Interest Rate Deep Dive: 3 Scenarios When They’re Raised and 3 Scenarios When They’re Cut

As massive levers of the economy, their movements can have a significant impact on a multitude of financial instruments, most directly on currencies, stocks, commodities, and bonds. One of the most important decisions central banks make in their meetings is what to do with interest rates; cut them, raise them, or maintain them at a constant level.

The financial markets tend to get a real shake when the decision isn’t to keep a neutral stance. This article is going deep dive into three likely scenarios that follow a central bank’s decision to either cut or raise interest rates.

First, a Brief Definition

Traders understand that it’s important to monitor interest rate movements because of their impact, but it’s good to take a breath and start with the definition. There’s no better jumping-off-point to understand the likely consequences resulting from big interest rate decisions.

Interest rates reflect the cost of borrowing money and are best understood as the opportunity cost of not using one’s money in the present to generate returns. They represent the time value of money, the idea that a dollar received in the future is worth less than a dollar received today, due to the potential for inflation, default risk, and other factors that affect the purchasing power of money over time.

As a key monetary policy tool used to regulate the supply and demand of credit, interest rates are influenced by a complex array of economic factors, including economic activity, inflation expectations, government policies, and global economic conditions.

Keeping that in mind, let’s jump into the consequences that traders need to be aware of when it comes to big interest decisions.

3 Likely Scenarios When Interest Rates Are Cut

Economic Stimulus

When central banks decide that they need to make borrowing cheaper, they decide to lower the interest rate in an accommodative action known as monetary easing. This encourages consumers and businesses to spend and invest more since they have easier access to credit. All this activity acts as a massive shot of adrenaline to the country’s economy, stimulating it for growth.

A key factor to consider whenever a central bank wants to boost economic growth is increased inflation expectations. A growth spurt can quickly turn into an inflation if not managed correctly.

Currency Devaluation

As a result of a central bank’s interest rate cut, currencies can be devalued. Investors and traders may seek higher returns in other countries, leading to a decrease in demand for the currency of the country where the rates were cut.

This can cause the value of the currency to decrease, making imports more expensive and exports more attractive. Traders may see increased volatility in the currency markets as investors react to the interest rate cut and adjust their portfolios accordingly.

Increased demand

With increased inflation expectations thanks to economic stimulus, the demand for goods and services goes up, which in turn pushes prices up. Traders could see increased demand for commodities such as oil and metals, as these tend to be inflation-sensitive and can benefit from higher prices.

At the same time, traders may also see a shift in demand towards stocks that are “inflation hedges,” such as real estate, utilities, and consumer staples since these tend to perform well in times of rising inflation.

3 Likely Scenarios When Interest Rates Are Raised

Reduced Inflation Expectations

As you would expect, opposite actions have opposite reactions. A central bank will often raise interest rates to combat inflation, like the Federal Reserve has been doing in 2022-23. This act of monetary tightening reduces inflation expectations, as higher borrowing costs typically slow down spending and investment and decrease demand for goods and services.

Whereas demand for commodities like oil increases when interest rates are cut, traders could expect a decrease in demand for these types of inflation-sensitive assets when rates are raised since the concern is centered more around the potential for economic contraction.

Currency Strengthening

Forex traders would do well to keep a very close eye on exchange rates whenever a central bank decides to raise interest rates. What usually follows is a more bullish outlook on the domestic currency, as higher interest rates tend to attract foreign investment.

If the Federal Reserve raises interest rates, for example, a stronger US Dollar could also impact the profitability of American companies that rely on exports, since they can make their goods more expensive and less competitive in foreign markets. Beyond currencies, traders may also see a shift in demand towards stocks for companies that are more domestically focused, as they are less likely to be impacted by a stronger currency.

The Attraction of Safe Havens

When a central bank raises interest rates, borrowing costs for consumers and businesses tend to go up. This can lead to a decrease in spending and investment, which can negatively impact the stock market and certain sectors that are particularly interest-rate sensitive, such as real estate and consumer durables.

Traders may also see a shift in demand towards safer assets, such as bonds and cash, as investors seek to preserve capital and avoid the higher borrowing costs associated with riskier assets. And if inflation remains a concern even when a central bank raises interest rates, demand could also increase for assets that are perceived as “inflation hedges,” like gold.

The Crux of the Matter

Traders need to factor central bank decisions on interest rates into their strategies whether the expectation is for a hawkish or a dovish monetary policy.

Regardless of how diverse your portfolio is, you should always stay informed on whether a central bank will cut or raise interest rates since the ripple effects extend far and wide across the entire financial market.