Interest rates are major market movers when it comes to forex trading. It is often the biggest factor determining the perceived value and direction of that currency. It controls the flow of global capital into and out of the economy, hence, the currency value. Usually, interest rate decision has a direct impact on currency’s movements, whether negative or positive. Not only for the short term, but it also affects currency’s outlook and rate against rivals.
What are Interest Rates?
The official definition is the borrowing cost, the amount charged by the lender to the borrower. Interest rate is determined by lenders based on several factors that include; Inflation rate, Collateral, Duration, Cost, and Risk. When the central bank raises or cuts the interest rates, other borrowing costs are affected. This affects consumers directly through applying higher or lower rates on commercial and retail financial services.
What affects Interest Rate?
Central banks decide Interest rates depending on the economic situation. The path of interest rate usually follows the economy’s direction. Interest rates are used by central banks as the main tool to control the national economy and facilitate optimum economic conditions in accordance with monetary policy objectives. A major factor in deciding the interest rate path is Inflation or price stability. Ideally, central banks aim to achieve steady economic growth while stabilizing prices. But, when the economy’s conditions get out of control, the interest rate interferes to get things right.
Higher interest rates are used to cap inflation and growth. It is because higher rates make borrowing more expensive and sitting on cash becomes more attractive. On the other hand, lower interest rates tend to encourage consumers and businesses to borrow more. It is usually coupled with easing lending requirements, which helps in boosting borrowing and spending, thus stimulating growth in case of downturns.
How to trade Interest Rates?
In the forex market, currencies benefit from higher interest rates against lower-yielding rivals. As interest rates go up, interest in the currency follows. Same as any markets, investors look for higher return and the best economy to invest their money in. Here the big effect of interest rate differentials steps in. If you are offered a choice between 1% or 2% interest rate, which one will you go for?
None? Maybe. But usually, investors will go for the higher rate. Why? Because the higher a country’s interest rate is, the more likely its currency will get stronger. In contrary to currencies of lower interest rates, they are more likely to weaken in the longer term.
So, it is simple as that, interest rates directly affect global sentiment in currencies, consequently their valuation.
How to Benefit from Interest Rates Differentials?
Comparing one currency’s interest rate to another currency’s interest rate is very usual in forex trading. It is a very good clue about a currency’s expected value, whether it is going to weaken or strengthen. So, if you are a forex trader, you better keep an eye on interest rates differential. A widening interest rate gap benefits the higher-yielding currency while a narrowing interest rate gap reinforces the lower-yielding currency. So, when you’re trading you go for buying currencies with higher interest rates and sell the one with a lower interest rate in case of widening differential, and the opposite in narrowing the differential.
Interest Rate Expectations
Did you know that interest rate expectations affect market movements more than actual rates? In fact, forex traders don’t pay much attention to current interest rate levels, as they have been already priced in the current currency value. Instead, traders are interested in where interest rates are expected to go. As monetary policy adjustments affect interest rate expectations, you have to keep an eye on monetary cycles, knowing when interest rates are expected to be hiked or cut.
Many factors contribute to expected interest rates. One is observing the central bank’s projection of interest rate path. Federal Reserve, for example, publishes its Dot Plot on a quarterly basis, which reflects the committee’s expectations for interest rate path. In addition to economic data such as labor market, GDP, and Inflation which gives a clearer view of where the economy is heading.
So, Why Forex Traders do care about Interest Rates?
Interest rates are vital in the forex market. Your decision as a trader depends highly on where the currency’s interest rate is going. To sum up, let’s say that good economic performance means higher sentiment, interest rate hikes, and currency’s higher value. While poor economic performance means lower sentiment, interest rate cuts, and currency lower value. Which one will you choose?
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