Did you know that the announcement of the Fed funds rate is arguably the most watched and traded event for traders and investors all over the world? The Fed's rate decision impacts not only the US economy but also the global economy. However, it also has a huge - and immediate - impact on financial markets including currencies, stocks, bonds and even commodities.
But why is the Fed interest rate so important? How does it impact different markets? More importantly, how can you trade the Fed rate decision and any potential volatility from it?
How to trade Fed rates - What is the Fed funds rate?
The Fed funds rate is the interest rate banks charge each other to lend Federal Reserve funds overnight. Banks borrow these funds from one another to meet and maintain strict reserve requirements.
It is also used as a tool by the Federal Reserve to manage the country's money supply in order to achieve a healthy economy, while also serving as a benchmark for interest rates on savings, loans, credit cards and more. Any changes in the interest rate causes significant movement in the financial markets, especially the US dollar.
When is it? 7:00 PM 19:00 GMT , on the dot.
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How to trade Fed rates - How is the rate determined and when is it released?
The Federal Reserve (Fed) has a mandate to conduct monetary policy to achieve its macroeconomic objective of "maximum employment and stable prices." To do this, the Fed created its own policy-making body called the Federal Open Market Committee (FOMC) which is composed of 12 members; seven members of the Board of Governors and five of the 12 Federal Reserve Bank presidents.
The FOMC schedules eight meetings per year but also holds unscheduled meetings to review economic and financial developments. It is in these meetings where the FOMC decides where to set the Fed funds rate, also known as the Fed interest rate, or just the Fed rate. The decision to adjust interest rates, or keep them on hold, is typically in response to changes in the economic outlook.
Inflation is rising fast ,wages are increases as are the goods we buy , especially energy !! The markets and even Jerome Powell has factored in a rate hike.
The Fed interest rate decision on Wednesday, May 4th, 2022, at 19:00 GMT has factored in a rise. The economic calendar also gives us some more information such as the previous interest rate which in this example is 0.50% and the forecast, another 0.50% hike.
Will we get a surprise? 0.75?
Closer to the time of the release the calendar will be updated with a forecast of what the market and leading economists are expecting the decision to be. At the time of the release, the 'actual' number will be updated.
If the actual number is higher than the previous or forecasted number it is known as a Fed rate hike. Typically, the US dollar will rise on this occasion - depending on what has already been anticipated by the market.
If the actual number is lower than the previous or forecasted number it is known as a Fed rate cut. In this situation, the US dollar will typically fall - again, depending on what has already been anticipated by the market.
At this stage, it is important to remember that markets move on anticipation or expectation of a particular result. Large institutions will already start to adjust their positions and portfolios if there is a higher likelihood of one result over another. Any large moves at the time of the actual result could mean that the market has been caught by surprise.
How to trade Fed rates - What causes changes in the rate?
One of the most important goals for the Federal Reserve is to keep inflation steady at a rate of two percent. Inflation refers to the rate at which the price of goods and services increase. While there are many factors the FOMC take into consideration when setting interest rates, inflation is one of the biggest influencers.
Post Covid demand and Ukrainian war has exasperated inflation causes.
If inflation gets too high, the Fed may look to increase the Fed funds rate. This reduces the amount of money banks have to lend which slows consumer borrowing and demand. It can also make consumer debt more expensive forcing people to spend less thereby reducing demand and bringing prices of goods and services lower.
If inflation falls, it is an indicator that consumers are not spending, among other things. This is a problem for the central bank as it could lead to an economic downturn. In this situation, the Fed is more likely to cut interest rates to stimulate economic activity. A lower interest rate means cheaper borrowing for both consumers and businesses which in turn could lead to economic growth.
How to trade Fed rates - What impact does the rate decision have on markets?
Interest rates have the ability to dictate the flow of capital into and out of a country. In theory, if a country cuts interest rates it tends to lose its value against others. This is because a lower interest rate means a lower rate of return on instruments such as government bonds. If a country increases interest rates, fund managers, investors and pension portfolio managers may try to move their capital there to benefit from a higher rate of return.
If you had the option to receive a higher interest rate on your savings or a lower interest rate on your savings where would you move your capital to? Now think about how much money global financial institutions will move around to do the same thing! But, as we stated earlier, the market moves on anticipation or expectation. If investors feel a country is likely to increase or cut interest rates in the future they will already start to move their capital before an announcement may be made. This is why tracking the news and the economic calendar can pay off in the long run.
When it comes to the Fed rate decision and its impact on the US dollar, it can be tricky as the US economy is the world's biggest. If US economic growth is poor, then it's likely the global economy is doing poorly. Therefore, if the Fed does cut rates to stimulate the economy, investors may keep their capital in US dollars as it's the world's reserve currency and is deemed as one of the safest and most stable of global currencies to hold.
How to trade Fed rate decisions
For traders, one of the ways to trade a possible Fed rate hike, or Fed rate cut, is to simply try and capitalise on the potential volatility of the news announcement. Markets tend to trade quietly in the run-up to high impact news announcements before increasing in volatility once the result is announced.
Any impact on the stock market to a change in the interest rate changes is generally experienced immediately, while, for the rest of the economy, it may take about a year to see any widespread impact.
Higher interest rates tend to negatively affect earnings and stock prices (with the exception of the financial sector).
What Happens When Interest Rates Rise?
When the Federal Reserve acts to increase the discount rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.
Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So individuals consumers are impacted through increases to their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.
Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income. When consumers have less discretionary spending money, businesses' revenues and profits decrease.
So, as you can see, as rates rise, businesses are not only impacted by higher borrowing costs, but they are also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.
Interest Rates and the Stock Market
If a company is seen as cutting back on its growth or is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company's stock.
If enough companies experience declines in their stock prices, the whole market, or the key indexes many people equate with the market—the Dow Jones Industrial Average, S&P 500, etc.—will go down. With a lowered expectation in the growth and future cash flows of a company, investors will not get as much growth from stock price appreciation. This can make stock ownership less desirable. Furthermore, investing in equities can be viewed as too risky when compared to other investments.
However, some sectors stand to benefit from interest rate hikes. One sector that tends to benefit the most is the financial industry. Banks, brokerages, mortgage companies, and insurance companies' earnings often increase—as interest rates move higher—because they can charge more for lending.
Interest Rates and the Bond Market
Interest rates also impact bond prices and the return on certificate of deposits (CDs), Treasury bonds, and Treasury bills. There is an inverse relationship between bond prices and interest rates: as interest rates rise, bond prices fall (and vice versa). The longer the maturity of the bond, the more it fluctuates in accordance to changes in the interest rate.
When the Federal Reserve raises the federal funds rate, newly offered government securities—such as Treasury bills and bonds—are often viewed as the safest investments. They will usually experience a corresponding increase in interest rates. In other words, the risk-free rate of return goes up, making these investments more desirable. As the risk-free rate goes up, the total return required for investing in stocks also increases. Therefore, if the required risk premium decreases while the potential return remains the same (or dips lower), investors may feel stocks have become too risky and will put their money elsewhere.
The great news is on Thursday the UK will make its rate decision, learn to trade it.