Why Interest Rates Matter for Forex Traders and the Forex Market

The direction of the forex market is primarily dictated by changes to interest rates within the global banking system.

Each country’s central bank is responsible for deciding how high to set the interest of any money borrowed from (or invested with) them at any given time, and these figures are instrumental in determining the perceived value of their respective national currency around the world.

Gaining a solid understanding of how different nations’ central banks operate and make key monetary decisions can prove hugely beneficial to your ability to read the market and, ultimately, make profitable predictions when trading.

One of the primary motivations that banks have for varying their interest rates is maintaining price stability within the economy, as well as keeping the financial phenomenon known as ‘inflation’ at tenable levels.

What is Inflation?

Inflation refers to the slow, gradual increase in the price of goods and services over time. A quantitative measure often expressed as a percentage, the term describes the constant rise in the general level of pricing for almost everything within an economy — food items, clothing, property and so on — whereby a single unit of currency is, in effect, worth less than before and so can be used to buy less than it did in preceding periods.

Inflation is the reason why it was possible for your grandparents to purchase a brand new car for only a few thousand dollars in the 1960s, while nowadays a vehicle of comparable quality and luxury can easily cost ten times that figure.

Moderate, incremental inflation is recognised as a natural result of healthy economic growth, and so is considered desirable. However, too much inflation too fast can have a devastating effect on the economy — for example, the hyperinflation crisis that plagued Zimbabwe in 2008, where citizens had to carry practically worthless banknotes around in a wheelbarrow to buy goods. The country eventually abandoned the Zimbabwean dollar as a currency altogether the following year after the price of a loaf of bread hit 1.6tr dollars!

For this reason, most central banks are constantly examining the state of their economy for potential signs of trouble, including key indicators such as the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE).

Further reading: https://uk.investing.com/economic-calendar/cpi-67

How Do Interest Rates Affect Inflation?

Central banks around the world often make the decision to increase the interest rates they offer to borrowers as part of their efforts to keep inflation at sustainable levels.

This is because higher, less competitive interest rates generally serve to curb the growth of the economy, encouraging consumers and businesses alike to save more of their earnings and borrow less as loans become more expensive.

Conversely, falling interest rates tend to make borrowing money a more attractive prospect as the amount extra that you’ll be expected to pay back for the privilege decreases — which has the knock-on effect of boosting spending across the economy, spurring growth!

Interest Rates and the Forex Market: How Do They Relate?

As a result of the changing levels of economic stimulus being promoted by different central banks at any point in time, capital is constantly flowing in and out of countries around the world at varying rates.

While higher domestic interest rates may discourage borrowing, they simultaneously tend to be more attractive to those looking to invest their own funds as they naturally entail a greater return on investment; therefore, the higher the interest rate, the more likely a country’s currency is to strengthen as its perceived global value increases relative to competing currencies.

Consequently, many forex traders spend a lot of their time thinking about future changes in interest rates as a possible indication of where the market is likely to head next — because as we’ve seen, as interest rates increase, the value of the related currency often follows suit.

For example, if interest rates within a certain banking zone have been consistently on the decline for a while, it makes sense that at some point they will have to come back up for the country to remain financially competitive. This means over time more and more traders will come to believe a change is imminent, and they will gradually begin to act accordingly — particularly towards the end of monetary cycles where decisions are typically announced!

What are Interest Rate Differentials?

Expectations from notable economists regarding interest rates’ direction of travel are monitored in a number of key reports throughout the year, which traders will often factor into their own predictions; a major example is the US Federal Reserve’s ‘dot plot’, which is published after every Fed meeting and includes personal projection opinions from 16 prominent Fed officials.

Indeed, comparing the two countries’ respective interest rates within a currency pair is a common method used by traders to discern whether a particular currency is on track to strengthen or weaken — the difference between the two is known as the ‘interest differential’, and can assist speculators in identifying shifts that may not otherwise be immediately apparent.

Generally speaking, an increasing gap between two interest rates is beneficial for the higher-yielding currency in the pair, whilst a narrowing gap serves to increase the value of the lower-yielding currency. Occasions when the two interest rates diverge completely and move in opposing directions can cause sharp swings in the market!

These interest rate differentials are also commonly relied upon in carry trades, whereby money is loaned from a currently low-interest country for conversion into the currency of a country with a higher interest rate to capitalise on the accelerated appreciation.

Further reading: https://www.fxempire.com/education/article/how-to-use-an-interest-rate-differential-278060

Nominal vs Real Interest Rates: What’s the Difference?

In financial terminology, the term ‘interest rate’ can be used to refer to two separate figures, known as the ‘nominal’ and ‘real’ interest rates, respectively.

The nominal rate is the rate of interest before factoring out the effects of inflation; this is usually the official figure or base rate given by the bank. For instance, if you borrow $200 at an 8% nominal interest rate then you can expect to pay back an extra 8% of that sum for the duration of the loan (without adjusting for inflation).

On the other hand, the real interest rate is what remains — the extra value you owe to the lender as a charge for borrowing the money — once you’ve factored in naturally occurring inflation to the price of the loan.

In other words:

Real Interest Rate = Nominal Interest Rate — Expected Inflation

The same distinction is also apparent when you’re investing; if you had a bond that carried a nominal interest yield of 8%, but the inflation rate is already set at 6%, then your real yield — the actual increase in your overall purchasing power — would actually only be 2%.

This is a significant difference, so it’s always worth differentiating between the two!