More often than not, when there’s an interest rate hike or when traders are expecting one, demand for that country’s currency rises and so does its value. On the other hand, when a central bank cuts rates or is expected to do so, demand for their currency drops along with its value. This is because the central bank’s benchmark interest rate dictates the rate of return for holding that country’s assets.
Just this week, ECB officials caused quite a ruckus in the markets by saying that they are considering negative deposit rates. This isn’t the first time that this issue has been brought up, as ECB Governor Draghi talked about negative rates back in June. How in the world is that supposed to work?!
Positive deposit rates mean that local banks get a small return for storing some of their cash reserves with the central bank. By implementing negative deposit rates, a central bank would end up charging banks for keeping cash stored in their vaults. In other words, having negative deposit rates would discourage local banks from keeping more cash lying around instead of lending it out.
Of course changes in deposit rates also tend to have an impact on overall interest rates. You see, when banks can no longer earn returns from keeping cash with the central bank, they are likely to seek gains elsewhere. And with more cash to lend to individuals and businesses, banks won’t mind charging lower loan rates just to encourage more borrowing.
With banks getting smaller profits from lending money out, they could wind up offering lower returns on their investment products and securities. In effect, this would drag down average interest rates in the country, eventually resulting to weaker demand for its assets and currency.
The potential impact isn’t always as straightforward though, as some naysayers argue that local banks could simply pass the cost of negative deposit rates to consumers. If that’s the case, banks would end up charging higher loan rates and therefore discourage borrowing activity. This is probably one of the potential repercussions that FOMC official James Bullard is worried about when he mentioned that the Fed should study the impact of negative deposit rates.
Editors’ Picks
EUR/USD retreats below 1.0700 as USD rebounds
EUR/USD lost its traction and retreated slightly below 1.0700 in the American session, erasing its daily gains in the process. Following a bearish opening, the US Dollar holds its ground and limits the pair's upside ahead of the Fed policy meeting later this week.
USD/JPY recovers toward 157.00 following suspected intervention
USD/JPY recovers ground and trades above 156.50 after sliding to 154.50 on what seemed like a Japanese FX intervention. Later this week, the Federal Reserve's policy decisions and US employment data could trigger the next big action.
Gold holds steady above $2,330 to start the week
Gold fluctuates in a relatively tight channel above $2,330 on Monday. The benchmark 10-year US Treasury bond yield corrects lower and helps XAU/USD limit its losses ahead of this week's key Fed policy meeting.
Week Ahead: Bitcoin could surprise investors this week Premium
Two main macroeconomic events this week could attempt to sway the crypto markets. Bitcoin (BTC), which showed strength last week, has slipped into a short-term consolidation.
Five Fundamentals for the week: Fed fears, Nonfarm Payrolls, Middle East promise an explosive week Premium
Higher inflation is set to push Fed Chair Powell and his colleagues to a hawkish decision. Nonfarm Payrolls are set to rock markets, but the ISM Services PMI released immediately afterward could steal the show.
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