The persistent pressure on consumer prices has caused the main central banks to turn the wheel from expansionary monetary policies to others that aim to contain the inflation: that is, restrictive policies. The increase in rates is the most powerful tool.
An increase of interest rates it increases the price of money and the reward that investors receive in government debt, while discouraging consumption and withdrawing excess liquidity from the economy. This ends up slowing down the dynamics that affect consumer prices.
It is worth mentioning that this decrease in inflationary pressure it may take several months. In advanced economies, the transmission mechanism of the effects of monetary politics to the economy can take from 12 to 18 months and that depends a lot on the level of banking in that economy.
However, an increase in interest rates does present an immediate reaction in the markets, as investors adjust their positions to their new reality. The search for benefits causes them to react in advance to the effects that the movement is expected to bring.
This is why monetary policy decisions are usually one of the most anticipated events by investors in the economic calendar. This fundamental rate information drives exchange rates up or down, or share prices cyclical, as the economy is expected to react.
Rates and the exchange rate
A good performance of Gross domestic product US (GDP) usually leads to a strengthening of the dollar in the foreign exchange market. Otherwise, a negative figure like the one presented on Thursdayweakens the greenback and helps, or at least lessens the pressure, on other weaker currencies.
(On this point we clarify that the reaction in the market to the data of a country is directly related to the relevance that the country has in the global economy. A figure published in Mexico affects local assets, while one from the United States causes larger moves)
Following this logic, an increase in rates that arouses positive economic expectations can help the currency of the country in question, but it must also be clarified that there is another intrinsic reason. Higher rates in a healthy market drive demand for that country’s assets.
This is because the higher rates offer better rewards to investors who take advantage of the spreads between the rates of one country and another with a strategy called Carry Tradewhich is to fund at low rates to obtain returns at high rates, hedging the exposure to the exchange rate
The explanation is as follows: You bet on an appreciation of the currency with high rates. Leverage is sought with the currency of a low rate country and used in the currency of high rates. That is invested in your high debt. The benefit is in the difference in rates and is obtained even if the currencies do not vary.
It is a technique that the large market participants (which are those who have sufficient capacity to move prices) have practiced in the foreign exchange market since its inception. In it we find one of the main reasons for changes in currencies when monetary policy is modified.
“This is one of the predominant factors, although not necessarily the main one. Asset liquidity is also important. It is not the same that we think of Carry with the Argentine peso, with low liquidity, than with the Mexican peso”, explained Jorge Adrián Calderón, CEO of Bull&Bear.
An example of what is explained in this text is the recent recovery that gave the euro its first increase in interest rates in 11 years of European Central Bank (ECB). This single block currency, which came to trade below parity with the dollartoday it is bought for $1.0220 spot price.
Interest rates compete with those of other markets. Economic conditions that offer fewer possibilities for investment require higher rates, but they are also studied according to their risk. For these and more reasons, the foreign exchange market remains attentive to interest rates.
