The biggest factor that drives the foreign-exchange market is interest rate changes made by any of the eight global central banks. ("Get to Know the Major Central Banks" provides background on these financial institutions.) These changes are an indirect response to other economic indicators made throughout the month, and they possess the power to move the market immediately and with full force. Because surprise rate changes often make the biggest impact on traders, understanding how to predict and react to these volatile moves can lead to quicker responses and higher profit levels.

Interest Rate Basics

Interest rates are crucial to day traders on the forex market for a fairly simple reason: the higher the rate of return, the more interest accrued on currency invested and the higher the profit. (Read "A Primer on the Forex Market" for background information.)

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), that move is not always a wise decision. If trading on the forex market were this easy, it would be highly lucrative for anyone armed with this knowledge. (Read more about this type of strategy in "Currency Carry Trades Deliver.")

That isn't to say that interest rates are too confusing for the average day trader – just that they should be viewed with a wary eye, like any of the regular news releases. (Read "Trading on News Releases" to learn more.)

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 the bank will decide by examining the most relevant economic indicators, namely:

(Read more about the CPI and other signposts of economic health in our Economic Indicators tutorial.)

Predicting Central Bank Rates

Armed with data from these indicators, a trader can practically put together an estimate for a rate change. Typically, as these indicators improve, the economy is going well and rates will either need to be raised or, if the improvement is small, stay the same. On the same note, significant drops in these indicators can mean a rate cut in order to encourage borrowing. (Read more about these factors in "Forces Behind Interest Rates.")

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 heads tend to play a vital role in interest rate moves, but are often overlooked in response to economic indicators. That doesn't mean they are to be ignored. Any time a board of directors from any of the eight central banks is scheduled to talk publicly, it will usually give an insight into how the bank views inflation.

For example, on July 16, 2008, Federal Reserve Chairman Ben Bernanke gave his semiannual monetary policy testimony before the House Committee. At a normal session, Bernanke reads a prepared statement about the U.S. dollar's value, as well as answers questions from committee members. At this session, he did the same. (Read more about the head of the Fed in "Ben Bernanke: Background and Philosophy.")

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 even though fears of a recession were influencing all other markets.

The 10 A.M. session was widely followed by traders, and because it was positive, it was anticipated that the Federal Reserve would raise interest rates, which brought a short-term rally by the dollar in preparation for the next rate decision.

Figure 1: The EUR/USD declines in response to 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 would result in a $440 profit for traders who acted on the announcement.

Forecast Analysis

The second useful way to predict interest rate decisions is through analyzing predictions. Because interest rates moves are usually well anticipated, brokerages, banks and professional traders will already have a consensus estimate as to what the rate is.

Traders should take four or five of these forecasts (which should be very close numerically) and average them in order to gain a more accurate prediction.

When a Surprise Rate Occurs

No matter how good your research is or how many numbers you have crunched before a rate decision is made, central banks can throw a curve ball and knock all predictions out of the park with a surprise rate hike or cut.

When this happens, you should know which direction the market will move. If there is a rate hike, the currency will appreciate, which means that traders will be buying it. If there is a cut, traders will probably be selling it and buying currencies with higher interest rates. Once you have determined this:

  • Act quickly! The market tends to move at lightning speeds when a surprise hits, because all traders vie to buy or sell (depending on hike or cut) ahead of the crowd, which can lead to a significant profit if done correctly.
  • Be aware of a volatile trend reversal. A trader's perception tends to rule the market at the first release of data, but then logic comes into play and the trend will most likely continue on in the way it was going.

The following example illustrates the above three steps in action.

Going into 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 wasn't long before it got back on track with its current trend, which was upward. The reason it didn't continue free falling was that, despite the rate cut, the NZD still had a higher interest rate (at 8%) than most other currencies. (Learn how commodities influence the New Zealand dollar in "Commodity Prices And Currency Movements.")

As a side note, it is import to read through the actual central bank press release (after determining whether there has been a surprise rate change) to gain understanding of 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.

For related reading, see "Formulating Monetary Policy."