Interest Rates and Their Importance
The most important reason for all the traders to follow the economic calendar as a part of their strategy and search for the new economic releases are interest rates. All the other economic releases help traders understand the consequences on interest rates. It means that market participants are trying to get the picture of what is going to happen after the two interest rates were released. All participants should know that modern economy in its basis is closely connected to interest rates, primarily, because the interest rates have an effect on consumer spending. However, the central banks use interest rates as a way to control inflation. Interest rates can depend on many factors, like the government’s orders to the central bank to realize the government’s goal; the currency of the principal amount being lent or borrowed; as well as supplies and demands of the market.
For example, if we want to be a part of the market, we must observe the releases like Consumer Price Index (CPI) which are crucial for this process.
Economic releases with possible interest rate should be observed with care, and when the currencies are bought, we should buy call options. On the other hand, we should buy put options if the downside is preferred. It means that the monetary policy will be established and that the banks will cut the interest rate.
Interest rate as Monetary Policy Operational Target
As we already mentioned, interest rates are the ways that central banks use in order to fight inflation. This further means, the higher the rates, the higher the cost of loans. Therefore, they will be less capable of buying on credit. It affects inflation, and consequently, if consumer expenses go down, demand for products and services will also go down. As a result, the prices will not rise as quickly. A low-interest rate as macroeconomic policy, on the other hand, can be dangerous and lead to the economic bubble creation, which means that the enormous amounts of investments can come into the real-estate market and stock market. This means that the interest rate modifications are made to keep inflation within a target range for the benefit of all economic activities. Further, we have to bear in mind other activities on the market. The differential of the interest rates is called the difference between the interest rates of two different currencies. It makes the currency pairs move in a way that the currency with the higher interest rate is of greater interest to investors. Because of this fact, we should adjust the buying put or call options for the interest rate differential as well.
Staying on the Right Side of the Market – Example
First, you should know that there is no timetable when it comes to interest rates, no way to know when to starting a tightening or when it will be an easy process. To get the idea of how hard it is to stay on the right side of the market, we will give you the example of China. Their banks have meetings over the weekend, which means they act on rates on the weekend and the influence on the market will come at the opening on Monday. Even though the Chinese currency is not tradable, this is an important event, since the equities from all over the world are moving considering the situation in China. This event has the major effect on the Australian economy because more than 30% of its exports are going to China. It can cause the AUD-USD trade rather complicated.
Reactions to Interest Rate Moves
Usually, in the case of a hike we are eager to buy a currency, and in the event of cut we are rather selling them, which is the standard reaction to any interest rate hike or cut. It means that in the first case we use call options, and in the second case we use put options. One of the crucial things when it comes to interest rates is that central banks are managing to find possible changes in many ways, even before they change the actual interest rate. Therefore, we must follow a final interest rate decision on press conferences, rather than observe the market to act decisively when the announcement comes.
Forward Guidance and Central Bank Communication
Communication about the possible future course of monetary policy is called “forward guidance” Both individuals and businesses use this information in order to make decisions on spending and investments. Besides, the central banks are to maintain the price stability.
For all the market participants press conferences are crucial events since any interest rate hike, or cut can be downplayed. Therefore, all that you were expecting can go down the drain. The press conferences do not have to provide the information on the interest rates as you expected. For instance, picture that the European Central Bank (ECB) says that they are raising the interest rates. The next step for market participants would be to buy the Euro since this is a very positive statement. In the meantime, the bank can find other solution, which they will announce at the press conference. On the press conference, the President of the ECB says that the increase of rate is short-term. Momentarily, the market participants will start selling the Euro instead of buying it, regardless of the actual rate increase.
Even though the central banks have different agendas for communicating the monetary policies, one thing is in common – all interest rates are announced on a clear scheduled way. For instance, Reserve Bank of Australia (RBA) has meetings on a monthly basis, usually on a first Tuesday of the month, except January. On this meeting, they declare the interest rate decision. The press conferences which go after follow the decision announced at the meeting. Between the two meetings, two weeks after the meeting, they also release monetary policy minutes and explain the monetary policy decision.
The monetary policy minutes are offering the details of the meeting and explanation of their decision concerning the interest rate which is also a valuable feedback to binary options market participants.
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References and Further Reading:
- Interest rates and currency prices in a two-country world (Robert E. Lucas Jr.)
- Federal Reserve Information and the Behavior of Interest Rates (Digest Summary) (Christina D. Romer and David H. Romer)
- The effect of changes in the federal funds rate target on market interest rates in the 1970s (Timothy CookThomas Hahn)
- A One-Factor Model of Interest Rates and Its Application to Treasury Bond Options (Fischer Black, Emanuel Derman, and William Toy)
- Is the Fisher effect for real? A reexamination of the relationship between inflation and interest rates (Frederic S. Mishkin)