How Interest Rates Affect Forex Trading
Watching Bloomberg and CNBC will make any new trader confused beyond belief. So many types of economic data flowing on the screen and the different analysts giving their opinions, this can leave traders with a heart rate above 150 bpm thinking: “what will happen to my long USD position?” In this article, we will discuss how interest rates affect Forex trading so that you are not left chewing your nails or grinding your teeth until there is nothing left.
If you listen to economic analysts, usually the first thing they talk about is how interest rates will be affected by a certain economic release. Before getting stressed, the key is to realize that economic data is watched by market participants because this data determines what the reserve bank of the country will do to interest rates.
So, the first step to understanding fundamentals is recognizing that the main factor determining the price of a currency is the interest rate, determined by the reserve bank of that country and that all economic data boils down to how it will affect the interest rate going forward.
All traders should at least have a basic understanding of the fundamentals driving market prices so let’s take a look at how interest rates affect Forex trading. As a general rule, higher interest rates are beneficial for the value of a currency i.e. the value of the currency should increase, while lower interest rates are negative for the value of a currency i.e. the value of the currency should decrease.
Why does an increase in interest rates lead to a currency appreciating in value?
Think of it like this, if you were to make an investment you would put your money into an asset with a higher rate of return. Rising interest rates offer an opportunity to make more money from the investment which increases the demand for the currency. Like all markets Forex is driven by supply and demand, so the increase in demand leads to the currency appreciating in value.
To understand this fully we can look at the opposite side. When interest rates are lowered by a reserve bank, investors are not attracted because this does not offer them an opportunity to make high returns. As a result, they will not invest and may even pull out some of their money denominated in that currency and reinvest into a higher-yielding currency. Consequently, there is a lack of demand and a high supply (sellers) in that currency. The forces of supply and demand then depreciate the value of that currency.
But how does this affect my trading?
Forex trading involves putting two currencies against each other and measuring their value relative to one another i.e. a currency with a higher interest rate attached to it should increase in value relative to the currency with the lower interest rate. As with all trading approaches, this is not always the case as there are too many factors that affect Forex prices. But historically over long timeframes, this relationship usually plays out. This brings us to our next question…
To what extent will interest rate changes impact my trading?
Your approach to the market will determine this, let me give some examples to illustrate this: If you approach the market as a fundamental trader then most of your resources and time will be focused on understanding and forecasting interest rate changes.
However, if you focus on technical analysis then interest rate changes will play less of a role, but it is still good to have a basic understanding of interest rates to maximize your profit potential. You may, for example, decide to close your positions to manage risk before a major rate decision or you may not consider a signal to enter right after a reserve bank announcement and instead wait for more confirmation.
Long term technical traders will also pay more attention to interest rates than short term technical traders because as we discussed over longer periods if one currency has a higher interest rate it will usually increase vs the currency with a lower interest rate. It will take experience in the market to determine your formula to successful Forex trading and how much you take interest rates into account, all that is required is hard work and patience.
Good luck and happy trading.