What Is Market Sentiment (Part II)?
What are the factors that influence the market sentiment? Interest rates play a major role affecting the supply and demand of currencies. Trends in interest rates are one of the most significant factors influencing market sentiment.
Interest rates in each country are decided by the respective central banks. Every currency in the world has an interest rate attached to it. FED determines the interest rates in US. Reserve Bank of New Zealand determines the interest rates in New Zealand. Similarly the Bank of Japan determines the interest rates in Japan.
Now some currencies will have a higher interest rate. These currencies will attract the most attention from the savvy international investors who are always looking for a better interest rate yield on fixed income securities. This also depends on the economic and geopolitical risks of that country.
The value of money decreases when there is an upward revision of prices of most goods and services in the country. You will ask what causes fluctuations in the interest rates. In simple terms, inflation!
Central banks control inflationary pressures by increasing the interest rates. Monetary policy is an important tool for the central banks. Central banks are responsible for ensuring the price stability in the domestic economies.
Suppose the inflationary pressures are increasing in the US economy. FED would raise the Federal Fund Rate. Federal Fund Rate is the rate the banks charge each other for overnight loans. When overnight rates changes, retail banks will adjust their prime banking rates! This accordingly affects businesses and individuals in the economy.
The most important way in which interest rates can affect the currencies is through the widespread practice of carry trade. A carry trade involves shorting of a low interest rate currency to go long on a higher interest rate currency in order to gain the difference between the two interest rates. This difference is known as the Interest Rate Differential.
So you can see currencies with higher interest rates are highly sought after by investors looking for a higher return on their investments. The carry trader is paid the interest rate on the currency on which he/she is long. He/she must pay the interest rate on the currency that has been shorted.
Investors tend to shift their assets to higher interest rate currency from lower interest rate currency. They have to buy that currency for that transfer of funds and assets. This increased demand for the currency pushes the currency price relative to other currencies. As a general rule, rising interest rates tend to strengthen a currency relative to other currencies.
In 2005, Japan was offering almost zero interest rates on Japanese Yen deposits. The interest rates had been made almost zero to fight a decade long deflationary cycle and kick start the economy again. There was a lot of interest in Japanese investors to invest in New Zealand dominated assets. NZD was paying a higher interest rate as compared to the near zero interest rate being offered on JPY.
So in general rising interest rates should boost the market sentiment for that particular currency. The opposite is also true and interest rates cut would result in bearish sentiments regarding the currency of that country.
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