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Does The Interest Rate Affect Forex Rates?

This article looks at the ways in which a change in interest rates can affect forex rates.

Forex Rates and Interest Rates

Forex rates are affected by a range of factors and the interest rate of a country is an important factor.  Shifts in the interest rate indicate a policy and monetary based reaction to changes in the economy.  Changes in the rates can create immediate changes in the forex market as it may be prompted by a fundamental change in a country’s policy.

Interest Rate Basics

The effect interest rates have on forex rates is the higher the return rate, the higher the amount of interest accrued and the more profit is available.  Based on this fact, traders should think about borrowing currencies with a lower interest rate to purchase currencies that carry a higher interest rate.  This is known as a carry trading strategy.  The main problem with this strategy is that if there are movements in the currency rate, it could wipe out your profits.  You have to be aware of the risks involved in carry trading as you could suffer major losses if you are not.

Interest Rate Calculation

The central bank controls the monetary policy of a country.  When the economic health of the country is good, the central bank may make the decision to increase the interest rates in an attempt to curb inflation.  If the economy suffers a blow, the central bank may lower the interest rates to promote borrowing.  By keeping abreast of news announcements related to inflation, employment levels and consumer spending, you may be able to get insight into the possible move by the central bank.

Attempt to Predict the Central Bank’s Decision

There are two methods you can use to try and make a prediction of the central bank’s decision regarding interest rates.  The first method is by being aware of major news announcements and the second method is by doing forecast analysis.  If you intend keeping up to date with news announcements, you should keep a keen eye on releases by the central bank relating to inflation.  The central bank normally issues a public announcement regarding the levels of inflation prior to making a decision on interest rates.

Surprise Interest Rate Adjustments and Forex Rates

You should be able to gain insight into what the central bank may do, but sometimes the banks will release a surprise rate change.  When this happens, the banks often make a decision that is opposite to what traders and investors predict.  In this case, you should be prepared to move in the direction the market is going.  When the interest rate is increased, the country’s currency will increase.  When the interest rate is decreased, the country’s currency will decline.  Once you are aware of the interest rate movement, you have two options.

  • Respond quickly to the available information.  The trends in the forex change rapidly when the market is hit by a surprise.  All the forex traders will be trying to obtain a position before everyone else and that is what you should be doing too.  By entering a trade before everyone else, you have the opportunity to increase your profit on the trade.
  • Be alert to potential reversals in the trend.  Once the data has been released, the emotions and perceptions could cause an odd movement in the forex market.  As soon as this period has passed and traders’ emotions have returned to normal, the trend will normally continue on its original path.

If you wish to base your trades on the interest rate, you should pay close attention to forex news.  The banks often release relevant data shortly before they adjust the interest rate.

 

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