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:

(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 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.

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. (Learn how commodities influence the New Zealand dollar in Commodity Prices and Currency Movements.)

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.