The Fed funds rate is one of the most important benchmarks for investors and traders all over the world. Its adjustment significantly affects exchange rates and the economic situation of countries. Let's take a closer look at how all this can affect the stock and forex markets in the U.S. and around the world. It will help us understand why investors and traders pay so much attention to this indicator.
What is Monetary Policy
We will mainly mention the interest rate from the perspective of the US Federal Reserve system since it has more influence on the markets and is the most recognizable indicator. To begin with, we need to understand what a country's monetary policy is and how it is regulated. The welfare of any state is based on the state of the economy. And since money is the lifeblood of the economy, government influence on the monetary system is of paramount, if not primary importance.
Direct intervention and administrative measures have proven to be ineffective, so in today's world, government agencies influence macroeconomic parameters indirectly, using monetary policy methods. This policy is conducted through the influence on the development of inflation, investment, the loan capital market, and the regulation of non-cash payments.
The state does not manage economic processes directly but authorizes the central bank to do so through the execution of laws. In the United States of America, there is no central bank. There is the Department of the Treasury, there is the Federal Reserve System, which makes decisions about changing the prime rate. Thus, changing and regulating the interest rate is the main instrument of regulating the monetary policy of the state.
Depending on the state of the country's economy, the government may have different economic policy goals. Sometimes the state needs to stimulate economic growth, and sometimes, on the contrary, to slow down the economy that has "accelerated" too much to avoid a classical crisis of overproduction or high inflation. These processes are regulated mainly by changes in the Fed's rate in the economy.
What is the Fed Funds Rate?
Dollar quotes are not only driven by supply and demand, but they are also driven by the government by raising or lowering the Fed Funds rate. Essentially, this includes the interest rate at which the Federal Reserve lends to private banks. The commercial institutions, in turn, lend money to customers with a predetermined fee. They cannot raise or lower the value of their services too much. In the first case, the bank will lose customers, and in the second case, it will not make its own profits. As a result, the higher authorities manage the cost of credit by increasing or decreasing the demand for their currency.
The significance of the U.S. Federal Reserve rate is that its numerical value is used to calculate all interest charges in the country. Loans made by the reserve bank are considered the least risky. All loans are granted overnight and are available only to those financial institutions that have an untarnished reputation. Depending on the type of lending chosen, institutions are charged different premiums. The terms and conditions of the loan determine the charges at which the loan is made.
The impact of the Fed Funds rate extends to many economic sectors. Its change can shift the rates of stocks, bonds, and other securities. Its adjustment always affects trade relations between countries, the cost of raw materials, and manufactured goods. The procedure controls the scale of production, making it harder or easier for private business managers. The Fed plays a critical role in trading. It directly affects rates and determines the size of the swap. A change in this rate can make currency transactions profitable for the trader. In just one day the brokerage commission can change so much that it becomes unprofitable for a trader to work on a particular investment instrument.
In general, the decrease in the key rate is unfavorable for the dollar. U.S. government bond yields fall, which can reduce the inflow of foreign capital. This is what happens when there is an interest rate differential. For example, a narrowing of the yield spreads of Treasuries and German Bunds, all other things being equal, could put pressure on the dollar against the euro. Here, it is important to assess real rates and yields, i.e., net of inflation. In addition, improving sentiment in the stock market reduces the demand for the dollar as a risk-free asset.
A weaker dollar stimulates U.S. exports. S&P 500 corporations generate about 38% of their revenue outside the United States. If the U.S. currency declines, when that revenue is repatriated, it is converted into dollars at a more favorable rate. As a result, exporters' earnings go up and their stocks go up. Notably, the situation needs to be viewed holistically. If the decline in Fed rates is combined with increased protectionism, the effect will not be so obvious.
In addition, the decline in the dollar plays in favor of commodity assets. This is favorable for stocks in the oil and gas and materials sectors. However, this factor is less favorable for other sectors because costs are rising.
The U.S. Federal Reserve: How the World's Most Powerful Central Bank Works
The U.S. Federal Reserve System is now considered almost the center of global evil. Yes, that is where they print dollars and increase the very same U.S. foreign debt, to which adherents of the theory of a global conspiracy and the imminent collapse of the existing financial system often like to cite.
Since the founding of the Federal Reserve System, its functions and actions have been entirely consistent with the country's financial and economic policies.
The system carries out the following purposes as defined by the Federal Reserve Act:
- Executes the plan of the Central Bank of the State;
- Keeps the balance between the commercial structures and the social spheres of the country.
- Controls the nation's banking system and protects the interests of depositors and borrowers.
- Issues the dollar, the domestic currency of the United States.
- Coordinates, controls, and manages the financial market
- Provides depository services to the U.S. government and other international institutions;
- Facilitates the functioning of both domestic and international payment systems;
- Resolves liquidity issues at local levels and lends to credit societies.
The current functions of the Fed have undergone some changes, and are consistent with the positions of the U.S. ruling elite These include:
- Implementation of government monetary policy.
- Stabilization of prices and employment.
- Regulation and control of banks, protection of clients' rights.
- Maintaining the stability of the financial system and suppressing risks in the financial market;
- Providing selected financial services to the U.S. government, individuals and financial institutions, and foreign official institutions through the management of the government payment transfer system.
A distinctive feature of the Fed is its function as a central bank, although its owner is not the government, but private individuals. This structure acts as a joint-stock company, the shares of which have a special status. The state directs the activities of the Fed by appointing managers. They are appointed by the president after approval by the Senate. The main contradiction of the System is that as a state structure, it is owned by private individuals.
The structure of the Fed has a striking difference from the structures of most central banks in the world. Decision-making is the responsibility of the twelve regional members of the system, who can control interest rates. This determines the growth trends of the economy, having a significant impact on its development.
So, the Federal Reserve is a specially created structure to act as a central bank. The Fed controls the commercial banking system in the United States. Despite the many myths and rumors around the Fed, it is clear that it is not a secret government at all. At the same time, this organization operates under its laws. Their activities are under the control of the Senate and the President. It is they who set the policy of action for the Fed.
How is the Rate Determined and When is it Released?
The U.S. central bank's discount rate is set by the Federal Open Market Committee (FOMC). This body normally meets eight times a year, but it can meet extraordinarily if necessary. Such a decision was made in March 2020 due to the deep economic crisis caused by the COVID-19 pandemic. Today, the basis for calculating the interest rate is the inflation target the Fed seeks to achieve. The inflation rate characterizes the growth rate of the economy because modern economic science considers moderate inflation to be an important stimulus for GDP growth. A low Fed interest rate improves the balance of trade, stimulates the growth of stock markets, and increases the income of exporting companies. A higher rate usually makes the U.S. dollar more expensive, which in turn increases the public's ability to pay and reduces U.S. foreign debt.
Periods of high and low interest rates tend to alternate, depending on current U.S. and global economic conditions.
What Causes Changes in the Rate?
Banks lend not only to consumers but also to each other. At the end of each day, U.S. banks are required to hold a certain amount of reserves, depending on asset levels. As financial institutions conduct transactions regularly, their balance sheet structure can fluctuate. To meet regulatory requirements for reserve levels, banks sometimes have to borrow overnight from their peers. The Fed tries to regulate the interbank overnight rate through the fed funds rate (key rate).
After the financial crisis of 2007-2008 and the Great Recession, the Fed actively bought assets to inject money into the banking system. As a result, the Fed accumulated over $2 trillion in excess reserves on its balance sheet, compared to less than $500 billion in 2008.
Periodically, the regulator removes excess liquidity from the system through reverse repo transactions. This means that Treasuries are transferred from the Federal Reserve's balance sheet to mutual funds and other dealers with the obligation to buy them back in a few days. The regulator sets a floor on reverse repurchase transactions. The Fed also sets a higher rate at which it pays the banks that hold funds on its balance sheet - the Interest on Excess Reserves (IOER). This is a kind of "ceiling".
The target key rate (effective fed funds rate) is between the "floor" and the "ceiling". The target level is regulated through operations of buying/selling Treasuries. When the rate needs to be raised, government bonds are bought by dealers as part of repo transactions, and liquidity is thereby withdrawn from the financial system. Banks in this scenario are not inclined to lend to each other, parking money from the Fed at a more favorable rate. And vice versa if the fed funds rate goes down.
What Impact Does the Rate Decision Have on Markets?
The Fed's interest rate has a powerful impact on all financial markets at once. Let us consider each of them individually. Currency falls under the direct influence of the designated interest rate. With the tightening of U.S. monetary obligations, investments in dollars are perceived more attractively. The U.S. currency becomes in demand not only at home but also in other countries. Speculators begin to favor it, pushing all other currencies aside. Consequently, the ratio of the U.S. dollar to other national currencies is changing, but the rate is far from being the only factor shaping quotes.
It is worth remembering that exchange rates are determined by the monetary policy of individual states, speculation by big players, the volume of imports and exports, balance of payments, and other indicators. In this connection, the correlation between exchange rates and credit rates may not be obvious. To make a correct prediction, it is necessary to study all factors.
The bond market is directly dependent on established credit conditions. As they harden, profitability increases across the entire class of fixed-income financial instruments. Accruals on bank deposits go up, and investors get additional earnings. The 30-year Treasury notes are an indicator of the situation. Too much of an increase/decrease in their profitability would indicate an imbalance in the country. The stock industry is inversely related to the federal interest rate. The higher it is, the harder it is for companies to get financing and accelerate their growth. Tight credit conditions are causing many industries to decline. Stock prices are declining, and so are expectations of corporate success. Only the most resilient players remain on the trading floor, receiving financing from private investors or making do with funds gained from the sale of commodities.
The impact on the stock market can be described as short-lived. In some cases, the Ministry outlines its plans for the coming sessions. Traders understand what to expect from the interest rate in the future and adjust the price in advance. Thus, a significant jump in rates after the next meeting may not be observed, because the players are prepared for the result.
Obvious changes on the chart occur only in situations when the Ministry of Finance makes an unexpected decision. After the release of such news speculators abruptly change their opinion about the assets and create a strong short-term trend. After a while, the excitement dies down, and the quotes return to their standard positions.
The world commodity and raw materials exchanges are largely dependent on the dollar quotation. The economic development of the U.S. makes the national currency one of the most important on the planet. The dollar is often used in transactions between countries, and an appreciation of the currency leads inevitably to a revision of product prices. So, what should a private trader do? First, invest in safe-haven assets, buying bonds and currencies of developed countries. Secondly, try to fix profits and withdraw them before the anticipated rate hike, and after the market correction to buy interesting assets at a low price. This option has a disadvantage - no one knows when exactly this correction will take place, the timing may be too long. Thirdly, if possible, it is possible to buy shares of banks, which receive additional income from an increase in the key rate. In any case, you need to be especially careful and, to maintain the profitability of the investment portfolio, improve your financial literacy: learn to read statements, study the ratings of issuers, and if necessary, do not hesitate to seek help from market professionals.
Interest Rate: What Is Going On Right Now
The Bank of England, in a fight against high inflation, raised its benchmark interest rate from 0.1 percent to 0.25 percent for the first time since August 2018. "At a meeting that ended Dec. 15, 2021, the committee voted by a majority (8 to 1) to raise the bank rate by 0.15 percentage points to 0.25 percent," according to a statement posted on the regulator's website on Dec. 16. The limit of funds for asset purchases is kept at 895 pounds. The U.K. inflation rate reached 5.1% in November. It is a record high in the last ten years and more than double the target of 2 percent set by the Bank of England. Central banks are now faced with a dilemma as they are forced to choose between rising inflation and the crisis caused by the coronavirus pandemic. The Omicron variant of the virus threatens a new pandemic, and the economy will need cheap money, but it is the policy of low rates that drives inflation.
On December 16, Norway's central bank also raised its benchmark interest rate - the second time in less than three months. It is now increased to 0.5 percent, and the Norwegian regulator does not rule out further increases in the coming year. Raising the interest rate in Norway occurred against the backdrop of a gradual recovery of the economy from the effects of the pandemic. Recently, inflation in Norway was more than five percent.
Meanwhile, the European Central Bank went its own way and is not showing any signs of interest rate hikes. It left its benchmark interest rate unchanged at zero percent, despite rising inflation rates in the euro area. The interest rate on bank deposits remained unchanged at minus 0.5 percent. According to new forecasts of the ECB, inflation in the Eurozone will grow up to 3.2% in 2022. Earlier experts believed that inflation will not exceed 1.7%. The U.S. Federal Reserve, at its last meeting in January, kept the rate at 0-0.25%. However, the regulator announced a rate hike soon to curb inflation, which is much higher than its forecasts (7% at the end of 2021). Most analysts expect the first rate hike as early as March, with more than four rate hikes expected on average this year.
How to Trade Fed Rate Decisions
The best trading strategy in the face of a Fed interest rate meeting and any important event with the same degree of uncertainty and lack of unanimity is to wait. It is quite clear that the forthcoming monetary policy statement will cause a significant spike in volatility, which will affect most currency pairs. In addition, the U.S. central bank's rate decision will be accompanied by Powell's explanations, which will have the biggest effect on market interest in the U.S. dollar. Most of the investment houses are now focused on the scenarios of events after the Fed's interest rate decision, rather than on what position to take before that, as there is a complete lack of unity of opinion on the most likely actions of the Fed among both economists and investors and even representatives of the regulator itself.
Unfortunately, trading on the Fed's decision does not just mean betting on whether it will be raised. At the meeting, the rate decision will be accompanied by comments from the Fed on the future economic outlook from Jerome Powell during the press conference.
Tactically, we expect a strong initial reaction of the dollar to the interest rate announcement, followed by a less sharp reversal of the price, after which we expect a brief consolidation before the speech of the Fed chief, which will undoubtedly be the trigger for another burst of volatility. By the time it is over, we expect the U.S. currency to start its more justified and long-term movement, which will last for more than one trading session.
Accordingly, we expect the following four things:
- The rate decision itself;
- Accompanying comments;
- Coverage of the economic outlook by the head of the Fed;
- The number of dissenting members of the Fed.
The US Dollar Index
The U.S. Dollar Index (DX) is a popular tool that shows the value of the U.S. currency against a basket of currencies. Its value allows you, firstly, to understand the average price of the main reserve currency, and secondly, to see the dynamics of the exchange rate, tracking whether the dollar is getting cheaper or more expensive. The index basket includes six currencies: the euro, the yen, the pound, the Canadian dollar, the Swiss franc, and the Swedish krona. So, when the Fed cuts rates, it reduces the value of the dollar against the currency basket.
For example, the U.S. Central Bank held an unscheduled meeting on March 03, 2020 and lowered the refinancing rate by 0.5% at once (two steps) to mitigate and prevent the coronavirus effect on U.S. economic growth. Against this backdrop, both the dollar itself and the DX fell. Now the Dollar Index is trading at 95.
As for future prognoses, the analysts of JPMorgan think that by the end of 2022 the dollar will strengthen in pairs with main currencies, while the euro, yuan, yen, and Mexican peso will go down. According to experts, the main trading theme next year will be a divergence of strategies of monetary policy of global central banks: regulators take different ways and pursue different goals. Analysts say that the U.S. Federal Reserve's upcoming rate hike signals the transition to the final phase of the medium cycle when the U.S. currency gets the most benefit.
Thus, considering the previous experience the experts from JPMorgan bet that the dollar will outperform low-yielding currencies as the first rise approaches. If the Fed starts to raise before the anticipated deadline or does it more aggressively than currently forecast, the DX will begin to strengthen even in pairs with high-yielding currencies.
How to trade Fed rate decisions using price action signals
The Price Action signals depend directly on the pattern that appeared on the chart. There are dozens of different figures indicating both a reversal and a continuation of the trend. Single or double candlestick patterns such as pin bars, rails, inside and outside bars, engulfing, etc., are especially common on a chart. Most of them indicate a trend reversal or price pullback.
When trading Price Action, one of the main roles is assigned to price levels. They will determine how strong the pattern signal will be and which direction the price will go.
There are several types of levels:
- Resistance and support. These lines are drawn from the lows and highs of price and show the range within which price is moving. The price can break out this range and move out of it, building a new channel.
- Trend lines. These are built when there is a directional trend movement on the chart. They may be directed upwards (a bullish trend) or downwards (a bearish trend).
- Corrected (Fibonacci and others). They are drawn if there is a clear trend on a chart, and they can play the role of resistance and support levels. They show the points of pullback and trend correction.
You can draw Price Action levels both manually and with the help of indicators. Let's consider one of the simplest trading methods based on Price Action. It is based on trading at resistance/support levels and pin bars. The strategy is suitable for all time frames. However, choosing a time frame, keep in mind that its value always correlates with the accuracy of the signals. In other words, the lower the time frame - the falser pin bars may appear on such a chart.
Let us remind you that a pin bar is a pattern consisting of a single candle with a very short body and a long shadow. The second shadow of the candle must be short. A pin bar is also called a "Pinocchio Bar," because it tries to trick the trader by pointing its long shadow (nose) in the direction the price is supposed to move. However, there is no movement in that direction, and the chart reverses in the direction of the short shadow of the pattern.
Open the chart of the desired asset and mark the resistance level by connecting the price maximums and the support level by connecting the price minimums. Now, all you have to do is watch the price movement, especially when it approaches the levels.
A buy trade can be opened if:
- The price has approached the support level.
- A pin bar has appeared near the level with its long shadow pointing downward and its short shadow pointing upward.
After closing the pin bar, a new order can be opened. We set Stop-Loss a few points below the long shadow of the pin bar. Take-Profit is placed at the level of resistance.
An order to sell can be made under the following conditions:
- The price reached the level of resistance.
- A pin bar has been formed at this level with its short shadow pointing downward and its long shadow pointing upward.
When the pin bar closes, it is possible to place a Sell order. We set the Stop-Loss order several points beyond the long candle of the pin bar. Take-Profit is set on the support line. This strategy can be complemented by any tool for additional signal filtering. For example, by adding a market volume indicator or at least a classical oscillator such as Stochastic or RSI. That is especially true when trading on time frames M1 or M5, where there is a lot of market noise, and the appearance of false pin bars is possible. Additional filters may not be used on older charts, as price action strategies give sufficiently accurate signals on higher time frames.
Conclusion
In conclusion, it should be noted that the interest rates of central banks are a very strong indicator of fundamental analysis. Undoubtedly, it has an impact on all markets of the world and countries, but this influence is strong, but not always direct. Sometimes it is worked out by the markets beforehand or implicitly.
To use the information about the interest rate correctly, an investor needs to know in which market and how to estimate it, to understand the degree of importance of key rates of different countries and the economic situation in the country of investment.
