Interest Rates and Their Importance
Level
1/4

Interest rates represent the main reason why traders are looking at the economic releases and basically at the economic calendar. The reason for that is the fact that all the other economic releases are only for traders to make an idea about how that could impact the interest rates. In other word, when news are released between two interest rate decisions, all market participants are doing is to try to have an idea about what the central bankers will do when they meet and decide on the interest rate.

Therefore, releases like CPI (Consumer Price Index) are vital for anticipating any more on interest rates.

If any economic release is being viewed as having possible interest rate hike for the central bank next time they meet, then the currency will be bought and in our case we should go and buy call options. The other side is true as well, if the economic news to be released during the month lead to the impression that the central bank, next time it meets for establishing the monetary policy will come and cut the interest rate, then the downside is favored and therefore we should buy put options.

Interest rate as Monetary Policy Operational Target

Interest rates are the tools central banks are fighting inflation: if the inflationary pressures are to the upside, then the central bank comes and hikes the interest rate. If the inflationary pressures are to the downside, then the central bank comes and cuts the interest rate. The interest rate differential is called the difference between the interest rates of two different currency, and this makes the currency pairs moving in the sense that the currency with the higher interest rate will be always more attractive to investors and therefore we should adapt the buying put or call options to the interest rate differential as well.

Federal Reserve BankStaying on the Right Side of the Market – Example

When it comes to interest rates there is no specific time table for starting a tightening or an easy cycle. Just to give you an example about how difficult is to stay on the right side of the market, consider China. The Chinese central bank is meeting over the weekend and when they act on rates, then markets are being influenced at the opening next Monday. It is important even if the Chinese currency is not possible to be traded, but equities from all over the world are moving based on what is happening in China. The Australian economy is highly dependent on what is happening in China as more than 30% of its exports are going to China so understanding that will make trading the audusd quite difficult.

Reactions to Interest Rate Moves

The classical reaction to any interest rate hike or cut is to look for buying a currency in the case of a hike and selling one in the case of a cut. This means call options are favored in the first instance and put options in the second one. One of the most important things when it comes to interest rates is the fact that central banks are trying to communicate possible changes in many ways before the actual interest rate is changed and this makes the event a non-event in the end. It is by far more constructive to look at the press conference, if any, that follows an interest rate decision rather than looking for market to move decisively at the announcement.

Forward Guidance and Central Bank Communication

This is being called forward guidance and central banks are looking to communicate as good as possible any changes in order to maintain one of their goals: price stability. Press conferences are quite important as any interest rate hike or cut can be downplayed in the press conference that follows. For example, imagine the ECB (European Central Bank) is coming and announces that they are hiking the interest rates (raising the rates). When such a thing is happening, the normal reaction is for market participants to buy the Euro as a currency as this is a bullish statement. However, it all may come to a change if on the press conference, the President of the ECB is coming and saying that the rate increase is temporary. At that very moment market will start selling the Euro instead of buying it, despite the actual rate increase.

Interest rates are announced on a clear scheduled way, each and every central bank having its own agenda for communicating the monetary policy. For example, RBA (Reserve Bank of Australia) is meeting on a monthly basis, at the beginning of the month, usually on a Tuesday, and they announce the interest rate decision. A press conference follows that decision and in between two meetings monetary policy minutes are being released as well.

These minutes are providing market participants with details regarding what members of the central bank discussed on the previous meeting and this is important as it tells market participants more about members view, they are bullish or bearish the overall economy, etc.

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