Interest rates changes and effects

F

fxloop

I have a question about interest rates ...

Can anyone tell me how does the interest rates rise/fall affect foreign exchange market and country's economy.

I know that interest rates rise is usually used to fight inflation but I don't know what is behind this idea, or better to say that I'm not sure whether I got it all right...

If interest rate rises it means that investors will start investing in dollar because they'll have bigger returns due to higher interest rates. But also on the other side stock market will decline due to
declining consumer spending, retail sales... (which leads to reduced corporate profits). If more investors invest in dollar expecting bigger returns from higher interest rate than other withdraw due to declining stock markets (and treasuries) dollar should rise. If dollar rises it would cause producers to lower prices (I think...) - declining prices = declining inflation

Am I right or wrong ?

tnx in advance,
fxloop
 
If interest rates rise the economy slows. For example, if you had to pay 13% to get a mortgage, you would probably buy a smaller house then if you only had to pay 5%, given that your desposable income remained the same. High interest rates keep many first time buyers out of the market. On the other hand, low interest rates can make real estate prices sky rocket.
 
as the price of the dollar rises, the overseas markets strengthen their positions in the dollar currency.

on the other hand as the dollar rises that means the other currency felt a little or a lot short of a dollar which would tend to make the other market less stable.
 
Quote from mrmarket:

A cheaper dollar means it is easier to export goods, making our trade balance actually more competitive.
More...

In addition to this there are many influences of interest rate changes on currency. One of the first is the strengthening of a currency as interest rates of a nation rise in relation to rates of other nations. This causes the accumulation of the currency (and thus its strength) as foreign investors and foreign banks purchase interest bearing instruments in that currency to obtain a higher yield.

Remember, the Fed can only effect very short term interest rates. The market controls all other rates but they are closely tied together through many complicated mechanisms.

As the Fed tightens short term rates through various methods, primarily corporations are forced to pay more for their various short term financing needs causing them to reign in expenses on items such as R&D, inventories, etc. unless sales strength justifies paying the higher rates. At some point the rates become too high for a given company and they begin to slow manufacturing or other operations. This is primarily how the Fed attempts to control the economy with their interest rate manipulations.

One of the most obvious benefits of a weaker currency is that other nations can buy our goods at a lower cost creating more demand. Their goods also become more expensive for us lowering demand for those. That is why you will see other countries try to support our currency from time to time.

A stronger currency works in the opposite fashion so if we are able to maintain our exports and have a stronger currency we can buy imports cheaper and maintain a more affluent life style. This is not done easily as you can see from our trade deficits.

To go into this more here is impractical as there are many books written on this very complicated subject. The above information should be common knowlege to master traders and and absolute necessity to currency traders.

Wally
 
excellent post Wally...

One more thing....while the direction of interest rates seems to be what influences markets, it is the absolute rate itself that will govern the economy.

Sure, a tightening of rates is going to spook investors but, in actuality, rates will have to increase for a very long time to get the absolute rates back up to the point where they will have a significant economic impact on how companies make their investment decisions.

A good capital investment project in a company has a one year return of about 15%. This is well in excess of our short term cost of borrowing.

Shoot...I just love those 0% credit cards, don't you?
 
This is a very complex subject and many good point have been reported in earlier post, you should have to consider this:

1) The absolute interest rate drive the market in the sense that a low interest give enought fuel to the market because peolple cannot make a lot of money in bond or abk account, in the opposite side a higher interest rate will be a limitation for the upside in the stock market because people could have obtain the same performance in bond market with no risk.

2) The differential interest rates between countries are also important, because investors spot if he can do a better performance on international market. Sometimes a higher interest rate mean that this economy have a better performance than the first, sometime this is because they are in the trouble, an evaluation is required in each case.

Also many other factors have to take in the decision, exchange rate is one of them. An example, fix exchange rate that come from the China will do a distorsion on interest rate and do complex economic phenomena very hard to analyse for future performance. This only a small piece from a big puzzle!
 
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