Deciphering the Beige Book: How Interest Rate Policies Shape Forex Markets

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Market importance: High importance.

Meaning: The Open Market Committee is responsible for setting interest rates, and the Beige Book is an important basis for the committee’s decision-making.

Release time: The Wednesday two weeks before each Open Market Committee meeting, 2 p.m. Eastern Time.

Frequency: Eight times a year.

Revision situation: No revision.

The official name of the Beige Book is "Summary of Commentary on Current Economic Conditions by Federal Reserve District", which is a compilation of some information from 12 Federal Reserve districts, which will be used for the next Open Market Committee. The Open Market Committee is responsible for setting interest rate policy.

Interest rate, in terms of its manifestation, is the ratio of interest amount to total borrowed capital in a certain period. For many years, economists have been working to find a set of theories that can fully explain the structure and changes in interest rates. The "classical school" believes that interest rate is the price of capital, and the supply and demand of capital determine the changes in interest rate.

Now, all countries regard interest rates as one of the important tools of macroeconomic regulation. When the economy is overheated and inflation is intensified, they raise interest rates and tighten credit; when the overheated economy and inflation are under control, they lower interest rates appropriately.

Therefore, the interest rate is one of the important basic economic factors.

Due to the impact of interest rate parity, the interest rate level has a very important impact on the exchange rate, and the interest rate is the most important factor affecting the exchange rate. We know that the exchange rate is the relative price of the currencies of two countries. Like the pricing mechanism of other commodities, it is determined by the supply and demand relationship in the forex market.

Forex is a kind of financial asset, and people hold it because it can bring capital income. When people choose to hold their currency or a foreign currency, they also consider which currency can bring them greater income. The yield of each country’s currency is first measured by the interest rate of its financial market.

When the interest rate of a currency rises, the interest income of holding that currency increases, attracting investors to buy that currency, therefore, it has a positive support for that currency; if the currency interest rate falls, the interest income of holding that currency will decrease, and the attractiveness of that currency will weaken. Therefore, it can be said that "interest rate rises, currency strengthens; interest rate falls, the currency weakens".

Now let’s talk about the interest rate parity theory. From an economic point of view, when the forex market is balanced, the income of holding any two currencies should be equal, which is: Ri = Rj (interest rate parity condition). Where R represents the yield, and i and j represent the currencies of different countries.

If the income of holding two currencies is not equal, arbitrage will occur: buying A forex and selling B forex. This arbitrage involves no risk. Therefore, once the yield of two currencies is not equal, the arbitrage mechanism will make the yield of two currencies equal.

That is to say, there is an inherent tendency and trend of equalization of interest rates of different countries’ currencies, which is the key aspect of the impact of interest rate indicators on the trend of forex rates, and also the key to our interpretation and grasp of interest rate indicators.

For example, after August 1987, as the U.S. dollar fell, people rushed to buy the pound, a high-interest currency, causing the pound exchange rate to rise from 1.65 U.S. dollars to 1.90 U.S. dollars in a short period, an increase of nearly 20%.

To limit the pound’s rise, from May to June 1988, Britain lowered interest rates several times, and the annual interest rate dropped from 10% to 7.5%. With each interest rate cut, the pound would fall. However, due to the rapid depreciation of the pound and the increase in inflationary pressure, the Bank of England was forced to raise interest rates several times, and the pound exchange rate began to gradually rise.

Under the economic conditions of the double opening of capital and trade, the scale of international capital flows is huge, greatly exceeding the international trade volume, indicating the great development of financial globalization. The impact of interest rate differences on exchange rate changes is more important than in the past. When a country tightens credit, interest rates will rise, forming interest rate differences in the international forex market, which will cause short-term capital to move internationally, and capital generally flows from low-interest countries to high-interest countries.

In this way, if a country’s interest rate level is higher than other countries, it will attract a large amount of capital inflow, reduce the outflow of domestic funds, and cause the international forex market to snap up this currency; at the same time, the capital account balance will be improved, and the exchange rate of the domestic currency will be increased.

On the contrary, if a country loosens credit, interest rates will fall, and the interest rate level will be lower than in other countries, which will cause a large outflow of capital, a decrease in foreign capital inflow, a deterioration of the capital account balance, and a sell-off of this currency in the forex market, resulting in a fall in the exchange rate.

Under the premise of strict equality of other conditions, the U.S. interest rate falls, the U.S. dollar’s trend is weak; the U.S. interest rate rises, and the U.S. dollar’s trend is good. From the price changes of U.S. Treasury bonds (especially long-term Treasury bonds), we can explore the direction of U.S. interest rates, which can help predict the trend of the U.S. dollar.

If investors believe that U.S. inflation is under control, then under the attraction of the existing Treasury bond interest income, especially short-term Treasury bonds, they will be favored by investors, and bond prices will rise. On the contrary, if investors believe that inflation will worsen or worsen, then interest rates may rise to curb inflation, and bond prices will fall.

In the first half of the 1980s, the U.S. dollar remained strong in the face of a large trade deficit and a huge fiscal deficit, which was the result of the U.S. implementing a high-interest rate policy, which attracted a large amount of capital from Japan and Western Europe to the U.S. The trend of the U.S. dollar is greatly influenced by interest rate factors.

Many trading systems are not suitable for use on the day of the Fed's interest rate resolution announcement, as well as the day before and the day after. This is because forex market volatility on these three days can be so intense that both trend and range strategies, or scalp strategies, are vulnerable to losses.

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