Let’s start from the end. Interest rates are the driving force behind economies and our global financial system. Everything in the global financial system is determined based on interest rates.
For instance, the equity market exploded in recent years despite the minor mini-crash caused by the covid-19 pandemic. Basically, we can find many explanations for this trend, but the most logical reason is… low-interest rates around the world.
There’s a lot of money around the world and a lot of rich people and private corporations. They need to not only save their money somewhere but also get this magic number called… annual return! And, it is not a secret that more than any other factor – interest rates affect currencies as well. Much like any other financial asset, the value of currencies and foreign exchange currency pairs exchange rates are largely influenced by interest rates.
Well, let’s start with theories – Imagine a scenario where you can get an annual return of 3% by using standard savings to account for a stable banking firm located in a developed and stable country. Sounds dreamy in today’s markets, right?
And indeed, if this is the case and commercial banks or governments will offer a fairly high annual return for simply depositing funds in a savings account, most people will prefer using this option rather than investing in the equity markets. Why? In theory, in the stock market or any other type of investment, you can basically make a return of 10%, 20%, or even a higher return. But… you can also lose your money. Then, obviously, most investors prefer to take a low risk and get a safe annual return rather than investing their money in some form of investment that has a significant risk.
As such, higher interest rates in a certain country means that money flows into its financial system and the demand for the local currency will rise. Now, it’s not over. Imagine another country has raised its rates to 3.5% with the same risk and the same terms. Where will the money go? That is, in a nutshell, the implication of interest rates in the forex and financial markets.
Now, it’s not over. Imagine another country has raised its rates to 3.5% with the same risk and the same terms. Where will the money go? That is, in a nutshell, the implication of interest rates in the forex and financial markets.
With that in mind, there’s one more factor to consider in the case of interest rates and forex trading. That is country risk. For example, Argentina’s interest rate currently stands at 37% but it is considered a risky country to invest in, partly because there’s high inflation of 51% and it has defaulted 7 times since 1827. Not a good sign, I would say. Therefore, when you are looking at interest rates to predict future price movements of foreign currencies, it is best for you to focus on major and minor currencies only. Less developed countries (exotic currencies) typically have very high-interest rates, which is, in this case, not a crucial factor to determine the strength or weakness of their economies.
Before we delve into the reasons why interest rates move in a certain direction, it is crucial to understand how the economic cycle works. The more you understand how the economic cycle works, the better investor you will become.
Normally, interest rates have a cyclical nature that is closely correlated with the economic cycle. This means that when an economy of a country is growing and the inflationary pressure is increasing as a result of the economic growth, the domestic central bank will increase interest rates in order to slow down the economic activity and therefore, prevent inflation. And it also works in the other direction when the economic activity is shrinking and a market is in a state of recession, central banks will lower interest rates to reduce the cost of borrowing, encourage lending, and to stimulate the economy.
Now that you understand the general concept of interest rates and the effect they have on capital movements around the world, you need to try to predict central banks’ next monetary policy moves. That’s the hard part.
Below we mention several methods that can help you to predict future interest rates set by central banks.
As mentioned, factors like inflation have a huge impact on forex market interest rates movements. And inflation is primarily caused by economic growth, which means that if a country releases good economic activity data, there’s a high chance for a rate hike. Simple as that. What you need to do is to learn how to read an economic calendar and use different economic indicators and market news to evaluate the strength or weakness of the economy.
Some of the most important events that indicate the growth of an economy are the unemployment rate, GDP, CPI, Non-Farm Payrolls (in the US), trade balance, housing index prices, etc. Additionally, perhaps the biggest factor of all is interest rate decisions and speeches from leading central bankers.
The CME FedWatch tool might be the most useful tool to predict interest rates, especially if you want to predict shifts in the US monetary policy. Ok, what is the FedWatch tool??? It is a tool offered by the Chicago Mercantile Exchange that analyzes the probability of the Federal Reserve central bank interest rate moving for the next meetings.
As you can see in the image above, there’s a 94.4% chance that the Fed will leave rates at the current level of 0%-0.25% in their meeting on 26th January 2022. But… for the next meeting in March, there’s a probability of 67.5% that the Fed will increase rates to 0.25%-0.50%.
Another way to try forecasting the next interest rate movements is to look at the general state of the economy and think like… a central banker. After all, economists and central bankers are responsible for maintaining financial and economic stability and keeping inflation in a range of 1%-3% (although many economists believe that an inflation rate of 4%-5% is acceptable).
So, because we all want to buy a house or rent a place to live in, and we need to eat – central banks must control prices and keep housing and food prices at a fair level. I mean, these are the two most basic needs for humans. When this happens and you are able to identify rising housing and commodity prices (as well stock prices), then you can predict that central banks will increase rates in the near future.
Forex traders use the interest rate differential between two currencies to enter long-term positions and exploit the interest rate differential of two countries. This technique is known as carrying trade and is one of the most common and popular methods that forex traders use to buy one currency versus the other.
To trade interest rate differentials, a trader will look to buy a currency pair with a higher interest rate and sell a low-interest-rate currency. This will enable the trader to get an annual return of the difference between the rates no matter what’s the direction of the currency pair. For example, if you currently decide to buy the New Zealand dollar and sell the Japanese Yen, you’ll be able to get an annual return of 0.85%. This is because the nominal interest rate in New Zealand stands at 0.75% and the nominal interest rate in Japan is -0.10% (yes, Japan has had a negative interest rate since 2016).
Unfortunately, in the current market conditions, using the carry trade strategy is less attractive due to the near-zero interest rates central bank policies across the world. Nonetheless, using the carry trade and taking advantage of interest rate differentials is still one of the most popular trading strategies in the Forex markets. So, keep it in mind and use it to evaluate a currency pair exchange rate price movements.
All things considered, changes in interest rates are crucial to forex traders since they have a significant impact on financial markets and Foreign exchange currency prices. And because central bank rates are already priced into currency pairs’ prices, traders usually try to anticipate the next move of central banks. In other words, it’s all about interest rate expectations.
Higher interest rates of one economy will lead to higher valuation of its currency versus other foreign currencies, especially when taking into account the forex carry trade strategy used by many investors and financial institutions. So, whatever trading strategy you are going to use, following interest rate changes and interest rate expectations is vital for good fundamental analysis.
In the next lesson, we’ll learn about technical analysis and how a technical analyst used different economic indicators to analyze foreign currency pairs.
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