UNIT B| Analytical Tools

3. Interest rates

Interest rates is one of the key components of monetary policy and it is strongly related to supply and demand for currencies. While the importance of individual fundamental indicators shifts over time, interest rates always appear to be relevant. They are important to economic growth, to the markets and ultimately to your own trading, and you soon shall understand why. In the previous Unit A you have learned that profits and losses are also affected by the rollover, comprised of the different interest rates of the currency pair, the settlement date, and the duration of the position. In this section we will approach the subject from a deeper fundamental perspective.

The government???s role in the economy is to influence the business cycle by keeping prices stable and working towards sustained growth. The first means to accomplish this is through fiscal policy, and the second - and perhaps the most important for us as traders - is the monetary policy, which means exerting control over the money supply. This has a direct relationship with interest rates.

In a society, some individuals have more money than their immediate needs require, while others have needs that require more money than what they have. An economy can grow faster if the people who have money lend a part of it to the ones who need it to accomplish their goals. Here lies the concept behind interest: lenders won't lend money for nothing; to entice people to lend money, the borrowers pay them interest.

Interest rates are basically the payment that a lender requires in return for lending money to a borrower. Normally, this payment is expressed as a percentage of the amount of the borrowed money. For example, if a borrower receives a loan of 1,000 USD for 1 year at a nominal interest rate of 5%, then the cost of that loan for the borrower, the so-called ???interest payment???, is 50 USD. The interest is the value or ???price??? of the money. Like the price of virtually everything else, it is determined by supply and demand.

In most developed countries, the government has a major influence on the quantity of money which is created or destroyed and on its value as a medium of exchange. In technical terms that is defined by the money supply and the interest rate. The government can increase the money supply by injecting money into the economy, or through monetary policies, encouraging the population to save or to spend money. However, there is a limit to how much money a government can put in circulation before the economy gets hurt. Money shall have always a relatively stable value, otherwise people lose faith in it as a medium of exchange with dire consequences for the economy.

Each economy has a central bank which manages the monetary policy. In the US the central bank is the Federal Reserve, or ???Fed??? as it is often called. When any central bank injects money into the economy through the banking system, banks begin to lend that money. Note that this is not the only way a government can inject money in the economy. It can also be directly injected in the real economy by promoting the public sector, creating infrastructures for example (schools, hospitals and so forth).
The fact is that a big part of the demand for money is for loans by individuals and businesses as people have virtually unlimited wants. And the more money there is available in an economy, the more there is to lend. Banks, in this case, make money by deploying that cash and charging interest and fees.

For this reason, governments are much concerned with keeping the value of money stable. By adjusting interest rates higher and lower, the economical growth can be slowed down or stimulated. The level of interest rates or, in other words, the value of money has a large effect on practically everything in the economy from consumption and employment to inflation.

A higher Federal Funds rate, in the case of the US economy, makes borrowed money more costly, meaning that people will also be less likely to start or expand a business. This can result in a rise in unemployment, less personal income, weaker consumption and on and on down the line. The opposite is of course also true when interest rates fall and business owners take advantage and access cheaper borrowed money. The impact is seen on financial markets as well with market participants borrowing money to leverage their accounts. This growing momentum can be sustained in time as long as individuals maintain their hope that rates will be kept low in the long run.

In order to effectively understand the concept of interest let's study its main characteristics:

Time Value

Under normal circumstances most people would prefer to receive one Dollar today rather than that same Dollar in one year. This is because a Dollar earned today can be put to work and potentially increase its value over time, and therefore its buying power in the future. buying power can raise in the future. For this reason a lender, being an individual or an institution, expects to be compensated for not being able to use the money during a certain period of time. Put it inversely, a Dollar received in the future has less value than a Dollar received today. This fact is what gives money time value.

By definition, interest rates are the rate of growth of money per unit of time. Time determines the present and future value of money. Since so many financial assets depend on time value, interest gains are one of the most fundamental factors in financial investments. Currencies, like many other assets, pay interest or can be paid off, and this payoff will depend on the interest rate. Hence the interest rate serves to allocate economic resources more efficiently because it provides information to market participants as to what is the best use of the money at any time. It tells them if it is best to hold or to spend it, and where to spend it.

Opportunity Cost

The present and future value of money allows an individual or business to quantify and minimize their opportunity costs in the use of money. Opportunity cost, in this context, is the benefit forfeited by using the money in a particular way. An investor, for instance, can put 1,000 USD to work on the financial markets instead of depositing it in a bank savings account that pays a certain annual interest. By doing this, the investor is renouncing to the interest payed by the bank and favoring the potential benefit of investing it in the markets.
However, the future value of a speculative investment is really unpredictable. In the case of financial investments, it can only be estimated by comparing specific investments with an interest rate that is either known or can be reasonably estimated by using the formulas for the present value and future value of money.

Therefore one of the major objectives of a financial system is to minimize the opportunity cost to lenders and borrowers by facilitating their interaction. When interacting, lenders can lend money at the highest possible rate and borrowers can borrow money at the lowest rate. Obviously the agreement will depend not only on time value and opportunity cost but also on the associated risk.

Inflation and Deflation Expectations

If the value of money is expected to be lower one year from now than it is today, because of prices going higher, then a lender wants to be compensated for that loss in value over the time period. He lender will then ask for higher interests in compensation for that loss.

Individuals and businesses invest to earn more purchasing power in the future. They will only invest or lend money that pays more than the expected inflation rate because inflation lowers the value of money. Therefore, the growth of purchasing power will depend not only on the stated rate of interest but also on inflation.

One of the most important economic factors analyzed to forecast exchange rates is the inflation rate. Inflation is an essential aspect to understand interest rates because it influences the opportunity cost associated with a currency. Inflation is the result of an increase in the supply of money, when there is more money to purchase the same goods. When comparing two currencies, it is the rate of growth of supply of one currency over the rate of growth of the supply of another currency that will determine the exchange rate between both currencies.

By comparing interest rates using the real interest rate differential model explained at the beginning of this chapter, investors can estimate the return on investments among several currencies. If a country raises its interest rates, its currency will strengthen because investors will shift their assets to countries with higher interest rates in order to gain a higher return. One example is the so-called carry trade, which involves borrowing currency from a country with low interest rates to invest it in a country with higher rates.

Nonetheless, the model behind the carry trade does not take into account inflation. Here is where the currency substitution and monetary models enter in action, taking monetary policies in consideration. Since economies do usually grow, the money supply has to grow with it to prevent the economy from entering in deflation. Monetary authorities will supply money a little bit faster than the economy is growing.

In theory, when the economy grows faster than the money supply, then deflation occurs because there is less money for the same amount of goods and services and consequently prices drop. At first it seems like an advantage, especially for the consumer, but it isn't, because of the same principles of time value of money. As prices fall, people hold onto their money since it will be more valuable in the future than it is now. With reduced spending, all the economical cycle is deteriorated as much as under a severe inflation.

Another serious economic problem with deflation is that it makes borrowing prohibitive. The loan payments remain the same, but they require a larger proportion of income to pay the debt. Because what it produced has now lower prices, individuals and businesses see their income dropping and are forced to curtail spending and investing, which accelerates even more the downward deflationary spiral.

Risk

In a growing economical environment, however, the opportunity cost and the time value of money, translated in higher returns on investment, are not the only characteristics guiding investors in their decisions as to where allocate their money. There is also the risk associated with the use of money, and investor's sentiment will continually oscillate between risk appetite and risk aversion. Lenders will not always easily determine who pays the most interest at the lowest risk because there is always a risk that a loan will not be paid back.

You should now have a good understanding of what interest rates are and also the important role that money supply plays in the economy. But like in the previous sections, we can not draw linear conclusions on which to base an analytical model to forecast exchange rate moves. There are some variables which hinder us from that possibility, namely: the fear of risk, the hope for a return and ultimately the faith in the medium of exchange. Words like ???fear???, ???hope??? and ???faith??? don't really sound like economic variables, but they are! This brings us to the next section where we will expand on sentiment indicators and leave the hard macro-economical data behind. Let's go!