Interest Rates

How Interest Rates affect the Forex Market

Perhaps no other economic indicator moves the markets like the expectation of interest rates as part of the monetary policy of a country.

Interest rates simply refer to the cost of borrowing, or the cost of credit. Interest rates charged on loans, mortgages and other investments are all benchmarked according to the interest rates set by the central bank, which represent the rates at which banks within a country will lend to one another. The interest rate is also the compensation to the lender for taking on the risk of lending to a borrower. This is why government bonds (instruments of credit issued by a government to its lenders) attract a payment of interest to bond buyers.

Closely related to interest rate decisions are statements regarding monetary policy for the present and the future, usually delivered by the central bank chiefs at press conferences shortly after the interest rate decisions are made public. Interest rates are one of the weapons that a central bank uses in the control of inflation. So whenever you hear of interest rates, you should also pay close attention to inflation.

Factors Affecting Interest Rates

Factors that can affect the interest rate of a country include:

a)    The amount of money in circulation.

b)    Consumer and producer inflation rates

c)     Demand and supply of credit in a country. Interest rates will rise when there is a demand for credit, as this tends to increase the volume of cash in circulation (an inflationary pressure).

It can be seen that all the factors are actually interwoven.

Why is the Interest Rate Relevant to Forex Traders?

Interest rates will ultimately determine the rate of returns of an investment into an economy.

Another application of interest rate to forex traders is in the carry trade. This is a trade strategy where the trader buys the higher-interest yielding currency and sells the lower-interest yielding currency. The aim is to earn from the differential in the two interest rates when the position is held overnight. Every single day that the position is held open, an interest rate differential payment known as the Rollover or Swap is paid to the trader with a long position on a higher yielding currency. Even though the carry trade no longer pays as much as it used to when the AUD and NZD were carrying interest rates of 8% and 8.25% as against the JPY’s less than 0.3%, it is still relevant today as traders can profit from trading the AUDUSD, NZDUSD, NZDJPY and AUDJPY using this strategy.

Trade Scenarios

What are the possible trade scenarios?

There are four possible scenarios in which the interest rate decisions can be traded:

a)    When the interest rate comes out as markets had predicted. This is usually a “No Trade”, but watch out for the tone of the accompanying statement.

b)    When a decision has been made to hold rates steady to the surprise of the market. This means that if the market is expecting a rate change (increase or decrease) and the central bank holds steady, expect some volatility to occur.

c)     If the central bank raises interest rates when the market expects the rates to be held steady, volatility will occur in the direction of the rate change.

d)    If the central raises or drops the interest rates beyond what the market expected them to do, then this will trigger volatility in the direction of the change.

Remember that the greater the deviation, the more the market volatility.

Even more important is the statements made by the central bank chiefs following the release of the data to the market. The statements are intended to explain the rationale behind the current decision, as well as paint a picture of the future direction of interest rates. If the statement is pointing to maintenance of status quo or a reduction in rates, then the statement is said to be “dovish”. If the statement starts to point towards a future laden with rate increases, then the statement is said to be “hawkish”.

It is very important that you recognize the tone of the statement if you want to trade this event. Markets can be very volatile when statements are being read. Here is an interesting example taken from the interest rate decision of the Reserve Bank of New Zealand on March 12th, 2014.

The Official Cash Rate (New Zealand’s interest rate) was raised from 2.5% to 2.75%. Ordinarily, this should already have been priced into the market since this was in line with the expectation.

interest rates 1

However, the statement by RBNZ Chief Graeme Wheeler nailed it, in which he signaled that there would be further rate hikes in future. This hawkish tone set the pace for the New Zealand Dollar to gain value against other currencies, especially the US Dollar as shown below:

interest rates 2

This represents a way to trade an interest rate decision. If the decision is in line with market expectations, watch the tone of the accompanying statement.

 

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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