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A beginner’s guide to forex trading

Lesson 7 of 7

Interest rates and the forex market

There’s a strong correlation between interest rates and forex trading. A country’s currency value is ruled by many variables, but the prevailing interest rate is one of the fundamental factors that has a big impact on it.

This makes keeping an eye on countries’ central bank interest rates very important, especially if you hope to trade on their currencies’ price direction.

This lesson will cover how interest rates affect currencies, interest rate differentials and how you can use this data to forecast a market’s near-term movements.

Why do interest rates matter to forex traders?

Interest rates are of utmost importance to trading forex because when a country’s interest rate changes, its currency generally follows with it.

Central banks have several monetary policy tools they use to influence the interest rate, the most common being:

  • Open market operations: the purchase and sale of securities in the market with the goal of influencing interest rates
  • The discount rate: the rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility

Additionally, central banks have two main tasks: to manage inflation and promote stability for their country’s exchange rate. They do this by changing interest rates and managing the nation’s money supply.

When inflation is ticking upwards, above the predetermined target, it’ll likely increase the lending rate (using its policy tools) which can restrict the economy and bring inflation back in check.

Did you know?

Central banks play a huge part in keeping a country’s economy as stable as possible. For example, the Covid-19 pandemic triggered a sharp economic downturn across the world. To mitigate any further damage to the US economy, the Fed took a number of actions.

Some of these included large investments in mortgage-backed securities and increased household and business lending, among several others. Many countries undertook similar measures, and each of them had an impact on the value of global currencies.

The economic cycle and interest rates

Economies are either expanding or contracting. An expanding economy is generally positive, while the opposite is true for a contracting one.

You’ve likely heard the term ‘recession’ before when world economies are discussed. This is what happens when an economy diminishes.

When economies are expanding (ie Gross Domestic Product (GDP) growth is positive), consumers start to earn more. Theoretically, higher salaries lead to increased spending, which gives rise to more money in circulation compared to the number of goods available.

This is what usually triggers inflation, and that’s where increased interest rates come into play. If you have a mortgage or a car loan with an interest rate tied to inflation, you’ve probably noticed that your rate sometimes goes up. Reserve banks do this to make lending costlier in an effort to reduce spending.

However, if the economy is contracting (ie GDP growth is negative), deflation or negative inflation becomes the issue. in this case, the central bank will lower interest rates to spur spending and investment in the economy. This helps companies loan money at low interest rates to invest in projects which in turn can increase employment, growth, and ultimately inflation.

The cycle goes something like this:

How do interest rates affect currencies?

Now that you’ve learned how inflation happens, think about how these changes might impact a country’s currency value. For instance, how do you think an interest rate hike might impact a currency?

Interest rate decisions impact forex markets because traders’ and investors’ expectations of interest rates also change following announcements, which ultimately leads to a change in demand for the currency.

The table below displays the possible scenarios that come from a change 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

But how does this impact forex trading? Let’s put this into perspective with an example.

Imagine you’re an investor in the UK , and you want to invest a large sum of money in a low-risk asset, like a government bond. Interest rates in the US are on the rise, so you start to buy US dollars to invest in US government bonds.

However, you’re likely not the only person interested in investing in the country. Many other investors could also try to take advantage of the increased yield, and thus increase the demand for US dollars. Because of this rise in demand, the dollar will likely appreciate in value.

This is the essence of the relationship between interest rates and currencies.

Below is an example of what could happen when the market expects the central bank to keep interest rates on hold (or unchanged), but the central bank decreases the interest rate instead.

In this example, the Reserve Bank of Australia was expected to keep interest rates on hold at 2% but instead cut it to 1.75%. The market was surprised by the rate cut, so AUD/USD depreciated as investors sold their Australian dollars to avoid losses due to the cut likely signaling negative inflation.

Understanding forex interest rate differentials

Interest rate differentials are simply differences in interest rates between two countries. That is, one country’s interest rate in a forex pair could be expected to rise while the other is expected to depreciate.

Let’s say you expect the US to suddenly hike interest rates, meaning you think the dollar may appreciate.

To try to increase your chances of making a profit, you could go long on the US dollar against a currency projected to lower interest rates. So you’re simply taking advantage of the expected divergence in the two countries’ monetary policies.

Changes in interest rate differentials are correlated to the appreciation and depreciation of a currency pair. This might be easier to understand visually.

The candlestick chart below compares the AUD/USD currency pair, outlining the difference between the two-year AUD government bonds and USD government bonds (in orange).

The relationship shows that as the AUD bonds’ yield decreases relative to USD bonds, so does the currency.

Interest rate differentials are widely used in carry trades. This is when money is loaned from a country with a low rate and invested in a country with a higher interest rate.

There are, however, risks involved with a carry trade – like the currency invested depreciating relative to the currency used for funding the trade.

Interest rate trading strategies

You can opt to trade the result of an interest rate news release, buying or selling the currency the moment the data is released.

Advanced forex traders may attempt to forecast changes in central banker’s tones, which can shift market expectations. They do this by monitoring key economic variables like inflation, and trade before the central banker announces the news.

Another method is to wait for a pullback on the currency pair after the interest rate result. If the central bank unexpectedly hiked rates, the currency is likely to appreciate. However, you don’t have to execute your positions at that time. Alternatively, you could wait for the currency to depreciate (‘pullback’) before executing the buy position

Lesson summary

  • Interest rate decisions tend to impact forex markets greatly
  • However, the main reason this happens is due to a change in demand following an announcement
  • Trading currencies with increased interest rate differentials could increase the probability of successful trades
  • You may want to keep up with economic data by following an economic calendar in order to forecast potential changes in market expectations
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