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INTEREST RATES
Higher interest rates make a domestic currency more attractive to foreign investment. Unexpected changes in interest rates create enormous volatility in the Forex market. Carry trading accelerates and enhances the impact of changing interest rates. There are two general interest rate strategies:
(a) Tight Monetary Policies (aiming to deal with high inflation) favor currency appreciation
(b) Flexible Monetary Policies (aiming to deal with weak growth and unemployment) lead to currency depreciation
In the eurozone, the official interest rates are decided every six weeks by the ECB Governing Council.
In the US, the FOMC holds eight (8) regularly scheduled meetings during the year (January, March, April/May, June, July, September, November, and December).
Employment/unemployment data play a major role in interest rate decisions. If employment is strong, the central bank can grow ‘hawkish’. Lower unemployment than expected favors currency appreciation.
Retail Sales reflect consumer confidence and can even reveal a spending pattern in the economy. Note, that non-dynamic spending is not included in this report (health care, education, etc.).
Historically, FED targets a 2% inflation. An extended period of high inflation pushes central banks to raise interest rates. Forex markets adore higher rates, thus, favor reports showing strong growth and high inflation.
The ISM report indicates new orders and forecasts upcoming manufacturing activity. ISM exceeding level 50, means economic growth, and lower than 50, indicates economic contraction.
Producer Price Index measures changes in the cost of producers. The index includes the first commercial transaction for many products plus some services.
The balance of trade, commercial balance, or net exports, measures the difference in value between a country's imports and exports. Exports exceeding imports create a surplus, and imports exceeding exports, create a deficit. A trade surplus enhances the long-term attractiveness and the value of the domestic currency.
Government bond yields reflect inflationary pressure, but also reveal the confidence of investors towards the future economic conditions. Significant changes in the yields of government bonds can be an early warning that something is going on.
Large foreign exchange reserves are important for monetary authorities (central banks) to properly implement their monetary policies. The currencies of countries with limited reserves are more vulnerable to attacks from large currency speculators, such as speculative hedge funds.
The general government deficit is the balance of income and expenditure of the government, including capital income and capital expenditures. The larger the general government deficit the worse for the domestic currency.
-"Net lending" means that government has a surplus.
-"Net borrowing" means that government has a deficit, and requires financial resources from other sectors.
The general government debt-to-GDP measures the gross debt of the general government as a percentage of GDP. A high debt-to-GDP ratio is a bad news for the domestic currency, as the higher the ratio the higher risk of default. A World Bank study showed that a debt-to-GDP ratio above 77%, for an extended period, affects economic growth.
