Some of the most important influences that drives movements in forex are the interest rate changes from eight of the world's most important central banks. Interest rate shifts represent a monetary, policy-based response as a result of economic indicators that assess the health of an economy. Most importantly, they possess the power to move the market immediately as one aspect of a country's fundamentals have now suddenly changed. Moreover, surprise rate changes may often make the biggest impact because these volatile moves can lead to quicker responses and higher profit levels. (Read Get To Know The Major Central Banks for background on these financial institutions.) 

 

Interest Rate Basics

Interest rates impact currencies in the following manner: the greater the rate of return, the greater the interest accrued on currency invested and the higher the profit. As a result, relatively high interest rates compared to others around the world leads to major shifts in capital as investors seek return. The task of forex investors is to try and predict changes in interest rates by analyzing factors such as news, economic reports, charts etc.  (Read A Primer On The Forex Market for background information.)

By now you probably understand that it is a valid strategy to borrow currencies with a lower interest rate in order to buy currencies that have a higher interest rate (This strategy is also known as the carry trade). However there is the risk that currency fluctuation may offset any interest-bearing rewards. If making a profit in forex was easy, then the carry trade would likely be the one-and-only strategy used by those armed with knowledge of interest rates. (Read more about this type of strategy in Currency Carry Trades Deliver.)

 

How Rates Are Calculated

Each central bank's board of directors controls the monetary policy of its country and the short-term prime interest rate that banks use to borrow from each other. When the economy is doing well, interest rates are hiked in order to curb inflation and when times are tough, cut rates to encourage lending and inject money into the economy.

Forex traders can gain clues into what the central bank (such as the U.S. Federal Reserve) will do by examining economic indicators mentioned in the previous section, such as:

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

 

Predicting Central Bank Rates

Using the data from these indicators and a rough assessment of the economy, a trader can create an estimate for the Fed's rate change. Generally speaking, as the indicators improve and the economy is doing well, rates will either need to be raised or, if the improvement is small, maintained. Likewise, significant drops in these indicators can mean a rate cut in order to encourage borrowing.

Beyond traditional economic indicators, there are two other areas that should be examined.

1. Major Announcements
Whenever the board of directors from a central bank is scheduled to make a public announcement, it will usually give some insight into how the bank views inflation.

For example, on March 15, 2017, U.S. Federal Reserve Chairman Janet Yellen spoke during a briefing in Washington after news that the Central Bank raised its benchmark Federal Funds rate for the third time since the financial crisis. News sent stock prices higher while the U.S. dollar moved lower, which you can clearly see in the chart below. (Read more about the head of the Fed in Ben Bernanke: Background And Philosophy.)

Figure 1: The USD/JPY declines in response to Fed\'s monetary policy announcement and briefing.

Source: Stockcharts.com

 

2. Forecast Analysis
Analyzing professional predictions can also be used to predict interest rate decisions. Since interest rates moves tend to be well anticipated beforehand, major brokerages, financial institutions and professional traders will have a consensus estimate as to what the rate is.

A good rule of thumb for traders is to take four or five of these forecasts (which tend be very close numerically) and average them in order to gain a more accurate prediction.

 

What to Do When a Surprise Rate Occurs

On occasion, central banks can throw a curve ball and knock all predictions out of the park with a surprise rate hike or cut, or even an announcement of an outright shift in policy.

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! Forex tends to move at lightning speeds when a surprise hits, because all traders will be competing in hopes of entering into a position (buy or sell depending on hike or cut) ahead of the masses. Doing so can lead to a significant profit if done correctly. 

· Be aware of a volatile trend reversal. A trader's perception/emotions often affects the market at the onset of the data's release, but then logic comes into play and the trend will most likely continue back on its original path.

The following example illustrates the above three steps in action.

In January 2015, the Swiss National Bank (SNB) shocked the world when it announced that it was abandoning the cap on the Swiss franc against the euro. The event and associated outcome, which you can clearly see in the chart, transpired despite repeated assurance weeks earlier from officials that the SNB was committed to defending the aforementioned cap. These types of surprise events have a dramatic impact on the fortune of forex traders. In many cases, a move like the one shown above could be enough to wipe out traders who take on too much risk.

Figure 2:The EUR/CHF drops in response to the SNB’s decision to abandon the cap on the Swiss franc against the euro.

Source: Stockcharts.com

 
 

Summary

Paying close attention to the news and analyzing the actions of central banks should be an important priority to forex traders. Changes in monetary policy will ultimately cause currency exchange rates to change. Understanding and anticipating these moves will allow you to identify trading opportunities.

Now that we touched upon one of the important news events, we will now discuss how to properly read and analyze a news release.

Entering A Trade

Related Articles
  1. Trading

    How CPI Affects the Dollar Against Other Currencies

    The Consumer Price Index is a broad measure of inflation, and inflation can have a dramatic impact on a currency's value against rival currencies.
  2. Trading

    The Forex Market: Who Trades Currency And Why

    The forex market has a lot of unique attributes that may come as a surprise for new traders.
  3. Trading

    Economic Factors That Affect The Forex Market

    Knowing the factors and indicators to watch will help you keep pace in the competitive and fast-moving world of forex.
  4. Insights

    How Interest Rates Affect The U.S. Markets

    Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation.
  5. Trading

    How Inflation-Fighting Techniques Affect The Currency Market

    Central banks use these strategies to calm inflation, but they can also provide longer-term clues for forex traders.
  6. Insights

    The Impact of a Fed Interest Rate Hike

    The Federal Reserve recently raised benchmark interest rates. With much attention on the Fed's policy, here's what happens when the Fed hikes rates.
  7. Trading

    How Equities Affect The FX Market

    We look at how you can predict a currency movement by studying the stock market.
  8. Personal Finance

    How Interest Rate Cuts Affect Consumers

    Traders rejoice when the Fed drops the rate, but is it good news for all? Find out here.
  9. Trading

    Fundamental Speed: The "Duck-And-Jab" Approach To Forex

    By using economic releases in a timely way, buyers can beat the "big players" without endless chart analysis.
Frequently Asked Questions
  1. When short selling a stock, how long does a short seller have before covering?

    The lender of the shares in a short sale has the ability to request the shares be returned at any time, with minimal notice, ...
  2. What major is required to take the Series 7 examination?

    Find out what educational requirements are needed for the Series 7 exam. Learn about the new Securities Industry Essentials ...
  3. What do the different colored candlesticks mean?

    A typical candlestick chart is composed of a series of bars, known as candles, which vary in height and color.
  4. How can I determine a stock's next resistance level or target price?

    Determining where the price of an asset will stop once it has hit a new high is one of the most difficult tasks for any trader.
Trading Center