Understanding Interest Rates and the Financial Markets

This week, the Federal Reserve, the Bank of England (BoE) and the European Central Bank (ECB) met respectively to discuss monetary policy for the final time in 2023.

As had been widely expected, all three central banks held rates steady. With the decisions themselves bordering on certainties, the markets were more interested in the accompanying comments from the three institutions, looking for hints as to when we can expect interest rate cuts to begin.

Whilst the three decisions were the same, the signals regarding rate cuts were varied.

The Announcements

First, the Fed. Members of the Federal Open Market Committee (FOMC) voted unanimously on Wednesday to keep interest rates unchanged, but struck a more dovish tone than had been expected, signalling the possibility of three quarter point cuts in 2024.

Next up was the BoE. Unlike the Fed, the decision to hold rates was not unanimous amongst members of the Monetary Policy Committee (MPC), with three out of nine members feeling a hike was appropriate.

With the vote itself revealing that hawks in the MPC have seemingly not yet had their fill of rate hikes, the accompanying announcement was also decidedly hawkish. The BoE pushed back on speculation that rate cuts were imminent, with Governor Andrew Bailey stating that interest rates needed to stay high for an “extended” period of time to deal with inflation that may prove stickier in the UK than elsewhere.

Finally, the ECB took the stage, and seemingly took their cue from the BoE. Interest rates remained unchanged but the ECB statement made a similar pledge to that of the BoE: “policy rates will be set at sufficiently restrictive levels for as long as necessary”.

Again, as with the BoE, the ECB seemed to give no indication that interest rate cuts were coming any time soon. Indeed, ECB President Christine Lagarde said that the issue of cutting rates was not even discussed during the meeting.

So, how did the financial markets react to all this? For those familiar with the impact interest rates have on the markets, the reaction was perhaps predictable. For those unfamiliar with the effect interest rates can have, keep reading and we’ll explain what it was and why it happened.

The Stock Market

As the Fed announced on Wednesday that rates would remain unchanged and signalled cuts were potentially on the way, Wall Street immediately cheered. In the hour that followed the announcement, the Dow, S&P 500 and Nasdaq Composite all jumped more than 1%.

Similar phenomena were witnessed as European markets opened on Thursday morning. The pan-European Euro Stoxx 50 Index and the UK’s FTSE 100 both opened the session more than 1% higher. However, in the wake of the BoE and ECB’s announcements, it was not long before both indices began giving back earlier gains.

Here we can observe a correlation between interest rates and share prices. Generally speaking, interest rate cuts, or speculation of interest rate cuts, tend to be met with a positive reaction in the stock market. On the other hand, higher interest rates tend to put pressure on share prices. Why is that?

Interest rates are one of the tools used by central banks to help control inflation. When inflation is high, interest rates are typically raised to tame it. Whilst higher interest rates work to bring down inflation, they can also have a negative impact on corporation profits.

This is for two main reasons. Firstly, higher interest rates reduce discretionary incomes, which subsequently dampens consumer demand. If people are buying fewer things than normal, this will negatively impact business sales and, thus, profits. Secondly, higher interest rates mean that it becomes more expensive for businesses to service their existing debt, which further weighs on profitability.

This logic, then, explains why stock markets reacted positively to the Fed’s announcement on Wednesday and negatively to the announcements of the BoE and ECB on Thursday. Of course, this relationship between stocks and interest rates is not always so simple, and there may even be stocks that can benefit from rising interest rates in certain conditions.

The Forex Market

So, we saw a noticeable reaction in the stock market to the three interest rate decisions this week, but what about the foreign exchange market? Can we observe anything similar there?

Within an hour of Wednesday’s dovish announcement by the Fed, the US Dollar Index, which tracks the value of the dollar against a basket of rival currencies, sank 1% and continued its descent in the hours which followed. Consequently, the index now sits at its lowest level since August.

Heading across the Atlantic, naturally, as the US dollar dropped, the GBPUSD and EURUSD currency pairs benefitted. Later, as the BoE and ECB poured cold water on the prospect of imminent rate cuts, both currency pairs benefitted again and continued to gain strongly during the session.

Here, we can identify pretty much the opposite reaction to the one in the stock market. Generally speaking, higher interest rates will have the effect of strengthening a currency, with lower rates weakening it.

The explanation is more straightforward than that of equities. Simply put, higher interest rates tend to attract an increased level of foreign investment. The subsequent increase in demand for a country’s currency has the effect of strengthening it against rival currencies.

In the case of the GBPUSD and EURUSD, this week’s interest rate decisions had a doubly positive result. Whilst the Fed’s signal that rate cuts may arrive soon weakened the USD, the BoE and ECB’s lack of such a signal strengthened the GBP and EUR.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.