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There is a strong correlation between interest rates and foreign exchange transactions. Forex is governed by many variables, but the currency’s interest rate is the fundamental factor that governs everything.
Simply put, the currency tries to follow the currency with the highest real interest rate. The real interest rate is the nominal interest rate minus the inflation rate.
Forex traders need to keep a close eye on each country’s central bank rates and, more importantly, predict currency movements as expectations change.
This article details foreign exchange rates and covers:
What are interest rates and how do they affect currencies.
Foreign exchange rate differences.
How traders predict central bank rates and how they will affect the foreign exchange market.
Important Forex Rates Trading Strategies.
What are interest rates and why do they matter to forex traders?
When traders talk about “interest rates,” they usually mean central bank rates. Interest rates are crucial for forex traders because when interest rates are expected to change, currencies often move with them. Central banks have several monetary policy tools that can be used to influence interest rates. The most common are:
Open Market Operations: The buying and selling of securities in the market for the purpose of affecting interest rates.
Discount Rate: The interest rate that commercial banks and other deposit-taking institutions charge on loans from their regional Federal Reserve Bank lending facilities.
The central bank has two main responsibilities: controlling inflation and promoting the stability of the country’s exchange rate. They do this by changing interest rates and managing the country’s money supply. If inflation rises, it is above the central bank’s target.
Business Cycles and Interest Rates
The economy expands or contracts. Everyone is better off when the economy is expanding, and worse off when the economy is contracting (recession). The central bank aims to control inflation while keeping the economy moderately growing by controlling interest rates.
As the economy expands (GDP growth is positive), consumers’ incomes begin to increase. More income leads to more spending, which leads to more money chasing fewer goods – which leads to inflation. If inflation is unchecked, it can be catastrophic, so central banks try to keep inflation at the target level, which is 2% (for most central banks), by raising interest rates. Rising interest rates make borrowing more expensive and help reduce spending and inflation.
Deflation (negative inflation) becomes a problem when the economy shrinks (negative GDP growth). Central banks cut interest rates to stimulate spending and investment. Businesses began borrowing money at low interest rates to invest in projects, which increased employment, growth, and ultimately inflation.
The loop is like this:
How do interest rates affect currencies?
Interest rates affect money markets by changing interest rate expectations, resulting in changes in the demand for money. The table below shows scenarios that could result from changes 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 Dependency in Forex Trading
Imagine you are an investor in the UK and need to invest large sums of money in risk-free assets such as government bonds. U.S. interest rates are rising, so start buying dollars to invest in U.S. Treasuries.
You (as a UK investor) are not the only ones investing in countries with higher interest rates. Many other investors are following the rise in yields, increasing demand for the dollar, which helps the currency appreciate. This is the essence of how interest rates affect money. Traders can try to predict changes in interest rate expectations, which can have a significant impact on the currency.
Here’s an example of what happens when the market expects the central bank to keep rates on hold but then cuts them. In this example, the Reserve Bank of Australia should have kept the interest rate at 2%, but lowered it to 1.75%.
Understanding forex interest rate differentials
An interest rate difference is simply the difference in interest rates between two countries.
When traders expect a surprise rate hike in the U.S., they are assuming that the dollar might appreciate. To increase a trader’s chances of success, traders can buy the U.S. dollar against currencies with lower interest rates, as the two currencies move in the direction of their respective interest rates.
Interest rates and their differences have a significant impact on currency pair appreciation/depreciation. Changes in interest rate differentials correlate with appreciation/depreciation of currency pairs. Visually easier to understand. The chart below compares the AUD/USD currency pair (candlestick chart) and the spread between the AUD 2-year Treasury note and the USD 2-year bond (orange chart). This relationship shows that the yield of Australian dollar bonds relative to US dollar bonds, and the same is true of currencies.
Spreads are often used in carry trades. In carry trades, money is borrowed from a country with a low interest rate and placed in a country with a higher interest rate. However, carry trades carry risks such as B. the investment currency depreciating relative to the currency that funds the trade.
How to forecast central bank rates and the impact on FX markets
Fed funds futures are contracts traded on the Chicago Mercantile Exchange (CME) that represent the market’s expectation of the daily official federal funds rate at the expiration of the contract. The market always has its own predictions about the direction of interest rates. The trader’s job is to anticipate these expected changes.
In order for traders to forecast central bank rates, they need to pay close attention to what the central bank is currently monitoring. Central bankers are trying to make the public as transparent as possible about when they expect to raise interest rates and what economic data they are currently monitoring.
Central bank governors decide to raise or lower interest rates based on multiple economic data points. An economic calendar can help you stay abreast of the release of these data points. Inflation, unemployment and exchange rates are some of the key data points. Traders have to coordinate with central bank policymakers and almost try to predict their actions before they announce it to the public. This allows traders to take advantage of changing market expectations. This trading method is based on different fundamentals than technical analysis trading. Read our article on Technical and Fundamental Analysis to learn about the different ways to analyze Forex.
Forex interest rate trading strategies
Forex traders can choose to trade the results of news releases at interest rates, buying or selling the currency when the news is released. For more expert information, check out our trading news guide.
Senior foreign exchange traders can try to anticipate a change in the central bank governor’s tone, which could change market expectations. Traders will do this by monitoring key economic variables such as inflation and taking action ahead of the central bank governor’s speech. Watch our Central Banking Weekly webinar for expert commentary on the latest and upcoming central bank decisions.
Another way is to wait for the currency pair to pull back after interest results. If the central bank unexpectedly raises interest rates when the currency appreciates, traders can wait for the currency to depreciate before entering long positions – expecting the currency to continue to appreciate.
Key Concepts
- Interest rate decisions themselves are often less important than expectations about future interest rate movements.
Currency trades with widening interest rate differentials may increase the chances of a successful trade.
It is important to use the economic calendar to keep abreast of economic data to anticipate possible changes in market expectations.
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