When the US Federal Reserve cut its interest rate by 0.25% in July, it marked the first time it has done so since the financial crisis in 2008. And according to many analysts, the Fed may cut interest rates five more times by April 2020. The economic and financial impact of this interest rate cut indeed shows the importance of this tool that central banks around the world have at their disposal.
One financial area that is greatly affected by interest rates is the forex market. A country’s interest rate is a massive determinant of a currency’s perceived value. Hence, having in-depth knowledge of a country’s monetary policy should also give you an idea of where the country’s currency may be headed relative to other world currencies.
In this article, we will briefly cover why interest rates are so closely watched by serious forex traders.
Interest Rate Differentials
Forex traders often use a country’s interest rate to determine whether the currency’s exchange rate will strengthen or weaken against other currencies. This difference between the interest rates of two currencies, commonly called the interest rate differential, can help forex traders pick up currency shifts that, otherwise, might not have been easy to identify.
An increasing interest rate differential bodes well for a higher-yielding currency, while a decreasing interest rate differential bodes well for the lower-yielding currency. Sharp swings often occur when a decrease in one currency’s interest rate is accompanied by an increase in the other currency’s interest rate.
Nominal and Real Interest Rates
There is a significant difference between nominal and real interest rates, which is important for traders to understand.
Essentially, nominal interest rates are not considered accurate indicators of an economy and, hence, should be adjusted for inflation. This is when we get the real interest rate.
The real interest rate is calculated when the expected rate of inflation is subtracted from the nominal interest rate. While the nominal interest rate is often the base or stated rate on financial instruments such as bonds, market participants are primarily concerned with the real interest rate.
So, if for example a bond carries a nominal yield of 5 percent and the rate of inflation is 2 percent, the real interest rate would be 3 percent.
Interest Rates and Investment
As a general rule of thumb, an increase in a country’s interest rates attracts global investor attention since the returns to those who invest in the country will rise. When people invest in a country’s economy, this attention increases the yield and, hence, appreciates the currency of that economy. As a result, forex traders should keep a close eye on interest rate fluctuations in order to better predict the direction in which the country’s currency will move.
As you have now understood, interest rate cuts and hikes often result in fluctuations to currency exchange rates. It’s therefore crucial to research this before any trades are made. For example, a trader could choose to stick with only a few currency pairs in order to more easily stay on top on any news and policy changes concerning those currencies.
Additionally, all forex traders should closely monitor interest rate announcements from the central banks that are responsible for the currency they are trading. Here, it’s important to understand that even the slightest change in wording from one announcement to the next one can have a huge impact on the value of a currency.
Experienced and successful forex traders have learned how to interpret these clues, and can thus use interest rate announcements to their advantage.
How have interest rates influenced your experiences in the forex market? Let us know in the comments below!