How Interest Rates Impact Trading Decisions

The global interest rate market has a daily turnover of more than 6.5-trillion contracts per day and has a profound impact on all assets. Interest rates help determine the payment a borrower will make to a lender for a loan. As interest rates rise, the loan cost increases, and as interest rates fall, the price of a loan will generally decline. Interest rate levels can impact stock values, indices, bonds and forex markets. Here is how interest rates will impact online trading decisions.

How to Interest Rates Affect the Forex Markets?

The forex markets are one of the largest capital markets, with more than 5-trillion in daily turnover per day. The forex markets rely heavily on interest rates, which are embedded in the forward rates charged by brokers and dealers. The forward market used by forex traders may help determine the future direction of a currency pair.

The forward rate is the rate that is charged to hold a currency pair for longer than 2-trading days. The forward-rate compares to the spot rate, which is defined as the rate used to trade a currency pair when the settlement period is less than or equal to 2-trading days.

The forward rate incorporates interest rates and the borrowing costs to hold a currency pair. Suppose the currency you are purchasing has a higher interest rate, and you transact a forward transaction. In that case, you will receive the difference between the higher interest rate and the lower interest rate.

The forward curve can also be a driving force behind the movement of the forex spot rate. Over time, if a currency pair remains unchanged, the holder of higher interest rates currencies will gain. The rate differential is called the interest rate differential. Over time, the interest rate differential usually drives the movement of a currency pair.

How Do Interest Rates Impact the Stock Markets

Changes to interest rates can alter stocks and indices. While they do not impact stocks directly, a change in interest rates can change the course of stocks and indices. Interest rates will impact cash flows, which influence the value of stocks. Many stock analysts believe that a stock’s value is the discounted cash flow that a company will pay off. The discounted cash flow of a company changes with interest rates. As interest rates rise, the discounted cash flow will decline, making stocks of companies less valuable. As interest rates fall, the discounted cash flow will increase, making stocks of companies more valuable.

Changes to interest rates can also impact growth and spending. The lower the interest rate, the more willing people are to borrow money to make purchases, such as houses or cars. The reason is that most homes are purchased with mortgages, and most cars are either leased or paid via a financing program.

When consumers pay less in interest, this gives them more money to spend, increasing spending throughout the economy and boosting growth. Businesses also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing. This scenario generates higher output, and productivity increases.

Conversely, higher interest rates will reduce borrowing and therefore reduce spending. This situation will contract future growth. Strong growth will help stock prices move higher, as higher future cash flows will increase. Weaker growth generated by higher interest rates will reduce the value of stock prices.

How Do Interest Rates Impact Bonds?

Bond prices are directly affected by changes in interest rates. As interest rates decline, the price of a bond will rise, moving in the inverse direction.  As interest rates rise, the price of a bond will decrease. A bond is a loan that can be paid back monthly, quarterly, semi-annually, annually, or at maturity. When governments or corporations issue bonds, they use the prevailing interest rate borrow capital—the better the government or corporation’s credit, the lower the interest rate. For example, the U.S. Treasury will get a better borrowing rate than an emerging country. After a bond is issued, the price will float along with the prevailing market interest rate. While the payment at maturity will remain the same for a purchaser who bought a bond when it was issued, the price during the bond’s life will be impacted by the prevailing interest rate.

The Bottom Line

Changes in interest rates have an impact on many different securities. Interest rate changes have a direct effect on the price of bonds. Interest rates directly impact the forward-rate changes in the forex market and an indirect impact on stock prices. Interest rates are used in determining the value of loans, which can generate more or less spending and impact growth which can spill over into the value of stocks, bonds, and indices.