Interest rates and their importance for traders

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Why Interest Rates Matter for Forex Traders

The biggest factor influencing the foreign-exchange market is interest rate changes made by any of the eight global central banks.

These changes are an indirect response to other economic indicators observed throughout the month, and they can potentially move the market immediately and with full force. Because surprise rate changes often have the greatest impact on traders, understanding how to predict and react to these volatile moves can lead to higher profits.

Key Takeaways

  • Forex markets track how different currency pairs’ exchange rates fluctuate.
  • One of the primary factors that influence these exchange rates are relative differences in interest rates in each country.
  • While interest rates can often be predicted using economic models, news and surprise announcements can have immediate effects on rates that in turn affect FX prices.

Interest Rate Basics

Interest rates are crucial to day 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.

Of course, the risk in this strategy is currency fluctuation, which can dramatically offset any interest-bearing rewards. While you may always want to buy currencies with higher interest (funding them with those of lower interest), such a move is not always wise.

Interest rates should be viewed with a wary eye, as should any news release about interest rates from central banks.

How Rates Are Calculated

Each 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 will hike rates in order to curb inflation and cut rates to encourage lending and inject money into the economy.

Typically, you can have a strong inkling of what a bank will decide by examining the most relevant economic indicators; namely:

  • The Consumer Price Index (CPI)
  • Consumer spending
  • Employment levels
  • Subprime market
  • Housing market

Predicting Central Bank Rates

Armed with data from these indicators, a trader can put together an estimate for a rate change. Typically, as these indicators improve, the economy will be performing well and rates will either need to be raised or if the improvement is small, kept the same. On the same note, significant drops in these indicators can portend a rate cut to encourage borrowing.

Outside of economic indicators, it is possible to predict a rate decision by:

  1. Watching for major announcements
  2. Analyzing forecasts

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 Chairman 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.

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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.

Figure 1: The EUR/USD declines in response to the Fed’s monetary policy testimony. Source: DailyFX

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.

When a Surprise Rate Change Occurs

No matter how good a trader’s research or how many numbers they have crunched before a rate decision is made, central banks can deliver a surprise rate hike or cut.

When this happens, a trader should know in which direction the market will move. If there is a rate hike, the currency will appreciate, which means that traders will buy. If there is a cut, traders will probably sell and buy currencies with higher interest rates. Once a trader has determined the market movement, it is crucial to do the following:

  • Act quickly! The market tends to move at lightning speeds when a surprise hits because all traders vie to buy or sell (depending on a hike or cut) ahead of the crowd. 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.

Figure 2: The NZD/USD drops in response to a rate cut by the Bank of New Zealand. Source: DailyFX

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.

Interest rates and their importance for traders

In order to achieve astounding results and highly-accurate indicators through market analysis, you must have a deep understanding of basic economic and financial concepts. Today we propose going through the incredibly influential topic, in terms of the financial market, of interest rates. In doing this we will go through thoroughly the concepts, approaches to calculating this indicator, level of influence on trading rates, as well as the various ways of using the rate changes when trading. When the market is overbought, it gives you the opportunity to increase its potential in regards to the professional quality of market analysis based on financial tools.

So, interest rates are a basic tool used by market regulators in relation to monetary policies on the governmental level, as well as on the level of the economic sectors. Therefore, government tools regulate the most important drivers in this or that financial sphere in economically critical situations. This indicator has a macroeconomic character, linked to one of the most influential and powerful drivers for shifting market conditions, including sharp spikes in market volatility.

When considering interest rates within the context of trading, it is worth noting that the vast majority of traders closely follow the shifts in this indicator, as every interest rate correction leads to impulsive market movement, resulting in astounding profits or serious losses in any case. Let’s go through all the finer details.

What Are Interest Rates?

As we mentioned before, interest rates are a tool of government departments that regulate the economy. Through this tool, the government can either limit access to funds or, conversely, create the opportunity to borrow money very affordably. Therefore, when the economy is growing at too fast a pace, the government raises interest rates, if it has collapsed or stagnated, regulators decrease rates, making funds more accessible.

To put it into plain language, interest rates are an indication of a government’s assessment of the current market situation and also the cost of borrowing for the banks.

Therefore, by artificially manipulating rates for borrowing, either by limiting access to affordable loans or stimulating lending, the government aims to support the smooth and stable growth of their economy. On the forefront of this, interest rates begin to heavily influence the value of the national currency, causing spikes and fluctuations of other assets on the financial market.

Which is why it is vital for every online trader to analyze and forecast the shifts in this indicator. Once you have correctly familiarized yourself with the possible shifts in the rates, you, in turn, will gain have a very effective approach to technical analysis at your disposal, the ability to earn profit not only in long-term investments but through day trading as well.

Forecasting Rates

Typically, online traders evaluate the general economic situation of the country that issues the financial tool in order to forecast the rates. For example, traders take into account the economic situation in the US in order to have an understanding of what measures the Federal Reserve will take in terms of the interest rate. This in principle helps with analysis and forecasting the indicator. However, this approach doesn’t produce concrete data or rate reversal points. In order to forecast more precisely the possible actions, on the part of the regulator, in terms of interest rate policy changes, you must pay close attention to more concrete financial, economic and social indicators. The following are a basic list of the influential drivers that most affect interest rates:

в—Џ The Employment Levels
в—Џ The Consumer Price Index
в—Џ The Housing Market
в—Џ The Cost of Subprime Lending

Impulsive shifts in the specified indicators, either positively or negatively, are the precursors of further changes in term of lending policies, therefore in the interest rates. When analyzing interest rate drivers, you can set more concrete time frames and vectors of possible shifts, enabling you to make any corrections to your trading plan that are necessary.

It works relatively simply: if the aforementioned indicators grow at an average rate, then interest rates will remain stagnant or rise slightly. It signifies the healthy economic growth of the country, and, therefore, the attractive perspective growth of financial assets connected to that economy. If the indicators rise too quickly, the government is usually trying to lower the pressure on the economy by raising the rates. It is vital for preventing financial crises. And, conversely, when the indicators of the specified drivers fall sharply, regulators lower them, so that the financial market and the economy are filled with cheap funds, enabling growth. The collapse of rates usually signifies serious systemic problems in the economy of that country.

Besides clear technical financial drivers for forecasting interest rate shifts, there are also several unusual tools for detecting changes in lending policy:

в—Џ Statements of Central Bank Management – In order to forecast shifts in the interest rates, it is worth paying close attention to statements made by top management of central banks. The issue is that government bodies, like other bureaucratic systems, aren’t quick to apply regulatory norms. Hence, the question of raising and lowering rates is considered for lengthy periods of time, and any changes are announced long before the final decision.

Which is why it is important to listen closely to heads of central banks or the committee members who set interest rates, so as to better work out when and what kind of indicator changes will take place.

● Analyze Forecasts of Systematic Traders – The second approach to forecasting interest rate changes is utilizing the analysis of systematic traders. This issue is that announcements regarding changes in lending policy push big-time investors and banks to analyze the situation. In this case, not only largely analytical resources are being utilized, but administrative ones as well. Therefore, calculation compiled by large banks or investment funds can become a great foundation for forecasting rates. Typically, private investors are satisfied with utilizing the forecasts of two or three systemic traders to calculate a simple average that defines possible interest rate changes.

As you can see, there is nothing complicated about it at all. However, to ensure the quality of the analysis, you should consider various different indicators, and for that, you must be familiar with all the nuances of working with the financial market.
When forecasting changes in interest rates, despite fairly well-defined circle of drivers, there are times when regulators come to unexpected decisions that provoke strong market movements. On that note, there isn’t anything that can be said on the matter!
Regulators come to unforeseen conclusions or unexpectedly adjust interest rates in the following situations:

в—Џ Political reasons for the financial indicator’s change. This typically is caused by a change in approach taken by a new government, planning radical reforms to the national economy or financial sector

в—Џ Due to this, there is either a sharp decline of the financial sector or wide-spread economic stagnation
In such situations, possible rate changes won’t be announced early, it will all happen instantly. When this happens, online traders should be prepared for strong impulsive changes in asset volatility, therefore increasing the financial risk involved for traders. Usually, professionals advise against placing trades on the market.

Now, we propose considering how interest rates influence specific trading tools. This is fundamental to having a basic understanding of how this indicator influences specific assets.

Rates and Bonds

When calculating the profitability of government bonds, interest rates play one of the most influential roles in the indicator. The issue is that in this case, the bond’s income is equally, but conversely dependant on interest rate changes. So, when the interest rate rises, bond’s profitability always falls, and vice versa, when the rate declines, the bond increases in value. In general, changes in a bond’s’ value or profitability is not that important of an indicator for private investors. This is more the prerogative of large, industrial investors, who conduct operations directly with government bonds. However, there is an important point here for online traders. The issue is that the bond market heavily influences the liquidity of currency, therefore the dependence of bond value on the interest rate is often used by professionals as a way to identify currency trends. Typically, there is a certain equilibrium, where the fall in bond profitability pulls the currency market down, as well as government bond growth leading to the increase of currency value. Therefore, by evaluating the pattern of interest rate influence on bonds, you can more accurately following possible movements in the currency market.

Stocks and Interest Rates

Interest rates affect the stock market more indirectly than they do bonds. Here we will soon need to consider the level of influence through the prism of economic factors. So, when the interest rate is rising, banks receive more profitable credit terms, forcing them to further raise their own rates for providing consumer credit to the wider population or business loans for enterprises. Therefore, in the first we see a decrease in consumer means, leading to a decrease in profits for businesses and producers, then production cost increases and the price of goods rises. In the end, these changes not only influence real economic indicators but effect, in practice, the activities of enterprises.

On that note, the increase or decrease of interest rates is a strong driver of stock market indicators. However, it is worth noting here that the market can react very quickly to changes in lending policies. So you can obtain projections of the influence of interest changes on the market long before those changes take place. This is a direct result of actions taken by specialists from large companies, who, like all other market participants, have preliminary information regards rate changes.

For example, you can encounter the price of specific goods rising. This is due to the company’s premature awareness of rate growth, leading them to take out cheaper loans earlier, then passing on the cost of this to the customer. This is visible in the stock price minimal decline of these issuers in comparison with companies that didn’t react in time to the news regarding interest rate changes. Therefore, by closely following the work of asset issuers, you can forecast the company’s future asset cost fluctuations.

Conclusion

Analyzing economic, financial indicators, as well as forecasting possible changes in the lending policies of governmental bodies should become more important as a priority for traders when conducting technical analysis. So as you can achieve stable and accurate trading indicators, and strive to conquer the financial Olympus.

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Why Interest Rates Matter to Forex Traders

Interest rates make the forex world go ’round!

In other words, the forex market is ruled by global interest rates.

A currency’s interest rate is probably the biggest factor in determining the perceived value of a currency.

One of the biggest influences on a central bank’s interest rate decision is price stability or “inflation”.

Inflation is a steady increase in the prices of goods and services.

Inflation is the reason why your parents or your parents’ parents paid a nickel for a soda pop in the 1920’s, but now people pay twenty times more for the same product.

It’s generally accepted that moderate inflation comes with economic growth.

However, too much inflation can harm an economy and that’s why central banks are always keeping a watchful eye on inflation-related economic indicators, such as the CPI and PCE.

Country Central Bank
Australia Reserve Bank of Australia (RBA)
Canada Bank of Canada (BOC)
European Union European Central Bank (ECB)
Japan Bank of Japan (BOJ)
New Zealand Reserve Bank of New Zealand (RBNZ)
Switzerland Swiss National Bank (SNB)
United Kingdom Bank of England (BOE)
United States Federal Reserve (Fed)

In an effort to keep inflation at a comfortable level, central banks will mostly likely increase interest rates, resulting in lower overall growth and slower inflation.

Loans just become more expensive while sitting on cash becomes more attractive.

On the other hand, when interest rates are decreasing, consumers and businesses are more inclined to borrow (because banks ease lending requirements), boosting retail and capital spending, thus helping the economy to grow.

What does this have to do with the forex market?

Well, currencies rely on interest rates because these dictate the flow of global capital into and out of a country.

They’re what investors use to determine if they’ll invest in a country or go elsewhere.

For instance, if you had your choice between a savings account offering 1% interest and another offering .25%, which would you choose?

Neither, you say?

Ha! You would pick the 1%, right?

We hope so… because 1 is bigger than 0.25. Currencies work the same way!

The higher a country’s interest rate, the more likely its currency will strengthen. Currencies surrounded by lower interest rates are more likely to weaken over the longer term.

Pretty simple stuff.

The main point to be learned here is that domestic interest rates directly affect how global market players feel about a currency’s value relative to another.

Interest Rate Expectations

Markets are ever-changing with the anticipation of different events and situations. Interest rates do the same thing – they change – but they definitely don’t change as often.

Most forex traders don’t spend their time focused on current interest rates because the market has already “priced” them into the currency price.

What is more important is where interest rates are EXPECTED to go.

It’s also important to know that interest rates tend to shift in line with monetary policy, or more specifically, with the end of monetary cycles.

If rates have been going lower and lower over a period a time, it’s almost inevitable that the opposite will happen.

Rates will have to increase at some point.

And you can count on the speculators to try to figure out when that will happen and by how much.

While interest rates change with the gradual shift of monetary policy, market sentiment can also change rather suddenly from just a single report.

This causes interest rates to change in a more drastic fashion or even in the opposite direction as originally anticipated. So you better watch out!

Below is an example of one of many ways to monitor interest rate expectations and is one of the most-watched news releases.

The Federal Reserve’s “dot plot.” The U.S. central bank uses this signal its outlook for the path of interest rates,

The Fed Dot Plot, which is published after each Fed meeting, shows the projections of the 16 members of the Federal Open Market Committee (the bigwigs in the Fed who are actually are in charge of setting interest rates).

Interest Rate Differentials

Pick a pair, any pair.

Many forex traders use a technique of comparing one currency’s interest rate to another currency’s interest rate as the starting point for deciding whether a currency may weaken or strengthen.

The difference between the two interest rates, known as the “interest rate differential,” is the key value to keep an eye on.

This spread can help you identify shifts in currencies that might not be obvious.

An interest rate differential that increases helps to reinforce the higher-yielding currency, while a narrowing differential is positive for the lower-yielding currency.

Instances where the interest rates of the two countries move in opposite directions often produce some of the market’s largest swing.

An interest rate increase in one currency combined with the interest rate decrease of the other currency is a perfect equation for sharp swings!

Nominal vs. Real Interest Rates

When people talk about interest rates, they are either referring to the nominal interest rate or the real interest rate.

What’s the difference?

The nominal interest rate doesn’t always tell the entire story. The nominal interest rate is the rate of interest before adjustments for inflation.

Real interest rate = Nominal interest rate – Expected inflation

The nominal rate is usually the stated or base rate that you see (e.g., the yield on a bond).

Markets, on the other hand, don’t focus on this rate, but rather on the real interest rate.

If you had a bond that carried a nominal yield of 6%, but inflation was at an annual rate of 5%, the bond’s real yield would be 1%.

That’s a huge difference so always remember to distinguish between the two.

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