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Forex

How Do Interest Rates Impact the Forex Market?

Samson Ononeme | Feb. 8, 2019
How Do Interest Rates Impact the Forex Market?

This article extensively discusses why interest rates change and to what extent they influence the Forex market.

February 8, 2019 | AtoZ Markets - There is a correlation between interest rates and foreign exchange (forex) trading. Interest rates make the forex world go round and round! In other words, the biggest factor influencing the forex market is the global interest rates made by any of the eight global central banks.

Being one of the most important factors in determining the value of a currency, traders are now more focused on interest rates than anything else. While an unexpected interest rate changes often have great impact on traders, this article will thoroughly examine the following points:

  • What interest rates are and how they impact the value of currencies
  • Forex interest rate differentials
  •  How forex traders can predict central bank rates and their impact on the forex market
  • Trading strategies for forex interest rate

What Are Interest Rates and Why Are They Relevant to Forex Traders?

When you hear the phrase ‘interest rates’, it usually refers to central bank interest rates. Forex traders consider them as important because when the expected interest rates change, the higher the rate of return, the higher the profit on currency invested.

The central banks or the Fed have three major monetary policy tools used in achieving its monetary policy goals, and influencing interest rate is one of them. Here are the 3 most common tools and how they are used to sustain healthy economic growth: open market operations, the reserve requirement, and the discount rate.

1. Open Market Operations

This has to do with the buying and selling of government securities. They are either bought from or sold to the country's private banks. When the central bank buys securities, more money is added to the banks' reserves, and that gives them more cash to lend. However, when the central bank sells these securities, it reduces its cash holdings, leaving them with less money to lend.

2. Reserve Requirement

The reserve requirement refers to the money that banks must hold in cash overnight. They can either be kept in their vaults or on deposit at a Reserve Bank. A low reserve requirement allows banks to lend more of their deposits to consumers and businesses. It's expansionary because it increases the funds available.

3. The Discount Rate

This is the rate charged to commercial banks and other depository institutions on short-term loans they receive from their regional Federal Reserve Bank at a discount rate.

Lowering the discount rate is expansionary because the discount rate influences other interest rates as it encourages lending and spending by consumers and businesses. In contrast, higher rates discourage lending and spending by consumers and businesses. 

How Do Interest Rates Affect Currencies?

Interest rates are one of the major factors influencing the value of a currency. So how do we answer the above question? Put simply, if interest rates go up, the value of a country's currency tends to improve. Conversely, if interest rates go down, that causes the value of a currency to decrease.

Foreign investors find higher interest rates attractive, thus increasing the value and demand for a country's currency. This also works the other way. Foreign investors consider lower interest rates to be unattractive, and this decreases the currency's relative value.

Let’s examine this in a bit more detail.

For instance, if the Bank of England (BoE) were to raise interest rates from 0.5 percent to 1.0 percent next month, it would help the value of the British pound rise against other currencies, including the Euro or US dollar. Why is that?

This is because, when interest rates in a country increase, the yields/returns on offer for foreign investment in that country also tend to be high. That, of course, encourages investors to invest there, which requires them to buy that country’s currency.

That, in turn, raises the value of the currency since it is more in demand. In other words, high interest rates in the UK mean more reason to buy the pound, thus, increasing its value.

Other Factors Affecting Currency Value

While interest rates influence the value of a currency, it alone is not the determining factor. There are two other factors of greater importance; political and economic stability, as well as the demand for a country's goods and services.

A country's balance of trade between imports and exports can be a crucial factor to consider when determining the value of a currency. This is because the greater the demand for a country's products, the greater the demand for the country's currency.

What is more, impressive numbers, such as the Gross Domestic Product (GDP), including the balance of trade are also key figures that analysts and investors consider when assessing the worth of a given currency.

Understanding Interest Rate Differentials

An interest rate differential (IRD) simply measures the differences in interest rates between two currencies in a pair. If one of the currencies has an interest rate of 5 percent and the other 3 percent, then the IRD would be 2 percent. IRD calculations are most often used for pricing purposes in forex trading, fixed income trading, and lending calculations.

For example, if an FX trader expects the US to suddenly hike interest rates he anticipates that the value of the US dollar may appreciate. To increase his chances of making profits, the trader can buy the US Dollar against a currency with low interest rates as the pair is diverging in the direction of their respective interest rates.

Interest rates and their differentials play a large role in influencing the appreciation or depreciation of the currency pair. The changes in IRD are correlated to the appreciation or depreciation of the currency pair.

At this point, we'll use a visual aid to make it easier for you to understand. As the chart below shows, it compares the AUDUSD currency pair (as indicated in the candlestick graph) and the difference between the two-year AUD government bonds and also the two-year USD government bonds (indicated in the orange graph). The relationship reveals that as the AUD bonds yield decreases relative to the USD bonds, which is the same for the currency.

Worldwide, interest rate differentials are used in carry trades. In a carry trade, money is loaned from a country with a low interest rate and then invested in a country with a higher rate.

While the carry trade does earn interest on the interest rate differential, there are, however, risks involved with this strategy and that has to do with the uncertainty of currency fluctuations. When that happens, you risk wiping out the benefits of the carry trade.

Predicting Central Bank Rates

For a trader to predict central bank interest rates, he needs to keep a tab on what the central bankers are currently monitoring. Central bankers try as much as possible to be as transparent to the public about when interest rates will be increased and which economic data is under their observation.

To keep up to date, two things are needed; watching out for major announcements and analyzing forecasts.

Major Announcements

Major announcements from the leaders of central bank play a vital role in interest rate moves. Hence, a trader must be in tune with these policy makers and try to predict what their actions will be before they are publicized.

They can also stay updated with the release of these data points using an economic calendar. In this way, traders can reap the benefits of the markets change in expectations.

Forecast Analysis

This is another way to predict interest rate decisions, by analyzing forecasts. This method is based on  fundamental and technical analysis. Because interest rates moves are typically anticipated, brokerage firms, banks, as well as professional traders will already have a consensus estimate as to what the rate should be expected.

Traders can take four or five of these predictions and then average them for a more accurate forecast.

Trading Strategies for Forex Interest Rate

Forex traders can decide to trade, buy or sell the country's currency the moment the interest rate news is released. However, experienced traders may attempt to forecast changes in the tones of the central bankers, which can shift market expectations. Traders usually do this by monitoring key economic variables like inflation, and trade prior to the speeches from the central banks.

Another effective strategy is to sit back and wait for a pullback on the currency pair after the interest rate is announced. If the central bank hiked rates unexpectedly, the currency should rise, a trader could then wait for the currency to fall before executing a buy position- with the hopes that the currency will continue to the upside.

Think we missed something? Let us know in the comments section below.

Disclaimer: The views and opinions expressed in this article are solely those of the author and do not reflect the official policy or position of AtoZ Markets.com, nor should they be attributed to AtoZMarkets.