Interest rates are probably the most watched number in the US right now. Investors have been monitoring the Federal Reserve’s action to try and predict the general direction of the monetary policy.
When talking about interest rates vs the stock market ever since the Fed began tightening in March 2022, there has been a series of interest rate hikes that greatly affect the financial market in general. On March 17, the Fed hiked the base rate by 25 basis points and later 50 basis points on May 5th. Thereafter, it has been hiking the fund’s rate by 75 basis points.
As a trader or investor in the foreign exchange market, the direction interest rates are taking is of great importance to you. It affects your trading in more than one way. If you aren’t sure how interest rates impact your trading, you can start by taking a trading quiz to polish your knowledge.
The Predictive Power of The Treasury Market
One of the greatest unknowns among traders today is the direction the economy is likely to take. This is because many of the parameters that determine how the economy behaves are also not easily determinable. For instance, no single investor can accurately determine where interest rates will be three or six months from today.
That being said, there are hints that traders use to try and figure out the market sentiments concerning the direction rates are taking. One of the sources of many of these hints is the $24 trillion treasury market.
The market for treasuries in the US has served lots of use cases in addition to being a market for investors. One of the use cases is the power to predict the direction of interest rates.
Treasury securities can be classified into different categories. However, the major classes are:
- Treasury bills- Short-term instruments with a maximum maturity of 364 days
- Treasury notes- Short to medium securities with a maximum maturity of 10 years
- Treasury Bonds- These are mainly long-term instruments with a maturity of between 10 and 30 years.
- Floating Rate Notes (FRNs)- These are securities whose interest rate changes based on the discount rate of treasury bills.
While all these securities are important in predicting the health and direction of the economy, treasury notes are the most significant. Investors usually look at the yield curves of the two and ten-year notes to get a feel of where interest rates are headed.
Short-Term Market Sentiments
The November nonfarm payrolls report showed a stronger economy going into 2023. Economists had predicted an addition of 200,000 jobs contrary to the 263,000 the economy added. The report also beat the hourly earnings estimate recording a 0.6% month-on-month increase against a 0.5% estimate.
The increase in wage growth and jobs added means the Fed will have to keep on tightening the economy. As of December 5th, futures have already priced in the possibility of an 81.2% chance of a 50-basis points rate hike and an 18.2% chance of a 75-basis points increase. The actual increase will be known in the December 15 monetary policy meeting.
Going into 2023, investors are looking at the possibility of the Fed cutting rates twice in the last quarter of the year. Treasury futures markets are showing signs that the rate hikes will peak somewhere in May 2023 at 4.9%. Thereafter, the rate of tightening will slow down to about 4.4% towards the end of the year as market volatility eases.
Impact On the Forex Market
Whether you are looking at the short-term or long-term direction of treasury securities yields, there will be an impact on forex either way. Despite other factors that are impacting the strength of the Us dollar such as the easing of Covid-19 lockdowns in China, there is still some strength left in the greenback.
The US dollar Index (DXY) has been crossing the 104.20 mark a couple of times. This means that compared to the basket of currencies in the DXY, the dollar still has a lot of wind in its sails.
Traders must carefully study the treasury yield curves both for short-term and long-term instruments. An upward-sloping curve means the market signals a case of rising rates in the future. On the other hand, an inverted curve means that the market sees the Fed slowing the fund’s rate hikes in the medium to long term.
Conclusion
Trading the forex market requires a careful interpretation of a bunch of trends including interest rates movement. Knowing whether the Fed will pivot or not by looking at the yield curves can help investors take a risk on or risk off positions. Whichever the case, refining your knowledge of forex before putting in your money is the best way to enhance your chances of success.
