With Donald Trump now elected the next U.S. president, investors once again are honing in on important global economic variables. Attention is on inflation, growth and employment, among other variables, and specifically how they may impact changes in global monetary policy.
After the Covid-19 pandemic in 2020 and subsequent increase in inflation, global central banks dramatically increased policy rates. They are now embarking on a rate-cutting cycle that will potentially run through 2025. Last week, both the U.S. Federal Reserve and the Bank of England reduced their policy rate by 0.25%, and Sweden’s Riksbank cut rates by 0.50%. Other central banks are expected to follow in the near term, with a few exceptions.
Why Should Domestic Investors Care About Interest Rates Abroad?
The differential in global interest rates is a major driver in the ebb and flow of investment capital. Simply put, higher interest rates attract money. International investors chasing higher yields have an impact on currency exchange rates, global yields and other markets. It’s important for investors to understand the current level of central bank monetary policies as well as the market expectations for the path and the velocity of those rates going forward.
Exhibit A: This Year’s Yen Carry Trade Unwind
A good example of global interest rate differentials impacting markets was the breakdown of the yen carry trade this August. For those unfamiliar with the term, a carry trade is an investment strategy where investors borrow from low-yielding countries to invest in higher-yielding countries. The strategy works well if rates are stable—or at least move as predicted.
However, the Bank of Japan surprised bond markets with a 0.25% increase in its policy rate. The move increased borrowing costs for those engaged in the strategy and initiated a rush to exit the trade. This unwind rippled through international markets, pushing the value of the yen higher versus other currencies and driving a meaningful decline in the Japanese Nikkei Index. Global investors sought safety in U.S. Treasuries, which forced domestic interest rates and equities lower.
What Do Global Interest Rate Differentials Mean To Retail Investors?
Funds tend to flow towards higher interest rates and away from lower rates. As a simple example, if yields are expected to decline faster in the United States than in Australia, investors might reasonably expect funds to move from the U.S. to Australia. Over time, the transferred funds will pick up additional yield and benefit from the expected change in currency exchange rates, even though the U.S. policy rate is slightly higher at current yield levels.
That potential outflow from one country into another can impact domestic bond and equity markets, as reflected in the earlier yen carry trade example. While markets were expecting the BOJ to eventually increase rates, it was the unexpected early move that caused disruption of the carry trade. Markets got the direction right but the speed wrong.
Policy Rate Speed And Direction Dictate Market Reaction
While the comparative level of global interest rates is important, it’s also essential to be aware of the market’s expectations for the vector of central bank policy rates. A vector is a representation of movement that includes both speed and direction.
The chart above reflects, for the most part, how markets expect a continued decline in global policy rates but with different vectors. Of the sample countries represented in the chart, Mexico is expected to lead the rate cut decline, while Japan is expected to increase its policy rate over the near term.
The Bottom Line: Global Central Banks Provide Context For All Investors
Given the upcoming shift in U.S. leadership, global central bankers and investors will be facing a difficult task: interpreting the effects of the new Trump administration’s fiscal policies and forecasting how that will impact their respective economies. With recent memory as a reminder, unexpected central bank policy moves can send waves through global markets. Now more than ever, it is important for investors to stay on top of potential policy rate changes and market expectations, not only for their domestic central bank but global ones, too.