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They may not set your pulse racing, but interest rates can help determine what trading strategies investors should employ. Helen Castell gets back to basics

Interest rates affect more than just your mortgage – and for the savvy CFD trader they should be a big factor behind every trade. As well as signalling which parts of the economy are in for a rough – or easy – ride, interest rates can determine which trading tool is best for you, and even how long you should hold a position.

Too many retail investors have a short-term or blinkered take on rates. But played properly they can help you pick safe sectors, find stocks that could outperform their peers and identify which shares to hedge.

So with rates still high, but cuts rumoured to be around the corner, what strategies should CFD traders be taking now, and what trades will make sense if and when that cut finally comes?

The hit rate

The most obvious effect of an interest-rate cut will be felt in the financing charge that investors pay to hold a CFD overnight, says Robert Gray, Head of Institutional UK at Saxo Bank.

‘If you have a CFD position in the morning and you get out of that position at the end of the day, then you don’t have to pay any financing costs. But if you don’t, then theoretically you’re borrowing a stock, so you have to pay interest over LIBOR,’ he explains.

‘If interest rates were high, then your financing costs would be high. Therefore your strategy may be to have very short-term positions,’ he notes. ‘If the Bank of England are going to be reducing rates this year, those financing costs are going to come down, and people will be more liable to hold longer-term positions.’

Financing charges for CFDs are admittedly small – currently around 25p per night per £1,000 position. So how much they influence a trading strategy will typically depend on the size of the trade, says Tom Hougaard, Chief Market Strategist at City Index.

‘If I’m trading 100 shares then it’s going to mean nothing to me,’ he notes. ‘But if I am trading 60,000 shares on a stock that’s £5 … it will soon add up to something. That’s £35 every single night, including on the weekend – so imagine if you held that for a month.’

Traders should always, however, view financing charges in terms of opportunity cost, he argues. ‘If interest rates are 5.5% in the UK, and City Index is charging you 2% on top of that, while that sounds like you’re getting a rough deal you also have to take into consideration that the 90% that isn’t tied up in margin can earn interest in a bank account.

‘So you’re not really paying the full 7% or 8% – you’re actually only paying a couple of percent, assuming you can put your other capital available in a bank account or a money-market instrument.’

Secondly, in a bear environment like today’s, shorting CFDs to hedge against equity falls actually earns the investor interest. ‘That is one of the great advantages of CFD and spread betting – not only do you have the ability to go short on a market and capitalise on a falling market, but you get paid to go short as well,’ says Hougaard.

‘At the end of the day, if you think there is an opportunity to make money when the market is going up, then you’re going to still take that,’ says Alex Orban, VP of UK Retail at E*TRADE Securities.

Exit wounds

Before he enters any trade, an investor should already have determined his entry and exit levels, and estimated the time he will remain in the trade – and hence what his total financing charge would be, he argues.

Anyone looking to hold a position for a very long time then should simply use a different tool to a CFD – for example equities – rather than let big financing charges dissuade them from riding market rises, he says.

The other major area in which rate movements affect a CFD trader’s strategy lie in their effect on underlying stocks.

‘Interest rates – both actual and forecast – are intrinsically part of virtually any trade,’ says Martin Slaney, Head of Spread Betting at GFT Global Markets UK. Expectations of where rates will move help determine the whole mood and movement of a market, with the anticipation of lower rates generally bullish for shares, and that of higher rates generally bearish, he notes.

‘Lower actual interest rates are on the whole positive for shares, as fixed-income products become less attractive as an asset to invest in,’ he notes. ‘I say “on the whole” because there is a fine line between when they are deemed indicative of a central bank’s unexpectedly strong fears of a slowing economy.’

The sector-driven trends that dominated stock markets in late 2007 are continuing into 2008, creating a highly divisive market that CFD traders can tap, says Andrew Gibson, Head of Strategy at Galvan Research and Trading.

‘Anything sensitive to interest rates seems to be going down, and commodity plays, miners and oils, are going up.’

Four sectors tend to be most vulnerable to high interest rates says Gibson: construction, land stocks and property, retail, and banks.

Land and property deals tend to be highly leveraged, funded largely through debt, and retailers suffer when consumers have less money in their pockets, he explains.

CFDs can be used to hedge falls in these sectors, by shorting CFDs in the same stocks that you hold physical shares in, says Orban. Shorting FTSE futures is another cost-effective way of hedging a big basket of share holdings, he notes.

Conversely, if the Bank of England comes through with the rate cut analysts are now forecasting for February, the above sectors should do well.

Housing stocks are Hougaard’s top tip in such a scenario. ‘Shout it from the mountain tops! If we get a rate cut I’ll be there,’ he says. ‘It cannot but benefit these people if we see an interest-rate cut.’

Go on the defensive

Banks similarly should benefit from interest-rate cuts as their customers have an easier time paying off their mortgages, he says. ‘Maybe their default rates are going to decline, so they won’t have to offset as much money for bad loans.’

Sectors such as pharmaceuticals, gambling, tobacco and beverages – called ‘defensives’ because they offer products that people will always need or want – should be unaffected by rate movements in either direction.

The same is true for commodities, mining and energy shares, and for certain sectors, such as telecoms, which are on a bull run for other reasons, says Hougaard.

‘We are still going to call up our friends and family and bitch about how bad things are,’ he notes. ‘Vodafone would love to make a big hit into India, where it’s easier to get a mobile phone than a landline, for example… I’d definitely want to buy Vodafone shares.’

How much debt an individual company holds can also affect its performance in different interest-rate environments, notes Gray. ‘You look at the fundamentals of the company – if it has got a lot of bonds on issue, or if it has a lot of debt that it has to pay.’

As an extreme example, Northern Rock has a lot of debt outstanding to the Bank of England. ‘If rates are going down, it’s going to be easier for them to pay that off – the stock itself will maybe perform a little bit better,’ he says.

‘But if you have got a company that is very cash rich – it doesn’t actually borrow any money at all – then obviously the interest rate going down doesn’t necessarily make any difference to it.’

Get real

Meanwhile, it is important that traders are clued up on how and when interest-rate movements impact on share prices, with some failing to understand why certain stocks or sectors fall when their most recent results are rosy, says Gibson.

‘I think part of the problem is that the stock market is forward looking – anywhere between six and 18 months ahead of the real economy,’ he says. ‘There’s a lot of negativity priced in that may not be evident in the results themselves.’

‘Now of course, if that news doesn’t end up happening, or is not as bad as the stock market is pricing in, then prices will rise, stock prices will rise.’

Trading on currency markets also relies heavily on interest-rate news, and the effects here can filter through to stock markets, says Slaney.

When interest rates go up, in general the base or first-named currency rises in forex trading, he says. ‘Because more interest can be earned on a currency, and because it also often signals a strong economy, currency value depends on how well the economy is doing, and how forex traders perceive the language that usually accompanies a rate decision.’

Carry trades are a common way of gaining from different interest rates on different currencies, says Orban. Investors would go long on a currency that pays them a higher rate of interest and short one with a lower interest rate. ‘Dollar-yen is the typical one.’

And forex movements can ultimately lead back to stocks. ‘The recent strong pound/weak dollar trend has resulted in those companies who export to the US facing lower revenues and earnings,’ Slaney notes. ‘No company is immune to the effect of FX rate changes.’

So, when the next interest-rate movement comes, try to think beyond your mortgage payments and take a common-sense approach, advises Orban. Ask yourself which companies it will affect and how, and what way you could be trading them. Sometimes the soundest strategies rely on a bit of back to basics.