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Trading Tutorial – Federal Funds Rate and its impact

2019-2-20 10:43 | By : MEX Analyst Team

I briefly introduced what is the PMI and the behind-the-scenes last time. Have you had a nice catch with the market trends after reading that article? Today I will provide you with another interesting topic - the Federal Funds Rate. Interest rates are widely adopted - credit cards, mortgages, bank loans, etc., showing the utmost importance of interest rates in our life. Do you know what kind of factors these interest rates are based on? The answer is simple and we can start with the world biggest economies- United States. Its currency, US dollar, is therefore the most circulated currency in the world and the main foreign exchange reserve of the central banks in various countries. The decision of Federal Reserve on interest rate as well as the attitude of parliamentary officials have caught the global attention every single time. The success of investors' forecast on the currency and future global economic trends, to a large extent, come down to the level of understanding of the Fed's funds rate 

What is the Fed rate? 

  Today's topic - the US Federal Reserve interest rate, also known as intra-bank lending rate. To ensure interest rates keep up with the latest economic trends, Fed officials hold eight meetings per year. To put it simple, when the Fed decides to raise interest rates, it is equivalent to reducing the money supply. In addition to an increase in the intra-bank lending rate, it also means that the coupon rate of the newly launched bonds by US government will be more attractive. While US government bonds are recognized as the most stable investment products, an increase in the coupon rate of bonds leads to hot money around the world pushing up the demand for US dollar, leading to a prolonged upward movement. 

How to make good use of the results of Fed decision on interest rates in the forex market? 

 Up to this point, it is reasonable investors may think that when the Fed raises interest rates, it would be the perfect buying time for the US dollar. However, it is noteworthy that, in addition to the unexpected interest rate adjustment (Only happened once across the ten-year historical data), the market has already priced in the decision. The subsequent movement is highly likely different from the expectations among investors so the federal funds rate is taken as a lagging indicator. Investors should pay close attention to the unexpected price swing by the release of Federal decision on interest rates and make sure risk management is in place so as to avoid unnecessary losses caused by large price swing.                          

Federal funds rate, however, is more than a lagging indicator to predict the price movement of US dollar. A change of federal funds rate actually gives us a hint at how Federal officials, top economists in the world, think of mainly the current US economy. A decrease in Federal funds rate is taken as expansionary monetary tool to boost up the gloomy economy through encouraging businesses and individuals to lend. (Think of Japan!). Also, we are expected to see more loose monetary policy in the midst of recession according to the graph above. For example, Federal Reserve kept the rate real low after period of global financial crisis and Euro sovereign debt crisis. As a result, it is of important economic indicator worth close attention of us.

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