One of the main factors that influences the value of currencies is the interest rate set by the central bank of each country. The interest rate is the cost of borrowing money, and it also reflects the return on saving money.
The higher the interest rate, the more attractive the currency is for investors, because they can earn more from their deposits. The lower the interest rate, the less appealing the currency is, because it offers lower returns.
Forex traders need to pay attention to the current and expected changes in interest rates, as they can affect the demand and supply of currencies.
This article will explain:
- What are interest rates and how they impact currency values.
- How the difference between two countries' interest rates affects their exchange rate.
- How traders can anticipate changes in interest rates and their effects on the forex market.
- Some key forex trading strategies based on interest rates.
WHAT ARE INTEREST RATES?One of the main topics that forex traders discuss is ‘interest rates’, which usually means the rates set by the central bank of each country. Interest rates are very important for forex traders because they affect the value of the currency. The central bank can use different methods to change the interest rate, such as:
- Buying and selling securities in the market to affect the supply and demand of money.
- The discount rate: The rate that commercial banks and other financial institutions pay when they borrow money from the central bank.
The main goals of the central bank are to control inflation and keep the exchange rate stable for their country. They do this by adjusting interest rates and managing how much money is in circulation. When inflation is rising above the central bank’s target, which is usually 2% (for most central banks), they will raise the interest rate (using the methods above) which can slow down the economy and lower inflation.
The economy and interest rates
The economy can be either growing or shrinking. When the economy is growing (GDP Growth positive), people earn more money. More money leads to more spending, which leads to more demand for goods and services – causing inflation. If inflation is not controlled, it can be harmful, so the central bank tries to keep inflation at its target level by increasing interest rates. Higher interest rates make borrowing more expensive and help reduce spending and inflation.
If the economy is shrinking (GDP growth negative), deflation (negative inflation) becomes an issue. The central bank lowers interest rates to encourage spending and investment. Businesses start to borrow money at low interest rates to invest in projects, which creates jobs, growth, and eventually inflation.
The cycle can be summarized like this:
HOW INTEREST RATES IMPACT CURRENCY VALUES?The effect of interest rates on the forex markets is through a shift in how traders anticipate interest rates to change, which leads to a shift in how much they want the currency. The table below shows the different outcomes that result from a shift in interest rate expectations:
| MARKET EXPECTATIONS |
ACTUAL RESULTS |
RESULTING FX IMPACT |
| Rate Hike |
Rate Hold |
Depreciation of currency |
| Rate Cut |
Rate Hold |
Appreciation of currency |
| Rate Hold |
Rate Hike |
Appreciation of currency |
| Rate Hold |
Rate Cut |
Depreciation of currency
|
Interest rate relevance to forex trading
Suppose you are a UK investor who has to invest a large amount of money in a safe asset, like a government bond. Interest rates in the US are increasing so you start to buy US Dollars to invest in the US government bonds.
You (as the UK investor) are not the only one investing in the country with higher interest rates. Many other investors follow the higher return and so increase the demand for US Dollars which makes the currency stronger. This is the main idea of how interest rates affect currencies. Traders can try to predict changes in how the market expects the interest rate to change, which can have a big impact on the currency.
Here is an example of what happens when the market expects the central bank to keep interest rates unchanged, but then central bank lowers the interest rate. In this example, the Reserve Bank of Australia was expected to keep interest rates at 2% but instead cut it to 1.75%. The market was caught off guard by the rate cut so the AUD/USD fell.
EXPLAINING FOREX INTEREST RATE DIFFERENCES
Interest rate differences are simply gaps in interest rates between two countries.
If a trader expects the US to unexpectedly raise interest rates he/she expects the US dollar may get stronger. To improve the trader’s chances of success, the trader can buy the US Dollar against a currency with low interest rates as the two currencies are moving in opposite directions of their respective interest rates.
Interest rates and their differences have a big influence on the rise/fall of the currency pair. The changes in interest rate differences are related to the rise/fall of the currency pair. It is easier to see visually. The chart below shows the AUD/USD currency pair (candlestick graph) and the gap between the two-year AUD government bonds and the two-year USD government bonds (orange graph). The relationship shows that as the AUD bonds yield drops compared to the USD bonds, so does the currency.
Interest rate differences are commonly used in carry trades. In a carry trade money is borrowed from a country with a low rate and put in a country with a higher interest rate. There are, however, dangers involved with the carry trade such as the currency invested in losing value compared to the currency used for paying the trade.
HOW TO PREDICT CENTRAL BANK RATES AND THE EFFECT ON FX MARKETS?
Fed funds futures are contracts traded on the Chicago Mercantile Exchange (CME) that show the markets expectations of where the daily official federal funds rate will be when the contract ends. The market always has its own estimate of where the interest rate will be. A trader’s job is to predict a change in those expectations.
For a trader to predict central bank rates he/she will need to watch closely what the central bankers are currently watching. Central bankers try to be as clear as possible to the public about when they expect to raise interest rates and which economic data they are currently watching.
The central bankers decide to raise or lower interest rates based on several economic data points. You can stay updated with the release of these data points using an economic calendar. Inflation, unemployment, and the exchange rate are some of the major data points. The trader must be in sync with the central bank policy makers and almost try to predict what their actions will be before they announce it to the public. This way the trader can enjoy the benefits of the markets change in expectations. This method of trading is based on the fundamentals which is different to trading using technical analysis. See our article on Technical vs Fundamental analysis to understand the different ways to analyze forex.
FOREX INTEREST RATE TRADING STRATEGIES
Forex traders can choose to trade the outcome of the interest rate news release, buying or selling the currency the moment the news comes out. See our guide on trading the news for more expert information.
Advanced forex traders may try to predict changes in central banker’s attitudes, which can change market expectations. Traders will do this by watching key economic variables like inflation, and trade before central banker’s speeches. See our Central Bank WeeklyWebinar for expert commentary on the latest and upcoming central bank decisions.
Another method is to wait for a correction on the currency pair after the interest rate outcome. If the central bank unexpectedly raised rates, the currency should get stronger, a trader could wait for the currency to get weaker before executing a buy position- expecting that the currency will continue to get stronger.
