All a man needs to know to make money is to appraise conditions –  Jesse Livermore

While reductive, Jesse Livermore’s quote speaks about one of the most influential things that impacts a trader’s bottom line: general conditions or, stated differently, market dynamics. Market dynamics change constantly and that’s why great traders emerge after a couple of market cycles: they adapt and survive during changing conditions.

We’ve already spoken about volatility in recent times so today let’s cover a broader topic: the changes that take place during a rising interest rate environment, which we are approaching quickly.

The Impact of FED Hikes

To understand the full spectrum of effects that rising rates have on market conditions, we need to understand one basic concept: money markets (Fed Funds, the discount window, the overnight repo rates) are the primary vehicle that facilitates trading. You can view money market conditions as “liqudity conditions” for global trading endeavours on behalf of banks and leveraged players.

Now a rising yield curve alone does not necessarily equate to a reduction in liquidity. As rates rise, liquidity can actually increase as the trillions of dollars in global savings – which are largely invested in pension funds, mutual funds, investment accounts and other bonds – garner higher returns because the interest they earn increases.

However, if the central bank tightens other credit conditions, then liquidity diminishes quickly. For example, if  the Fed stops reinvesting dividends in mortgage and bond markets, that would tighten liquidity a bit. So, going forward, we can expect tighter liquidity since the Fed will have to unwind it’s balance sheet. But liquidity can also be impacted by banks’ capital reserves.

But in the current environment, we’ve already had a the Bank of England and the Reserve Bank of Australia hinting at exiting their own easing cycle, in order to not fall far behind the Fed. In the case of concurrent tightening by central banks (which is what usually happens, as clearly shown by the chart below by Reuters) rising rates can potentially crimp liquidity even without touching balance sheets and/or capital reserves.

We also need to keep in mind that leveraged accounts rely on access to credit facilities to use as collateral to increase the volumes they trade within markets. The lower rates are, the more they can borrow and hence the more they can leverage. As rates increase there can be an initial increase in liquidity as higher yields throw off higher earnings, however that remains dependent upon credit, collateral quality and the ability to compete with higher yields in competing financial products.

Bottom line: money markets provide the liquidity that facilitates trading. Banks and leveraged accounts use this liquidity to finance their trading endeavours. More liquidity generally means it’s “cheaper” for these entities to trade, and thus there can be more turnover, more participation, more trendiness.  As rates rise and liquidity is pulled from the system, the marginal speculative account needs to be more careful what he engages in because the opportunity cost of cash margin calls increases. The faster the pace, the higher the impact.  Asset selection and trade selection become more important.

 

About the Author

Justin Paolini is a Forex trader and member of the team at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.