Why are interest rates so important for FX traders?

Interest Rates

When it comes to the forex markets, there is one aspect that trumps just about anything else. Many people might think that economic indicators may move the markets a lot. Of course, you will often see reports such as employment, inflation and so on making a major impact.

However, it is interest rates which plays a major role behind these market moves. If you look at it, a jobs report might have a big impact on the FX currency pairs. But the reason why it has such an impact is because how the report can influence interest rates.

Central bankers meet almost once a month (depends from one central bank’s schedule to another). In such meetings, the central bank’s monetary policy making staff assess the economy.

The assessment includes inflation, labor market, GDP growth and so on. As you can see, these economic indicators tend to have an influence in the decision making.

Thus, while in one way the economic indicators might seem to have a big impact, the reason behind this impact is the way they can shift the interest rate expectations.

Why should you as a trader pay attention to interest rates?

The general rule of thumb is that when interest rates rise, they tend to make the currency more in demand. Due to the higher rate of interest, major investors tend to follow currencies that have higher rates.

But it is not just interest rates that matter. Investors also tend to consider various other aspects such as the geo-political factors, the overall stability of the economy and so on. In major developed economies, interest rates haven’t risen more than three percent in recent years.

But if you look to the developing economies, you can see that interest rates are much higher. In general, the developing economies have interest rates starting at a minimum 5 percent, if not more.

One of the reasons behind this is because that is how developing economies tend to attract investors. In return for higher interest rates, the developing economies are able to use the capital towards their infrastructure spending or for debt financing.

With higher rates, there is also a risk as well. Most of the developing economies do not enjoy a stable geo-political scenario comparing to developed economies. This in itself creates a risk for investors.

Coming back to the developed economies where interest rates aren’t that high, even a 2% is sometimes considered a good return.

Thus, investors looking for lower risk, but a slightly higher reward tend to chase currencies that have higher rates.

What influences interest rate decisions?

There are a number of factors that influence the interest rate decisions. Generally, it can depend from one central bank to another. Typically, central banks have a mandate. The mandate can be to maintain price stability (also known as inflation) or to ensure low unemployment.

The Federal Reserve Bank in the United States for example has a dual mandate to maintain both inflation and jobs. Quite recently, the Reserve Bank of New Zealand also started to follow a dual mandate.

Thus, the factors can change depending on the central bank.

A central bank usually starts with setting an inflation rate that it wants to target as well as the unemployment rate. In doing so, it can then begin to influence interest rates.

When rates are low, the central bank encourages borrowing in the economy. This leads to more job creation and rising demand. Once demand picks up, you can see this reflected by increase in GDP, lower unemployment rate.

Once the GDP and unemployment rate are on track, slowly, this gives rise to higher inflation. Higher inflation comes as investors have more money to buy goods. Thus, higher demand leads to price rise.

To curb inflation, the central bank then needs to increase interest rates. In turn, this lower the demand for goods pushing inflation lower. In doing so (hiking interest rates and cutting interest rates), the central bank is able to maintain or achieve the inflation and unemployment rates.


Read 981 times Last modified on Monday, 21 October 2019 06:10