Hello and Welcome to the ditto educational series that will provide you with the skills you need to become a forex trader!
Today we are going to be talking about interest rates fundamentally speaking and their effect on the forex markets. There is a strong correlation between interest rates and how they affect the forex market. Forex as we know is ruled by many variables, however the interest rate of a currency is the fundamental factor that prevails above all else.
Basically we are saying that money attempts to follow the currency with the highest real interest rate. The real interest rate is the nominal interest rate less inflation.
As Forex traders we must observe each country’s central bank interest rate over time and perhaps more importantly, when they are expected to change so that we may forecast changes within currencies and their respective pairs.
SO….WHAT ARE INTEREST RATES AND WHY DO THEY MATTER TO FOREX TRADERS?
When talking about interest rates forex traders are usually referring specifically to the central bank interest rates . Interest rates are massively important to us as forex traders because when the expected rate of interest rates change, the currency generally will follow with that change.
The central bank has several monetary policy tools it can use to influence the interest rate. One of which is the Open market operations which refers to The purchase and sale of securities in the market with the intention of influencing interest rates.
The discount rate is another important factor and is The rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility. Central banks have two main priorities in mind which are to firstly manage inflation and secondly promote stability for their country’s exchange rate. This is achieved by altering interest rates and managing the nation’s money supply.
In order to manage inflation when it is growing beyond the central bank’s target, they will increase the central banks rate using the previously mentioned policy tools which can restrict the economy and bring inflation back in to order.
When countries economies are expanding everyone is financially better off, and when economies are contracting or in recession for instance they are worse off. The central bank aim is to keep inflation under control whilst allowing the economy to grow at a gentle pace, all by managing the interest rate.
When economies are expanding then consumers start to earn more. More earning leads to an increase in disposable income and more spending, this in turn leads to more money chasing a diminished supply of goods which triggers inflation.
If inflation is left unchecked it can be to the detriment of a economy, so the central bank attempts to keep inflation at its target level of 2% as is the case for most central banks.
by increasing the interest rates borrowing becomes more expensive and helps reign in spending and inflation. If the economy is contracting then deflation can become a problem. The central bank counters this and lowers interest rates to encourage spending and investment.
Companies can then start to loan money at lower interest rates to invest in projects which will in turn increase employment, growth, and ultimately inflation.
This is a continuous cycle and balancing act that has indicators to observe that can help us foresee strength and weakness within a currency.
HOW DO INTEREST RATES
The way that interest rates impact the forex markets is relative to change in expectations of interest rates that lead to a change in demand for the currency.
Take a look at this table that displays the possible scenarios that could arise from a change in interest rate expectations. Knowing how the market is likely to react can lead to more high probability trade set ups and improve decision making surrounding managing your trades.
Resulting FX Impact
Rate Hike Rate Hold Depreciation of currency
Rate Cut Rate HoldAppreciation of currency
Rate Hold Rate Hike Appreciation of currency
Rate Hold Rate Cut Depreciation of currency
UNDERSTANDING FOREX INTEREST RATE DIFFERENTIALS
Interest rate differentials simply put are the differences in interest rates between two countries.
If we suspect that the US will unexpectedly hike their interest rates then we can assume that the US dollar may appreciate. So to increase our chances of success, we could buy the US Dollar against a currency with low interest rates as the two currencies are diverging in the direction of their respective interest rates.
Don’t forget that Interest rates and their differentials have a large influence on the appreciation or depreciation of the respective currency pair.
Interest rate differentials are widely used in carry trades. In a carry trade money is loaned from a country with a low rate and invested in a country with a higher interest rate. Please refer to our video on carry trades to learn more.
HOW TO FORECAST CENTRAL BANK RATES AND THE IMPACT ON FX MARKETS
The Fed funds futures are contracts traded on the Chicago Mercantile Exchange. they represent the markets expectations of where the daily official federal funds rate will be when the contract expires. The market always has its own forecast of where the interest rate will be. It is our job is to forecast the change in those expectations.
For us to predict the central bank rates we will need to keep a close eye on what the central bankers are currently monitoring. Central bankers try to remain as transparent as possible to the public about when they expect to increase interest rates and which economic data they are currently monitoring.
central bankers will increase or decrease interest rates based on several economic data points and You can monitor the release of these data points using ditto trades economic calendar.
Inflation, unemployment, and the exchange rate are some of the major data points you will need to observe. Our aim is to know everything in regards to the central bank policy makers and increase our chances of forecasting what their actions will be before they state it to the public. This way the we can reap the benefits of the markets change in expectations.
SO WHEN WE TALK ABOUT FOREX INTEREST RATE TRADING STRATEGIES
we are talking basically in terms of prediction or reaction! Forex traders can choose to trade the result of interest rate news buy buying or selling the currency the moment the news releases. This can be risky but some traders make very good money in doing so.
More seasoned forex traders may attempt to predict changes in central banker’s tones, which can shift market expectations. They do this by monitoring the key economic variables that we have discussed such as inflation, and trade before central banker’s speeches.
Other popular method involve waiting for pullbacks on the currency pair after the interest rate results. As traders start to close out their positions we could attempt to buy in or sell on the retracment in order to profit from the trend catalysed by the news release.
In summary it’s important to remember
That we must keep up to date with economic so that we may forecast changes to market expectations. The interest rate decisions are generally less important than the expectations for future interest moves and currencies with increased interest rate differentials could increase the probability of successful trades.
I hope you have enjoyed our discussion today ladies and gentleman please sit back and contemplate what you have learned today and remember Contemplation is the key to learning.