The forex market is largely controlled by interest rates. In fact, the interest rate is generally the single most important factor when it comes to determining the value of that specific currency. Investors will constantly look at how the interest rate on one currency compares to another, and they will use this information to take action in the markets.
It is essential for all successful traders to monitor the interest rates as they are set by various central banks all around the world. They need to keep their eyes on how those rates are set and what they truly mean for their specific trading strategy. Importantly, one of the most essential things to focus on is the interplay between interest rates and the inflation rate in a specific country.
Below, you’ll find a list of central bank authorities for each of the major global economies:
|Australia||Reserve Bank of Australia (RBA)|
|Canada||Bank of Canada (BOC)|
|European Union (EU)||European Central Bank (ECB)|
|Japan||Bank of Japan (BOJ)|
|New Zealand||Reserve Bank of New Zealand (RBNZ)|
|Switzerland||Swiss National Bank (SNB)|
|United Kingdon||Bank of England (BOE)|
|United States||Federal Reserve System (Fed)|
The idea of inflation is that the price of goods and services steadily increase over time as the money supply increases. For the most part, a moderate rate of inflation is accepted along with economic growth. That said, too much inflation can be harmful to an economy, and that is why central banks are always interested in keeping inflation in check. Thus, they may adjust interest rates in an effort to control inflation.
Central banks will often raise interest rates if they feel that inflation has gotten out of control. The idea behind this is that if interest rates increase, then the cost of borrowing goes up as well. That may temper the amount of borrowing and spending that people do, and that can help bring down inflation.
The inverse of this is also true. When central banks lower interest rates, consumers are incentivized to borrow and spend more. Lowering interest rates is seen as one way to attempt to stimulate the economy. When it works, the incentives are lined up just right for consumers to borrow the funds that they require to purchase the goods and services that matter to them. All of that extra spending fuels economic growth, but it can also increase the risk of inflation in a specific area as well.
How Does this Impact Forex Markets?
The forex markets are often dictated by what interest rates are doing in a specific country. Currency traders are always going to keep an eye on what is happening to interest rates, and they will respond by pushing the prices of certain currencies higher or lower based on the flow of money into or out of a specific country.
Traders will tend to seek out the highest interest rate that they can find. If you are offered 2% interest on your money compared to 1%, you will obviously take the 2%. The higher the interest rate, the more likely that the currency in that country will strengthen in value.
That being said, it is not always a simple one-to-one calculation. In other words, it may be possible to assume that a currency will likely move in a certain direction based on recent interest rate changes, but there is no guarantee that investors will follow the script perfectly. Some investors may still see some headwinds that have them concerned when it comes to the currency of a particular country. If that is the case, then they may still back off from investing in that specific country’s currency at this time.
Interest Rate Expectations
Forex traders do not typically spend a lot of time looking at the current interest rates of a specific currency. The expectation is that those rates are already priced in to the market right now. Instead, traders will tend to look at what rates may do in the future.
The job of a trader is to try to anticipate what will happen with interest rates in a specific country in the future. If they make the correct assumptions about the way that interest rates are set going forward, then it is possible that a trader can profit handsomely from their correct assumptions about the market. They may be able to benefit in terms of earning outsized returns on their investment dollars.
It is nearly inevitable that interest rates will eventually go in the opposite direction of where they have gone for the last periods of time. A shift in the way that interest rates have played out to the present moment in time is likely because central banks will feel the need to change their policies.
Professionals make expectations and predictions about where interest rates will go, and they publish those opinions on something known as the Fed Dot Plot, which is published after each Fed meeting and displays the projections of the sixteen members of the Federal Open Market Committee (the individuals at the Fed who manage and set interest rates).
You can see what that looks like here:
Interest Rate Differentials
The difference between interest rates offered by two different nations is what is known as the interest rate differential. This is critical to look at when trading because you will want to see how shifts between the currencies may come into play. You don’t necessarily anticipate the moves unless you understand the differences between the interest rates of these two currencies.
Here is a chart that shows the spread between two popular currencies, the Euro and US dollar:
You may be able to catch some large market swings when you trade two currencies that are very different from one another in terms of the interest rates that they currently offer.
Nominal vs. Real Interest Rate
Finally, take into account the fact that there is a difference between the nominal interest rate and the real interest rate:
Real interest rate = Nominal interest rate – Expected inflation
The real rate is simply the rate quoted by the central bank. However, the nominal rate takes into account the impact of inflation. Thus, there are critical differences between what is said to be the interest rate for a country and what the real rate as experienced by the people really is. This can also impact the health of an economy, and you will want to take it into account when trading.