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Interest Rates And The Forex Market

Interest rates and the forex market are related, and any serious trader should understand how. The article will educate you on this relationship and how to use it profitably on Dominion Markets.

Introduction To Interest Rates And Forex

Interest rates have a significant influence on the Forex market. After all, a country's interest rate determines the perceived value of its currency.

High interest rates attract investors who buy the country’s currency and increase its value. On the other hand, low interest rates chase investors who dump the country’s currency, decreasing its value.

Variations in the foreign exchange rate can be advantageous or disadvantageous to you. When a country raises its interest rates, its currency's value increases. This means that you can earn profit by buying that currency.

If a country's interest rate suddenly decreases, its currency's value also decreases. This means you could lose money if you were in a long position.

To put it differently, knowing how interest rates function and how to anticipate changes in them is the first step towards leveraging them to your advantage.

Dominion Markets offers the opportunity to enjoy low spreads when trading. Remember, interest rate decisions trigger higher volatility. In that case, Dominion Markets’ core competence, which is low latency, gives a great advantage.

Impact Of Interest Rates On Exchange Rates.

Changing interest rates is critical to a central bank's monetary policy measures. Imagine it as a control knob that enables central banks to regulate a range of factors, such as borrowing patterns, economic growth, and inflation.

Increasing Interest Rates

Thus, an increase in interest rates is equivalent to turning up the knob by a bit. Such a move is used to lower inflation. Borrowing gets slightly more expensive when interest rates rise.

Additionally, when borrowing declines, individuals and companies may tighten their belts, preventing prices from soaring. That's not all, though. An increase in interest rates may also attract international investors seeking greater value for their money.

The local currency may gain strength from this increase in demand, making it more valuable than other currencies.

Bank of England rate hike

Bank of England rate hike

The Bank of England raised rates on the 3rd of August, 2023, leading to an increase in the price of the GBP/USD pair.

Lowering Interest Rates

Conversely, lowering interest rates by a central bank is equivalent to moving the knob in the opposite direction. This time, it's similar to gently nudging the economy.

Reducing the cost of borrowing could lead to increased loan applications, business investment, and consumer spending. It's similar to giving the economy a little boost to encourage expansion.

However, keep in mind that every action has a reaction. Foreign investment may decline as interest rates fall because investors may no longer find the returns enticing.

As a result, the local currency may become less attractive in the global exchange market. This lowers its exchange rate.

Swiss National Bank rate cut

Swiss National Bank rate cut

The Swiss franc fell against the dollar when the Swiss National Bank cut rates on the 21st of March 2024.

As you can see, these changes in interest rates represent more than just figures on paper. They cause ripples in the economy, altering the value of currencies.

Interest Rates And Market Expectation

The expectation of varying economic events causes markets to fluctuate constantly. While interest rates fluctuate, they do so less frequently than they used to. Most forex traders don't pay much attention to current interest rates because they are already priced in the currency's value.

Where interest rates are expected to go in the future is more significant. It's important to know that interest rates usually change when monetary policy shifts or when monetary cycles end.

If rates have declined steadily for some time, the opposite is nearly inevitable. At some point, rates will have to go up. Furthermore, you may rely on the speculators to make an effort to predict when and how much that will happen.

How Market Expectations Affected The Dollar?

A good example is the changing outlook for US interest rates in 2024. As inflation reached its highest point and then decreased, investors began considering the upcoming change in the Fed's monetary policy. This caused a lot of market fluctuation, especially for major currency pairs.

As more economic data came in, investors changed the outlook and expectations for rate cuts. The market began to anticipate a delay in the first cut, moving it from March to September, as economic data continued to indicate persistent high inflation.

As a result, the dollar rallied against most major currencies, like the euro, in the first quarter of 2024. The chart below shows the downtrend in EUR/USD that resulted from the shifting market expectations.



How To Predict Interest Rate Changes?

Globally, different indicators influence fluctuations in interest rates. Upbeat economic data shows that the economy is doing well. If this leads to an increase in prices, central banks are forced to increase interest rates. When economic data is bad, central banks lower interest rates to help the economy and improve cash flow.

Below are the two major predictive indicators you can use to capitalize on interest rate changes in Dominion Markets.

Central Bank Announcements

Frequently, individuals dismiss crucial announcements of central bank policymakers. Nonetheless, it is essential to anticipate changes in interest rates based on these pronouncements and speeches.

These reveal the bank's perspective on the state of the economy, inflation, and the outlook for the future. An example is the Bank of Canada governor, Tiff Macklem.

BoC governor Macklem speaks

BoC governor Macklem speaks

Policymakers constantly speak about the economy. These speeches reveal clues about what they expect will happen in the future. These clues shape the outlook for interest rates in the market, allowing traders to predict currency moves.

In addition, during policy meetings, central banks provide economic projections that demonstrate their expectations for the future. These also affect the outlook for interest rates. Good traders follow these closely to make trading decisions.

Forecast Analyses

Traders can also use forecast analyses to predict changes in interest rates. Interest rate fluctuations are mostly known to banks, brokerages, and experienced traders because they are almost always predicted. Forecasts can be averaged to produce a more accurate prediction.

Therefore, when predictions for a particular country show declining interest rates, be ready to sell its currency. On the other hand, forecasts for rising interest rates provide good buying opportunities.

Understanding Forex Interest Rate Differentials

Simply put, an interest rate differential is a variance in interest rates between two nations. A trader thinks the US dollar will go up if he expects the US to raise interest rates.

To improve their chances of success, the trader can buy the US dollar against a currency with low interest rates. The appreciation or depreciation of a currency pair significantly depends on interest rate differentials.

How To Trade Interest Rates

FOMC policy meeting

FOMC policy meeting

To trade interest rates, forex traders wait for a central bank policy meeting like the one shown above. After the meeting, the central bank will announce the new interest rates. Traders can trade before or after the announcement to take advantage of the volatile market.

Moreover, traders can trade policymaker speeches, which give clues on the outlook for interest rates. For instance, you can trade a speech by Federal Reserve Chair Jerome Powell. Depending on your ability to predict, you can place your trade in anticipation of the speech or after.

Another strategy is to trade the announcement of an economic report that influences the outlook for interest rates. Such reports include inflation, GDP, and employment.

Join Dominion Markets now to use your knowledge of interest rates to make smart trading decisions and advance your trading career.