FX: Interest Rate Decisions
Hello traders, welcome to the pro trading porch and the third module Think Rate, Follow global micro trends.
Now in this lesson we are going to focus on Forex or FX, and the way we are going to focus on following global market trends in the forecast market is by following the interest rate decisions from the central banks.
Now I know this might sound complicated but it’s actually not. So I’m going to try to simple this out for you guys right now. I’m going to first show you or explain to you what this interest rate is and then what happens when they decide to lower the interest rate or hike it.
So central banks monetary policies will tell you directly if a currency is weak or strong. Interest rate decisions will tell you how the outlook of an economy is through the eyes of the central bank. Alright, so that is why we are going to focus on this rate decision. The interest rate decision is the interest rate at which the depository institution lends funds maintained at the federal reserve to another depository institution. So basically this is the interest rate at which banks lend each other money overnight. If a central bank decides to keep the interest rate close to zero, this means that the outlook of the economy is not stable and caution is needed. So what the central bank is going to do is it’s going to lower its interest rate close to zero for the banks to have access to cheaper loans. The result is a weak currency. And the reason central banks do this is because they want to put more money in the hands of commercial banks so they have more money to lend out to their clients so there is more money circulating in the economy. And a sustainable growth is achieved because remember that the critical state in an economy is not a lack of money but a lack of loans. The result is a weak currency. Why, because the economy is pushed by the central banks to achieve sustainable growth.
On the other hand when central banks decide to hike this rate, the outlook of the economy looks more stable. Unemployment levels are acceptable, sustainable growth and target inflation has been achieved. So the central banks can now hike these interest rates because there’s no need for them to have such an intrusive monetary policy anymore. So the result is a strong currency.
Let’s take it from the beginning in a bullet point. If the interest rates are close to zero and remain unchanged the result is a weak currency. So you are going to look for opportunities to go short on that currency. And if the interest rates are being hiked, the result is a strong currency so you’re going to look for buying opportunities on that currency.
Now let me show you the federal funds rate from 1952 until today. As you can see around 2008 when the housing crisis hit the U.S., the federal reserve quickly started to move this interest rate close to zero and it has been maintained until today. This is the federal target rate and the BOE or the Bank of England based rate. And as you can see they pretty much follow each other and in the year 2008, when the crisis hit the economy they also moved their interest rate close to zero and have maintained it ever since.
And this is a monthly GBP USD chart. You can see that around May 2008 the GBP is started to depreciate strongly falling 5,700 pips in only seven months and if we go back you can see that this aligns perfectly with the interest rate decision.
Now I’m going to show you the daily chart off the GBP USD from that period in time. You can see that these pitched rectangles are the drops in the GBP and then you have the retracements back. When the currency is weak, you are going to look for short opportunities because the drop of 2,800 pips is much better or will yield a better reward to your exposure than trading this choppy retracement of a thousand pips.
Again we have a drop of 3,400 pips and a retracement of 1100 pips and then a drop of 2200 pips so basically, as you can see by following the interest rate decisions of central banks you can see through the eyes of central banks the outlook of the economy. And by applying the concepts learned today you can trade the correct side of the market.