Interest Rates

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How Interest Rates affect the Forex Market ?

The interest rate is the bank overnight rate at which a nation’s central bank lends money to domestic banks in order to maintain reserve requirements. The biggest factor influencing the foreign exchange market is interest rate changes made by the central banks.

Key Takeaways

✓ The Central bank sets target interest rates at which banks lend to each other overnight in order to maintain reserve requirements.
✓ The Central bank sets the discount rate, the interest rate at which banks can borrow directly from the central bank.
✓ If the Central bank raises interest rates, it increases the cost of borrowing, making both credit and investment more expensive. This can be done to slow an overheated economy.
✓ If the Central bank lowers rates, it makes borrowing cheaper, which encourages spending on credit and investment. This can be done to help stimulate a stagnant economy.

Interest Rate Basics

The Central bank’s board of directors controls the monetary policy of its country and the short-term rate of interest at which banks can borrow from one another. The central banks hikes rates in order to curb inflation and cut rates to encourage lending and inject money into the economy.

Interest rates are crucial to traders in the forex market because the higher the rate of return, the more interest is accrued on currency invested, and the higher the profit.

Predicting Central Bank Rates

The Central bank interest rates decisions are affected by major economic indicators, which track the overall health of the economy.

✓ Unemployment change
✓ Consumer Price Index
✓ Non Farm Payroll

Major Announcements

Major announcements from central bank leaders tend to play a vital role in interest rate moves. However, they are often overlooked in response to economic indicators. Whenever a board of directors from any of the eight central banks is scheduled to talk publicly, it will typically provide insights into how the bank views inflation.

For example, on July 16, 2008, Federal Reserve Chair Ben Bernanke gave his semi-annual monetary policy testimony before the House Committee. At a normal session, Bernanke would read a prepared statement on the U.S. dollar’s value and answer questions from committee members.

Bernanke, in his statement and answers, was adamant that the U.S. dollar was in good shape and that the government was determined to stabilize it although fears of a recession were influencing all other markets.

The statement session was widely followed by traders and, because it was positive, traders anticipated that the Federal Reserve would raise interest rates, which brought a short-term rally on the dollar in preparation for the next rate decision.

The EUR/USD declined 44 points over the course of one hour (good for the U.S. dollar), which resulted in a $440 profit for traders who acted on the announcement.

Forecast Analysis

The second way to predict interest rate decisions is by analyzing predictions. Because interest rates moves are typically anticipated, brokerages, banks, and professional traders will already have a consensus estimate as to what the rate will be.

Traders can take four or five of these forecasts (which should be very close numerically) and average them for a more accurate prediction.

Interest Rate Change

An example, a trader should know in which direction the market will move. If there is a rate hike, the currency will appreciate, which means that is a buy signal for traders. If there is a rate cut, that’s a sell signal for traders. and buy currencies with higher interest rates.

✓ Act quickly. The market tends to move at lightning speeds if a surprise hits because all traders vie to buy or sell. Fast action can lead to a significant profit if done correctly.
✓ Watch for a volatile trend reversal. A trader’s perception tends to rule the market at the first release of data, but then the trend will most likely continue on its original path.

The following example illustrates the above steps in action.

In early July 2008, the Reserve Bank of New Zealand had an interest rate of 8.25%—one of the highest of the central banks. The rate had been steady over the previous four months as the New Zealand dollar was a hot commodity for traders to purchase due to its higher rates of return.

In July, against all predictions, the bank’s board of directors cut the rate to 8% at its monthly meeting. While the quarter-percentage drop seems small, forex traders took it as a sign of the bank’s fear of inflation and immediately withdrew funds or sold the currency and bought others—even if those others had lower interest rates.

The NZD/USD dropped from .7497 to .7414—a total of 83 points, or pips, over the course of five to 10 minutes. Those who had sold just one lot of the currency pair gained a net profit of $833 in a matter of minutes.

As quickly as the NZD/USD degenerated, it was not long before it got back on track with its upward trend. The reason it did not continue free falling was that despite the rate cut, the NZD still had a higher interest rate (at 8%) than most other currencies.

As a side note, it is import to read through an actual central bank press release (after determining whether there has been a surprise rate change) to determine how the bank views future rate decisions. The data in the release will often induce a new trend in the currency after the short-term effects have taken place.

The Bottom Line

Following the news and analyzing the actions of central banks should be a high priority to forex traders. As the banks determine their region’s monetary policy, currency exchange rates tend to move. As currency exchange rates move, traders have the ability to maximize profits—not just through interest accrual from carry trades, but also from actual fluctuations in the market. Thorough research analysis can help a trader avoid surprise rate moves and react to them properly when they inevitably happen.