In the masterclass «Be a Trader: Fundamental Analysis» with Roman Kravchenko
In May, one of the most relevant topics for discussion was the European Central Bank’s rate cut. Mario Draghi further scared investors by stating that the regulator might go as far as reducing deposit rates to negative values.
Why is it important for every trader and investor to know the size of interest rates set by the world’s largest central banks and the principles of their formation?
Other articles from the masterclass “Be a Trader”:
Where Do Rates Come From?
To understand how interest rates work, it’s necessary to look at the basics of investing. Theoretically, every investment is considered in relation to a risk-free asset, which are government bonds by definition. It is commonly believed that the state is always able to fulfill its debt obligations to creditors since it has the power to print money.
Naturally, any investor would prefer a risk-free investment in government bonds over something with a higher risk level. The basis is the market price of bonds, which depends on the current market rate. The market rate, also known as the spot rate, is directly dependent on the central bank’s interest rate.
By changing the interest rate level, the central bank influences the yield of all assets denominated in the national currency. In a global and open market, this accordingly affects the attractiveness of these instruments for investors.
In the case of an increase in the interest rate, investors actively buy the currency of the country where the change occurred, thus increasing its value, and sell their national currency, which lowers its exchange rate. When the interest rate decreases, the yield of all types of assets falls, negatively affecting the attraction of investments. This phenomenon is known in the market as «Interest Rate Arbitrage», also known as «Carry Trade».
The Key Role in Currency Exchange Rates
As you can imagine, interest rates are not set arbitrarily. The real interest rate refers to the nominal rate minus the inflation rate. Notably, if the growth of the rate does not match the growth of inflation and GDP, the national currency’s exchange rate may even decrease.
An example is the United States. In 1994, during a period of stable economic growth, the growth of inflation and GDP outpaced the growth of interest rates, causing real interest rates to decline. The Federal Reserve raised the interest rate several times throughout 1994. As a result, the U.S. dollar depreciated almost the entire year. For instance, the dollar to deutsche mark rate fell from 1.76 to 1.48 over 10 months.
If we dig deeper, it should be noted that the difference between the interest rates of two countries (interest rate differential) plays a key role in forming the exchange rate of their currencies. For example, if the real interest rates of two countries are approximately the same (which, as we remember, indicates similar returns when investing in the economies of these countries), then a central bank increasing its interest rate will cause a shift in yield in favor of investments in that currency and, consequently, increase demand for it and raise its exchange rate.
Depending on the characteristics of the national economy, central banks, by adjusting the interest rate level, perform functions such as regulating inflation, deflation, supporting or slowing down economic growth.
Interest Rates of the World’s Largest Central Banks
Interest Rate of the Federal Reserve – Target Fed Fund Rate
The main interest rate in the United States is set by the Federal Open Market Committee (FOMC). It is called «Target Fed Fund Rate» and is the main global interest rate.
Interest Rate of the European Central Bank – Refinancing Tender
The European Refinancing Tender rate is the equivalent of the American Target Fed Fund Rate. The European refinancing rate is the minimum rate at which applications for funds are accepted within the ECB tender. Every two weeks, in order to support liquidity in the financial system, the European regulator conducts a tender for the placement of funds. That is, in essence, it is the minimum rate at which the ECB conducts transactions on the open market. Refinancing Tender is the second most significant interest rate in the world.
Interest Rate of the Bank of England – Repo Rate
Repo Rate is the interest rate at which the Bank of England lends short-term loans to British banks, with the collateral being securities. Banks are obligated to repurchase their assets after a certain period at a specified price.
Interest Rate of the Swiss National Bank – Libor Rate
The target three-month Libor rate is used by the Swiss National Bank as a tool for monetary policy regulation. It is the midpoint of a two percent range. It is also known as the base rate through which the SNB influences loan, savings, and mortgage interest rates.
Interest Rate of the Bank of Japan – Overnight Call Rate Target
Overnight Call Rate Target is the equivalent of the American Target Fed Fund Rate. The interest rate of the Bank of Japan serves as a benchmark for the average value on the market for short-term deposits. To bring interest rates on bank deposits closer to the target value, the Bank of Japan manipulates government securities.
Interest Rate of the Bank of Canada – Overnight Rate Target
The Bank of Canada Overnight Rate Target is a benchmark for loans for banks and financial institutions. Through its changes, the Canadian regulator influences bank loans, savings, and mortgage volumes.
Interest Rate of the Reserve Bank of Australia – Official Cash Rate
Official Cash Rate is the interest rate on interbank short-term loans, which the regulator maintains through market operations with government bonds.
Interest Rate of the Reserve Bank of New Zealand – Official Cash Rate
Official Cash Rate is a tool for regulating short-term interest rates on the financial market. The regulator accepts deposits from commercial banks at a rate 0.25% below the official rate and lends at a rate 0.25% above the official rate.
Interest Rate of the People’s Bank of China – Base Interest Rate
Base Interest Rate of the People’s Bank of China serves as a benchmark for commercial banks’ basic rates. By changing the rate level, the Chinese regulator influences all types of loans. Notably, the interest rate of the People’s Bank of China, due to the length of the financial year, is always a multiple of 9.
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FAQ
What are interest rates and why are they important?
Interest rates are set by central banks and influence the cost of borrowing and investment returns. They affect currency values, inflation, and economic growth, making them crucial for traders and investors.
How do central banks influence exchange rates?
Central banks adjust interest rates to impact currency demand. Higher rates typically increase a currency’s value, while lower rates may decrease it, affecting global investment flows.
What are the main interest rates of major central banks?
Major central banks set key rates such as the Fed Fund Rate (U.S.), Refinancing Tender (EU), Repo Rate (UK), and others. These rates guide monetary policy and influence financial markets worldwide.
