Understanding Interest Rates in the Foreign Exchange (FOREX) Market

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Just after understanding the fundamentals of the Forex market, a considerable factor which drives the market is the Interest rate. In this article, we would be exploring the concept of interest rate and how it affects trading in the Forex market. 

Interest rate revealed
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courtesy dailyfx.com

The Forex market deals with currencies from different countries all over the globe and these currencies are the main instruments of trade. This goes to say that of all the variables that govern the FX market, the interest rate of a currency might just be the most important of them all. In determining the value of a currency, one major factor to consider will be the interest rate of the currency. 

When traders refer to interest rates they are simply saying central bank interest rates and the world of Forex revolves around this concept. The real interest rate is the nominal interest rate less inflation. Traders need to wrap their heads around this to ensure that trades are made efficiently. 

The Central Banks have monetary policies that they can use to influence the interest rate of a currency. Some of these include Open Market Operations which involves the sale and buying of securities on the market to influence interest rates. Another being the discount rate which is the rate charged on loans received by commercial banks and other depository institutions from their Regional Federal Reserve Banks Lending Facility. 

In all these, the Central Bank’s goal is to ensure that inflation in the country is managed and the country’s exchange rate remains stable. Inflation may be defined as the persistent rise in the general price level of goods and services and it is generally accepted that economic growth comes with moderate inflation. However, if inflation becomes too much, it can be harmful to a nation’s economy. At this point, the Central Bank will adjust the interest rate to manage inflation. 

Let’s take a look at this scenario. When economies grow, shown by a positive increase in the GDP, consumers’ income will increase and this will lead to a subsequent increase in their spending and purchases. This will increase the volume of money in circulation and there will be much money chasing fewer goods in the market. This in turn will trigger inflation. 

To curtail this, the Central Bank will have to increase the interest rate which will make borrowing costlier and make businesses more likely to save, dampening the economic activities in the nation. Vice versa, If economies contract, deflation becomes a major issue and the Central Bank will have to lower the interest rate which will encourage businesses to collect loans as the rates have been lowered. This in turn will help to boost retail and capital spending and will cause the economy to grow. 

From all these, the main takeaway here is the money tends to follow a currency with a high-interest rate as it is more likely to strengthen and those with low-interest rates will probably weaken over some time.

Interest Rates and Expectations

One beautiful aspect of the market is its ever-changing nature as the expectation of certain events and the emergence of different situations can influence the market. The same things apply to the interest rate except they almost don’t change as often. Due to this, traders keep their focus on where the interest rate is expected to go and not where they currently are. 

Another noteworthy point is that interest rates are subject to change due to monetary policies, or to be more specific, the end of monetary cycles. If rates have been on a downward trend for a while, it’s most likely that a turnaround is expected to happen. Rates will eventually increase at some point and with proper examination of economic indicators as well as analyzing forecast, you can trust speculators will try to figure out when and by how much that will happen. 

Along with gradual shifts in monetary policy, interest rates can change at the drop of a hat due to a single report or a major announcement. Hence, watch out and keep your eyes open!

Interest Rate Differentials

An interest rate differential is simply the difference between the interest rates of the currencies in a currency pair. Many FX traders compare these two rates and use them as a basis to determine the possibility of the strengthening or weakening of a currency. An interest rate differential that increases is positive for the higher-yielding currency while the interest rate differential that decreases reinforces the lower-yielding currency. Keep an eye out for currency pairs where the interest rates of both currencies are moving in an opposite direction. They are the perfect equations for sharp swings!

How Does Interest Rate impact the forex market? 

Interest rates impact the foreign exchange markets through changes in expectations of interest rates which lead to a change in the demand of a currency. Below is a table that covers all the possible scenarios that may arise from a change in expectations of the interest rate. 

Market ExpectationsActual ResultsResulting FX Impact
Rate HikeRate HoldDepreciation of currency
Rate CutRate HoldAppreciation of currency
Rate HoldRate HikeAppreciation of currency
Rate HoldRate CutDepreciation of currency

Here is an example of what happens when the market expects the central bank to keep interest rates on hold, but then the central bank decreases the interest rate. In this example, the Reserve Bank of Australia was expected to keep interest rates on hold at 2% but instead cut it to 1.75%. The market was surprised by the rate cut so the AUD/USD depreciated.

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dailyfx.com

Understanding the concept of interest rate would be of great help in your journey to becoming a forex trader. Most persons skip this lesson and wonder why they make so many mistakes while trading. Well, stay on with us at fxcryptonews.com for more guides on Forex trading and news, updates, and events in the forex market.