Why Interest Rates Matter for Forex Traders
Simply put, interest rates make the forex world go ’round! In other words, the forex market is ruled by interest rates. A currency’s interest rate is probably the biggest factor in determining the perceived value value of a currency. So knowing how a country’s central bank sets its monetary policy, such as interest rate decisions, is a crucial thing to wrap your head around. ne of the biggest influences on a central bank’s interest rate decision is price stability, or inflation". inflation". Inflation is a steady increase in the prices of goods and services. It’s generally accepted that moderate inflation comes with economic growth. #owever, too much inflation can harm an economy and that’s why central banks are always keeping a watchful eye on inflation$related economic indicators, such as the %&I and &%'. In an effort to keep inflation at a comfortable level, central banks will mostly likely increase interest rates, resulting in lower overall growth and slower inflation. (his occurs because setting high interest rates normally forces consumers and businesses businesses to borrow less and save more, putting a damper on economic activity. )oans *ust become more expensive expensive while sitting on cash becomes more attractive. n the other hand, when interest rates are decreasing, consumers consumers and businesses are more inclined to borrow +because banks ease lending reuirements-, boosting retail and capital spending, thus helping the economy to grow. (he higher a country’s country’s interest rate, the more likely its currency will strengthen. %urrencies surrounded by lower interest rates are more likely to weaken over the longer term. &retty simple stuff. (he main point to be learned here is that domestic interest rates directly affect how global market players feel about a currency’s value relative to another.
Interest Rate Expectations arkets are ever$changing with the anticipation of different events and situations. Interest rates do the same thing / they change / but they definitely don’t change as often. ost forex traders don’t spend their time focused on current interest rates because the market has already priced" them into the currency price. 0hat is more important is where interest rates are EXPECTED to EXPECTED to go.
It’s also important to know that interest rates tend to shift in line with monetary policy, or more specifically, with the end of monetary cycles.
If rates have been going lower and lower over a period a time, it’s almost inevitable that the opposite will happen. 1ates will have to increase at some point. And you can count on the speculators to try to figure out when that will happen and by how much. (he market will tell them2 it’s the nature of the beast. A shift in expectations is a signal that a shift in speculation will start, gaining more momentum as the interest rate change nears. 0hile interest rates change with the gradual shift of monetary policy, market sentiment can also change rather suddenly from *ust a single report. (his causes interest rates to change in a more drastic fashion or even in the opposite direction as originally anticipated. So you better watch out!
Interest Rate Differentials &ick a pair, any pair. any forex traders use a techniue of comparing one currency’s interest rate to another currency’s interest rate as the starting point for deciding whether a currency may weaken or strengthen. (he difference between the two interest rates, known as the interest rate differential," is the key value to keep an eye on. (his spread can help you identify shifts in currencies that might not be obvious. An interest rate differential that increases helps to reinforce the higher$yielding currency, while a narrowing differential is positive for the lower$yielding currency. Instances where the interest rates of the two countries move in opposite directions often produce some of the market’s largest swing. An interest rate increase in one currency combined with the interest rate decrease of the other currency is a perfect euation for sharp swings!
Nominal vs. Real Interest Rates 0hen people talk about interest rates, they are either referring to the nominal interest rate or the real interest rate. 0hat’s the difference3 (he nominal interest rate doesn’t always tell the entire story. (he nominal interest rate is the rate of interest before ad*ustments for inflation. real interest rate = nominal interest rate – expected inflation (he nominal rate is usually the stated or base rate that you see +e.g., the yield on a bond-.
arkets, on the other hand, don’t focus on this rate, but rather on the real interest rate.If you had a bond that carried a nominal yield of 45, but inflation was at an annual rate of 65, the bond’s real yield would be 75. 8oohoo! (hat’s a huge difference so always remember to distinguish between the two.
o! Monetary Policy "ffects the Forex Mar#et
As we mentioned earlier, national governments and their corresponding central banking authorities formulate monetary policy to achieve certain economic mandates or goals. %entral banks and monetary policy go hand$in$hand, so you can’t talk about one without talking about the other. 0hile some of these mandates and goals are very similar between the world’s central bank, each have their own uniue set of goals brought on by their distinctive economies. 9ltimately, monetary policy boils down to promoting and maintaining price stability and economic growth. (o achieve their goals, central banks use monetary policy mainly to control the following:
the interest rates tied to the cost of money,
the rise in inflation,
the money supply,
reserve reuirements over banks,
and discount window lending to commercial banks
Types of Monetary Policy onetary policy can be referred to in a couple different ways. Contractionary or restricti$e monetary policy takes place if it reduces the si;e of the money supply. It can also occur with the raising of interest rates. (he idea here is to slow economic growth with the high interest rates. 8orrowing money becomes harder and more expensive, which reduces spending and investment by both consumers and businesses.
Expansionary monetary policy, on the other hand, expands or increases the money supply, or decreases the interest rate. (he cost of borrowing money goes down in hopes that spending and investment will go up. Accommodative monetary policy aims to create economic growth by lowering the interest rate, whereas tight monetary policy is set to reduce inflation or restrain economic growth by raising interest rates.
(he important thing to remember about inflation is that central banks usually have an inflation target in mind, say =5. (hey might not come out and say it specifically, but their monetary policies all operate and focus on reaching this comfort ;one. (hey know that some inflation is a good thing, but out$of$control inflation can remove the confidence people have in their economy, their *ob, and ultimately, their money. 8y having target inflation levels, central banks help market participants better understand how they +the central bankers- will deal with the current economic landscape. )et’s take a look at an example. 8ack in >anuary of =?7?, inflation in the 9.@. shot up to .65 from =.B5 in *ust one month. 0ith a target inflation rate of =5, the new .65 rate was well above the 8ank of 'ngland’s comfort ;one. ervyn @ing, the governor of the 8', followed up the report by reassuring people that temporary factors caused the sudden *ump, and that the current inflation rate would fall in the near term with minimal action from the 8'. 0hether or not his statements turned out to be true is not the point here. 0e *ust want to show that the market is in a better place when it knows why the central bank does or doesn’t do something in relation to its target interest rate.
Simply put, traders like stability. %entral banks like stability. 'conomies like stability. @nowing that inflation targets exist will help a trader to understand why a central bank does what it does.
Round and Round with Monetary Policy Cycles
0e *ust wanted to make sure you were still awake. onetary policy would never dramatically change like that. ost policy changes are made in small, incremental ad*ustments because the bigwigs at the central banks would have utter chaos on their hands if interest rates changed radically. >ust the idea of something like that happening would disrupt not only the individual trader, but the economy as a whole. (hat’s why we normally see interest rate changes of .=65 to 75 at a time. Again, remember that central banks want price stability, not shock and awe. &art of this stability comes with the amount of time needed to make these interest rate changes happen. It can take several months to even several years.
>ust like forex traders who collect and study data to make their next move, central bankers do a similar *ob, but they have to focus their decision$making with the entire economy in mind, not *ust a single trade. Interest rate hikes can be like stepping on the brakes while interest rate cuts can be like hitting the accelerator, but bear in mind that consumers and business react a little more slowly to these changes. (his lag time between the change in monetary policy and the actual effect on the economy can take one to two years.
%entral bankers can be viewed as either ha!#ish or do$ish, depending on how they approach certain economic situations. %entral bankers are described as hawkish" when they are in support of the raising of interest rates to fight inflation, even to the detriment of economic growth and employment.
0ith more investment coming into a country, demand increases for that country’s currency as foreign investors have to sell their currency in order to buy the local currency. (his demand causes the currency to increase in value.
Trade lows ! Trade "alance 0e’re living in a global marketplace. %ountries sell their own goods to countries that want them +exporting-, while at the same time buying goods they want from other countries +importing-. #ave a look around your house. ost of the stuff +electronics, clothing, doggie toys- lying around are probably made outside of the country you live in.
'very time you buy something, you have to give up some of your hard$earned cash. 0hoever you buy your widget from has to do the same thing. 9.S. importers exchange money with %hinese exporters when they buy goods. And %hinese imports exchange money with 'uropean exporters when they buy goods. All this buying and selling is accompanied by the exchange of money, which in turn changes the flow of currency into and out of a country.
(rade balance +or balance of trade or net exports- measures the ratio of exports to imports for a given economy. It demonstrates the demand of that country’s good and services, and ultimately it’s currency as well. If exports are higher than imports, a trade surplus exists and the trade balance is positive. If imports are higher than exports, a trade deficit exists, and the trade balance is negative. So: 'xports E Imports F (rade Surplus F &ositive +G- (rade 8alance Imports E 'xports F (rade Deficit F Hegative +$- (rade 8alance (rade deficits have the prospect of pushing a currency price down compared to other currencies. Het importers first have to sell their currency in order to buy the currency of the foreign merchant who’s selling the goods they want. 0hen there’s a trade deficit, the local currency is being sold to buy foreign goods. 8ecause of that, the currency of a country with a trade deficit is less in demand compared to the currency of a country with a trade surplus. Het exporters, countries that export more than they import, see their currency being bought more by countries interested in buying the exported goods. It is in more demand, helping their currency to gain value. It’s all due to the demand of the currency. %urrencies in higher demand tend to be valued higher than those in less demand. Hews moves fundamentals and fundamentals move currency pairs!
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o! to Trade F%ndamentals With C%rrency Crosses
If strong economic data comes out of Australia, you might want to look at buying the A9D. Cour first reaction might be to buy "+D-+*D. 8ut what if at the same time, recent data also show the 9nited States experiencing strong economic growth3 &rice action of A9D9SD may be flat. ne option that you have is to match the A9D against the currency of an economy that isn’t doing so wellJ. #mmmmJ what could you do3 Ah! (hank the forex gods for currency crosses! )et’s say you did some analysis, checked the 8aby&ips.com economic calendar +shameless plug!or &ip Diddy’s daily economic roundup +another shameless plug!- and you notice that the >apanese economy isn’t doing so good right now.
0hat do you do3 f course, like any self$respecting bully, you *ump all over this opportunity and go long "+D-1P2!
