Interest rates drive the currency market!
In other words, global interest rates govern the FX market.
The interest rate on a currency is most likely the most important factor in influencing its perceived worth.
So understanding how a country’s central bank develops its monetary policy, such as interest rate decisions, is critical.
Price stability, or “inflation,” is a major effect on a central bank’s interest rate choice.
Inflation is defined as a consistent rise in the pricing of goods and services.
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. In other words, inflation reflects a decrease in the value of money over time. It is measured as the percentage change in the price level of a basket of goods and services over a specific period of time, typically a year.
When the inflation rate is high, each unit of currency buys fewer goods and services; consequently, inflation is often considered a sign of a weak economy. Central banks attempt to control inflation by adjusting interest rates, thereby affecting demand for goods and services and, in turn, prices.
Inflation is the reason why, in the 1920s, your parents or your parents’ parents paid a cent for a soda pop, but now people spend twenty times more for the identical goods.
It is often assumed that moderate inflation is associated with economic growth.
However, excessive inflation can undermine an economy, which is why central banks maintain a close eye on inflation-related economic indices like the CPI and PCE.
|Reserve Bank of Australia (RBA)
|Bank of Canada (BOC)
|European Central Bank (ECB)
|Bank of Japan (BOJ)
|Reserve Bank of New Zealand (RBNZ)
|Swiss National Bank (SNB)
|Bank of England (BOE)
|Federal Reserve System (Fed)
When interest rates fall, consumers and businesses are more likely to borrow (because banks relax lending standards), boosting retail and capital spending and helping the economy grow.
What does this have to do with FX trading?
Currencies are dependent on interest rates because they govern the flow of global capital into and out of a country.
They are what investors use to decide whether to invest in a country or not.
For example, if you had an option between a savings account paying 1% interest and another paying.25%, which would you choose?
You mean neither?
We’re tempted to follow suit – store the money beneath the mattress, you know what we mean? – but that’s not an option.
Ha! You’d go with the 1%, right?
We hope so… because one is greater than two and a half. Currencies function in the same way!
The higher a country’s interest rate, the greater the likelihood that its currency will strengthen. Currencies that are surrounded by lower interest rates are more likely to depreciate over time.
It’s all quite straightforward.
The major takeaway here is that domestic interest rates have a direct impact on how global market participants perceive the value of one currency in relation to another.
Interest Rate Expectations
Markets are always shifting due to the anticipation of various events and scenarios. Interest rates do the same thing – they fluctuate – but not as frequently.
The majority of forex traders do not focus on current interest rates because the market has already “priced” them into the currency price.
What matters is where interest rates are EXPECTED to go.
It’s also vital to understand that interest rates tend to move in tandem with monetary policy, or more precisely, the end of monetary cycles.
If interest rates have been falling for a long time, the opposite is almost certain to happen.
At some point, interest rates will have to rise.
And you can bet that speculators will try to predict when and by how much this will happen.
It’s the nature of the beast, as the market will tell them. A movement in expectations signals the beginning of a shift in speculation, which will gain strength as the interest rate change approaches.
While interest rates fluctuate in response to a gradual adjustment in monetary policy, market sentiment can vary dramatically in response to a single report.
This causes interest rates to fluctuate more dramatically, or even in the opposite direction of what was expected. So you’d best be careful!
One of the most-watched news announcements is shown here as an example of one of several techniques to track interest rate expectations.
The “dot plot” of the Federal Reserve.
The Federal Reserve of the United States utilizes this signal to forecast the path of interest rates.
The Fed Dot Plot, which is published following each Fed meeting, depicts the projections of the Federal Open Market Committee’s 16 members (the bigwigs in the Fed who are actually are in charge of setting interest rates).
Interest Rate Differentials
Choose a pair, any pair.
Many forex traders begin by comparing one currency’s interest rate to another currency’s interest rate to see if a currency would weaken or strengthen.
The “interest rate differential,” or the difference between the two interest rates, is the essential metric to monitor.
This spread might assist you in identifying currency swings that may not be obvious.
An increasing interest rate gap serves to reinforce the higher-yielding currency, whilst a narrowing differential benefits the lower-yielding currency.
When the interest rates of two countries move in different directions, the market often experiences some of its greatest swings.
An increase in one currency’s interest rate combined with a reduction in the other currency’s interest rate is the ideal equation for strong swings!
Nominal VS Real Interest Rates
When individuals discuss interest rates, they are referring to either the nominal or real interest rate.
What’s the difference?
Nominal interest rates do not often tell the whole story. The nominal interest rate is the interest rate before inflation adjustments.
Real interest rate = Nominal interest rate – Expected inflation
The stated or base rate is usually the nominal rate that you see (e.g., the yield on a bond).
Markets, on the other hand, are more concerned with the actual interest rate.
If you had a bond with a nominal yield of 6% but inflation was at 5% per year, the bond’s true yield would be 1%.
That’s a significant distinction, so keep it in mind at all times.
Next Lesson: How Monetary Policy Affects the Forex Market