on its own once rates are hiked. If, however, either of these banks decides to hike rates, we could see the AUD and NZD go up further. Both currencies benefit from their higher interest rates because they get pumped from a little something called “carry trade” where traders and investors try to take advantage of interest rate differentials. With their central banks having high interest rates, demand for the AUD and NZD may rise as investors look for opportunities to do carry trades.

Moving on to the “in-betweens”… The ECB‘s rate stands at 1.00% while the BOE has theirs at 0.50%. The SNB and BOC currently share a rate of 0.25%. These rates are already at record lows for these central banks but are still higher than that of the USD and JPY. These currencies benefit when risk appetite increases as investors look for higher yielding investments. This has been the primary reason why these currencies have rallied against the USD and JPY as of late.

As it is, there are no signs that any of these central banks plan to hike rates any time soon. This past week, ECB President Jean Claude Trichet warned that it was still too early to declare that the recession is over. Trichet and his gang at the ECB are notorious for not cutting rates or implementing aggressive monetary policies, fearing that this could drive up inflation. He believes that things aren’t quite okay yet which may leave him with no choice but to keep the rate at its current level. Meanwhile, the BOE has recently expanded their asset purchase (quantitative easing) program. What does this mean? This indicates that the BOE believes that the economy needs more liquidity. However, with an interest rate at a record-low 0.5%, they had to use an alternative.

And lastly, we have the “safe havens” – the USD and JPY. First of all, let me just say that the JPY has kept their rates at 0.10% for a VERY LONG time and I don’t think anybody expects them to hike their rates any time soon. The US, on the other hand, has cut rates dramatically since the start of this recession. The US Fed’s pre-recession interest rate stood near 5.0%. In an attempt to fight the recession, the US took the lead and cut their rates first. Now, the rate stands at 0.25%.

Some believe that since it was the US who was first to act, they may also be the first to exit the recession. But how long will this take? Take note, the US Federal Reserve has combined rate cuts with other mega-stimulus plans in order to curb the recession. Seeing how risk sentiment has been driving the market, could a rate hike lead to an increase in risk appetite… and push other currencies higher? Or could it cause a shift back to fundamentals and boost the dollar?

It’s tough to say what central banks will do. At this moment, it is safe to say that they will be more cautious playing with interest rates. I don’t think we may see a rate hike soon unless we see some real evidence that this recession is on its way out the door. In the mean time, maybe I can actually take advantage of these low rates and get a car…

  • sergeyrar

    cool post! thanks

  • sergeyrar

    cool post! thanks