How to improve your trading by looking at interest rates: Part 3

5 de set. de 2022

Hey everyone! 👋

This month, we wanted to explore the topic of interest rates; what they are, why they are important, and how you can use interest rate information in your trading. This is a topic that new traders typically gloss over when starting out, so we hope this is a helpful and actionable series for new people looking to learn more about macroeconomics and fundamental analysis!

In our first post, we took a look at how to find interest rate information on TradingView, and how rates fluctuate in the open market. In our second post, we took a look at some of the decision making that investors have to make when it comes to investing in bonds (rates) vs. other assets.

Today, we'll be taking a look at how global investors understand interest rates, using three concrete examples.

Let's dive in!

As we mentioned last time, when it comes to understanding interest rates in any region, there are three main things to take a look at:

1.) Central Bank Funds Rate risk
2.) Inflation Risk
3.) Credit Risk



First, let's take a look at Credit Risk. 💥💥

Credit risk is something that happens when there is a risk that you may not get back the money you loan to a certain entity. For this series, since we're only looking at government bonds, this means the risk that the government won't pay you back.

Lesson: All things being equal, the more an entity (Company, Country) has to pay to borrow money, the less 'stable' they are in the eyes of investors.



Next, let's take a look at Inflation Risk. 💸💸

Inflation Risk is something that happens when there is a risk that your principal may lose buying power over time, faster than the interest rate, due to the rate of inflation.

For example, check out this chart:



In the Blue/White, you can see Turkish 1 year bond yields. In the green, you can see U.S. 1 year bond yields. Notice the difference in interest rates - the Turkish bonds pay 14%, and the U.S. bonds pay 3%. While the U.S. is a larger and more developed economy (and therefore runs a lower "credit" risk), some of the difference in yield comes down to the drastically different rates of inflation within the economy.

In the red, you can see the rate of inflation in the United States, and in the yellow you can see the rate of inflation in Turkey. Assuming a steady exchange rate, as Turkish Lira buy relatively less and less goods and services over time vs. The U.S. Dollar, investors will demand more yield to prevent against the loss in buying power.

Lesson: the direction of Interest rates tells you how investors think inflation might develop over a certain time horizon.



Finally, let's take a look at Central Bank Funds Risk. 🏦🏦

Central bank funds risk is something that happens when the Central Bank may move base funding rates adversely to your position.

Check out this chart:



It's the same chart as last time, but instead of the inflation rates superimposed on the interest rates, we've added the current Central Bank rates to the chart.

Remember, the Central Bank rate is the rate you get from the bank without "locking up" your money into a loan to the government.

Central Bank rate risk plays the biggest part in bond pricing, as you can see that interest rates and yields move together rather closely, especially as these are only 1 year bonds (we will look at the yield curve next week).

That said, given that Central Banks across the world are typically mandated to try and create stable prices for consumers, their actions are often dancing with inflation. Sometimes banks will raise rates too much and create deflation. Sometimes banks will raise rates too little and will be "behind" inflation (as many believe is currently the case).

Lesson: Interest rates are indicative of Central Bank policy, which is informed by several factors and varies from region to region. In other words - interest rates can describe the health of an economy. Too "High", and the Central Bank may have lost control. Too "Low", and the economy may be stagnant. These are generalizations, but they are a nice place to begin comparing regions on a relative basis.



And there you have it! Some concrete examples and lessons to be learned from looking at live moves in the market. Understanding these dynamics can be really helpful to building out a more comprehensive trading strategy. In other words, if you're trading FX, it's incredibly important to know interest rate differentials between countries, along with the underlying drivers of rates. Similarly, if you're looking at investing in a company, looking at that company's bond yields can tell you how much risk investors think the company has of defaulting on obligations.

Next week, we'll take a look at the Yield Curve, and include some more lessons about how you can use that information to begin forecasting prices and the overall economy.

- Team TradingView ❤️❤️