More recently, concerns of inflation and thus interest rates have been the driving force for the forex market, but why is this? And, what does all this technical jargon mean? In this short article, we aim to answer some of those questions and channel your inner macro-economist.
What are interest rates?
Simply put, an interest rate is the amount of interest due per period as a percentage of the initial loan. This relates to both government-issued bonds and company-issued bonds as well as other debt securities.
What causes interest rates to rise?
Monetary policy refers to controls in place by central banks to control the money supply. Central banks have multiple tools at their disposal, for example, bond buybacks (AKA: asset buyback program) and interest rates. More money supply generally results in a reduction in the interest rates and thus increased inflation and a general expansion of the economy! However, investors like to maintain a certain level of purchasing power, so if inflation is high and the perceived risk of debt is higher, then a higher interest rate will be needed to offset this. Hence, the central bank will most likely adjust its policy rate upwards.
What is the effect of rising interest rates?
A rise in interest rates means companies have to pay more interest to their lenders or bondholders. As a result, international investors seek to capitalize on higher yield debt because of the increased payoff, thus increasing demand for US dollar-denominated bonds, increasing demand for the Greenback. Furthermore, a hike in interest rates harms companies that have funded growth by taking out large amounts of debt; generally speaking, Tech companies fund development by becoming highly leveraged (More debt). Thus a hike in interest rates sends tech stocks downwards!
Hawkish and Dovish
An inflation Hawk is a policymaker favouring higher interest rates and reducing the money supply to keep inflation in check. That said, if central bank policy shifts to a more hawkish approach, then one would expect interest rates to rise, tech stocks to fall, and the value of the USD to rise.
An inflationary Dove is a policymaker that stands on the other side of the fence to a Hawk. Doves prefer lower interest rates and an increased money supply to promote growth and jobs in the economy, albeit by accepting higher inflation levels.
So there you have it! Next time you read something saying that policymakers appear more hawkish, the implications of this should now be apparent.