I am a bit confused about monetary policies, because any time I think I grasped the idea, I find myself wrong.
First of all, as long as I know, when a currency has a higher interest rate, it usually gets weaker as time goes on (which usually make carry trades unsuccesuful). An example of this could be EURTRY, or even EURUSD.
But then I see that a hawkish prospect could boost a currency, what, according to what I have stated, it should have the opposite effect.
Hawkish does mean interest rates are likely to rise, making investment in the currency in question, as opposed to another currency, more rewarding. So the currency rises against currencies with lower interest rates.
But a higher interest rate makes investment in the country’s real economy less rewarding as money is now more expensive to borrow in order to for, or expand a business.
So the real focus is on expectations, not in the real interest rate, when it comes to this kind of policies, right? I mean, a hawkish expectation on EUR should translate to EURUSD pair rise, although by the time that hike is made, a correction is expected. Should it be this way?
Yes, this is a common scenario. But its very difficult to come up with a strategy for private retail forex traders that uses interest rates and interest rate change expectations to time entry and exit.
Mate, then you need to understand first what Hawkish mean! It defines that interest could be rise anytime. To understand this you need to analyze the market very well. Currency will rise against another currency. Which currency can rise that you have to predict and here is the difference between novice trader and professional trader. With the lower rate of interest a currency could be rise. Some exceptional case could be happen for a country’s economic or environmental situation.
Thinking about FA can help with TA decisions - e.g. Eur/Usd
Pres Trump has made it known that he desires a weaker USD, the market expects that he will pursue policies and make choices with that in mind, for example the recent appointment of Fed Chair.
ECB are hinting about reducing/ending QE and the need to raise rates - as usual their cycle is just a tad behind the US.
With that in mind lets say a trader enters the market in increments of 2 lots with the aim of a 10 lot exposure.
The FA as above (and some others) suggest a buy, so he enters his first 2 lots at the beginning of this week at 1.2420.
Price goes against him, he enters again at 2350 Tuesday, another 2 lots.
Price yet again goes against him today, he enters yet again 2320, now 6 lots long
He is averaging down (all the pundits say don’t do it, never add to a loser).
Now he will wait until price starts to rise before adding his remaining 4 lots - based on FA
(he will take a few other things into account including S&P but that’s another story.)
Central banks take a hawkish stance when it wants to tame inflation. So, an increase in rate would generate greater demand for the currency which would push the value of the currency. However, over a period of time, the adverse impact of higher interest rate starts affecting the economy, such as higher trade deficits, leading to reduction in value of the currency.
With recent USD strengthening, just wanted to share some more thoughts on interest rates.
Interest rate differentials are just one input in the forex puzzle and the differences between U.S. interest rates and other countries are already supportive of the USD.
Another input to consider is a slowing China (and possible trade war).
This will suck liquidity out from the market, negatively affecting commodities and emerging markets (EM).
This will cause a repricing of risk and capital to flow back to the US.
Capital flows back into the US will cause the US dollar to strengthen.
Which creates a feedback loop…
Stronger dollar causes
Tighter global liquidity which causes
Risk repricing which causes
Capital (money) to flow back to the US. which causes
Back to #1
A stronger dollar weakens inflation (imports get cheaper). And with inflation slowing, or at least not growing, it limits the Fed from raising rates. And if rates aren’t going to be rising as fast as expected, this will be cause US equities to re-strengthen.
So with the interest rate differentials between the US and EU (and other countries) already being more attractive for capital and a rising equity market, more capital (money) will continue to flow back to the US which causes the dollar to strengthen further.
