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Interest Rates and the Forex Market

Interest Rates and 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 a 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 the 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, GBP would appreciate if the Bank of England (BoE) were to raise interest rates from 0.5 percent to 1.0 percent next month. 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