Why Interest Rates Matter for Forex Traders

Interest rate changes made by any of the world's most influential central banks can have a major impact on the foreign exchange market.

These rate changes usually are a response to economic indicators observed throughout the month. They potentially can move the market immediately and with full force.

Surprise interest rate changes can have a substantial impact on traders. Therefore, it's important to understand how to predict and react to them in your quest to secure profits.

Key Takeaways

  • Forex markets track fluctuations in the exchange rates of currency pairs.
  • The relative difference in the interest rates of countries is a primary factor in exchange rate movement.
  • Interest rates can often be predicted using economic models.
  • However, news and surprise announcements can have an immediate impact on rates which, in turn, can affect forex prices.
  • Unexpected changes in forex rates can present traders with profit opportunities.

Interest Rate Basics

Interest rates are crucial to day traders in the forex market. That's because the higher the rate of return, the more interest accrued on currency invested, and the higher the profit.

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

Interest rates should be considered carefully, as should any news release about interest rates from central banks.

How Rates Are Determined

Each central bank's board of governors 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 raise rates in order to curb inflation and cut rates to inject money into the economy and encourage lending.

Relevant economic indicators may provide an idea of actions a central bank may take. Some important U.S. economic indicators include:

Predicting Central Bank Rates

Data from these and other economic indicators can help a trader project and prepare for an interest rate change. Healthy economic activity can mean rates may be left unchanged. If the economy is too strong, the central bank may raise rates. On the other hand, weakness measured by indicators can portend a rate cut to encourage borrowing.

It's also possible to predict an interest rate decision by taking note of major announcements and analyzing economic forecasts.

Major Announcements

Major announcements from central bank leaders can provide vital information about interest rate moves. They shouldn't be overlooked in sole favor of economic indicators. When the board of any of the eight major central banks is scheduled to talk publicly, traders can glean insights into how a bank views inflation and, therefore, actions it might take.

For example, on July 16, 2008, Federal Reserve Chair Ben Bernanke gave his semi-annual monetary policy report to the House Committee on Financial Services. At a typical session, Bernanke reads a prepared statement on the U.S. dollar's value and answers questions from committee members.

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.

His statement was widely followed by traders who took it as a positive sign that the Federal Reserve would raise interest rates. This perception resulted in a short-term rally on the dollar in advance of the next rate decision.

The EUR/USD declines in response to the Fed's monetary policy testimony. Image by Sabrina Jiang © Investopedia 2021

The EUR/USD declined 44 points over the course of one hour, which was good for the U.S. dollar. The move 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 forecasts. Interest rates moves can be anticipated. As a result, brokerages, banks, and professional traders will already have a consensus estimate of what the rate may be.

Traders can take four or five of these forecasts (which should be very similar) 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've crunched before a rate decision is made, they still may be caught off guard by a surprise rate change by a central bank.

When this happens, a trader should understand in which direction the market will move. If there is a rate hike, the currency will appreciate. This means that traders will buy. If there is a rate 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 speed on a surprise because all traders vie to buy (or sell) ahead of the crowd. Proper preparation and fast action can lead to a significant profit.
  • Watch for a volatile trend reversal. Traders' perceptions may rule the market at the first release of data, but then the trend will most likely reverse back to its original path.

The following example illustrates the above steps:

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 and the New Zealand dollar was an attractive buy for traders due to its higher rate of return.

In July, contrary to all predictions, the bank's board of governors 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).

The NZD/USD drops in response to a rate cut by the Bank of New Zealand. Image by Sabrina Jiang © Investopedia 2021

The NZD/USD dropped from .7497 to .7414 for a total of 83 points, or pips, over the course of five to 10 minutes. Those who 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 dropped, it was not long before it reversed and continued its upward trend. It did not continue falling because, despite the rate cut, the NZD still had a higher interest rate (at 8%) than most other currencies.

As a side note, it is important to read actual central bank press releases to determine how a bank views future rate changes and decisions. The data in a release can spur a new trend in the currency after any short-term effects from a surprise change have taken place.

Why Are Interest Rates Important to Forex Investors?

They're important because, for one, some foreign currencies pay interest. Secondly, interest rate changes affect exchange rates. Changes in exchange rates move the forex market and that gives traders opportunities to make money.

What's a Central Bank?

A central bank is the organization with primary responsibility for its nation's economic prosperity, monetary policy, financial system health, and the stability of its currency.

What's the Central Bank for the United States?

The Federal Reserve is the central bank in the U.S. It's considered the most influential central bank in the world. Its Federal Open Market Committee (FOMC) meets eight times a year. At these meetings, committee members review economic conditions and decide whether monetary policy actions are necessary. The announcements that come out of FOMC meetings are closely watched by traders.

The Bottom Line

Following the news and analyzing the actions of central banks should be high priorities for forex traders.

As central banks determine their regions' monetary policies, currency exchange rates tend to move. As currency exchange rates move, traders have the ability to maximize profits. Profit potential exists not just with interest accrual from carry trades, but also from actual fluctuations in the market.

Thorough research and analysis can help a trader take advantage of surprise rate moves when they inevitably happen.

Article Sources
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  2. Reserve Bank of New Zealand. "OCR reduced to 8.0 percent."

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