What Do First Policy Rate Hikes Tell Currency Traders?

The Reserve Bank of New Zealand is the first central bank in the developed world to first hike the rates. What conclusion can traders draw from the market’s expectations on the first policy rate hikes?

In the currency market, exchange rates reflect the value of one currency in terms of another. Traders willing to speculate on the future direction of a currency pair use various tools available at their disposal – technical or fundamental ones.

Central banks and their actions are primary drivers of volatility in the currency market. Trading algorithms and new technologies made it possible for brokers to execute orders in milliseconds, so central banks’ language changed, striving for more transparency and clarity in order to avoid unnecessary volatility.

Out of all the central banks’ decisions, the ones regarding the interest rates are the most important for traders. Simply put, a currency is more attractive the higher the interest rate is.

In the developed world, inflation was not an issue in the last decades. The COVID-19 pandemic changed that, but real rates (i.e., interest rate less inflation rate) are expected to turn positive again once central banks start raising rates and inflation slows down.

Interpreting Market’s Expectations on Interest Rates

If we use the expected changes in the interest rates in the developed world and try to forecast future changes in the exchange rates, we get some interesting results.

For example, the Reserve Bank of New Zealand and the Bank of England are the first ones expected to raise their rates by 25, respectively, 15 basis points. That’s an increase of 0.25%, respectively 0.15%. It may not look like much, but if we compare to, say, the -0.5% interest rate on the ECB’s deposit facility rate, the gap widens.

Based on the graph above, one may favour a short position on the EUR/NZD exchange rate, a short position on the EUR/GBP, or a long position in the GBP/JPY. Only trading the currency market is not that simple. Multiple factors need to be considered, and the interest rate is only one piece of the puzzle.

But, the interest rates do offer an educated guess of what is priced in. Any deviations, such as the Bank of England delaying the hike, should create more volatility than the actual rate hike delivered as scheduled.