Forex Trading Library

Why Banking Crisis is Like a Rate Hike

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Since the banking crisis last month, there have been two main reasons that central banks have toned down the hiking. The first one is relatively straight-forward and obvious. The second one gets mentioned in passing, but few articles delve into it, because it’s a bit complicated.

Now that there appears to be a second round of worries over the banking system, it’s worth understanding this second issue. Especially if, as last time, the banking issue doesn’t lead to an immediate market collapse and investor attention turns elsewhere. After all, the ECB, Fed and BOE are all saying the banking system is well capitalized, and there isn’t anything to worry about. So, why are they citing the banking situation as a reason not to raise rates?

The bank rate effect

As you probably know, central banks control the money supply by changing the interest rate they charge regular banks. This, in turn, causes the interest rates that banks charge their customers to change. The idea is that higher interest rates makes people less likely to borrow money, which reduces the amount of money in circulation. By lowering the interest rate, more people are willing to borrow, and that increases the money supply.

What the latest crisis has done is made banks a lot more unwilling to issue loans, since that poses a liability for them. Banks typically price risk into the interest rate they charge clients. What that means is that the bank assumes that a certain amount of money that it loans out won’t be paid back. Executives do a statistical analysis to get that as closely representative of the actual amount. That is then added to the amount of interest the bank charges to offset the impact on its profitability.

Increased scrutiny is increased costs

In this sense, a higher amount of risk among banks translates into higher costs. Those higher costs are then offset by raising the amount of interest that the bank charges on loans. Which is the same practical effect as achieved by the central bank raising rates. The banking crisis has increased the amount of risk being “offset” by banks in an equivalent to one or two rate hikes, or between 25-50bps.

Central bankers take that into account when they decide to raise rates. Before the banking crisis, they expected to raise rates to a certain level in order to control inflation. Now they won’t have to raise rates that high, as long as banks continue to price in that increased risk, and still get the expected results.

What it means for trading

While the practical effect on inflation is the same as a rate hike, it’s not the same for currency pairs. In fact, the effect can be the exact opposite. Forex is driven primarily by capital flows of large investors looking to find a return on their investment by loaning out money. Therefore, the higher cost of borrowing money doesn’t affect them. The expectation of the central bank not raising rates as much, on the other hand, does affect the currency.

With the central bank expected not to raise rates as much, yields remain lower, making the currency comparatively less attractive. The practical effect of another round of worries about the stability of the banking system could likely be equivalent to the Fed not raising rates, and continuing to weaken the dollar.

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