Interest Rates and the FX Market

Interest Rates explained by professional Forex trading experts the “Interest Rates” FX trading team.

Interest Rates?

Many FX traders get confused about which fundamental news releases to focus on when making a trading decision. I suggest to these traders to follow news releases that potentially impact the currency’s interest rate. This article will explain why the interest rate movements are important to the value of the currency.

Each currency carries with it an interest rate. This is almost like a barometer of that economy’s strength or weakness.

As a nation’s economy strengthens over time, prices tend to rise as the consumers are able to spend more of their income. The more we make, the better our vacations can be, and the greater amount of goods and services we are able to consume. This creates a loop where more money chases roughly the same amount of goods which can lead to higher prices for those goods. The rise in prices is called inflation.
A side effect of high interest rates is that foreign investors desire to invest in that country. The logic is identical to that behind any investment. The investor seeks the highest returns possible.

By increasing interest rates, the returns available to those who invest in that country increase. Consequently, there is an increased demand for that currency as investors invest where the interest rates are higher.

Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital. If a country’s stock market is doing well and they offer a high interest rate, foreign investors are likely to send capital to that country. This increases the demand for the country’s currency, and causes the currency’s value to rise.

As you can see, it is not just the rate itself that is important. The direction of the interest rate can act as a good proxy for demand for the currency. The direction of the interest rate is obtained through the central bank’s language in the statement that accompanying their target rate decision.

The accompanying statement is analyzed word-for-word for any signs of what the central bank may do at the next meeting. Remember, the interest rate decision itself tends to be less important than the expectations for future interest rate moves.

High and increasing rates at the beginning of an economic expansion can generate growth and value in a currency. On the other hand, low and lowering rates may represent a country experiencing difficult economic conditions which is reflective in a reduction of the currency value.

The Widening Interest Rate Differential

In early 2009, the worldwide economy was bottoming out as the United States credit freeze began to thaw. The Fed kept U.S. interest rates at all-time lows while the Reserve Bank of Australia began their process of increasing their target benchmark rate.
Those traders were rewarded as the AUDUSD exchange rate began a 30 cent rise while earning an additional daily dividend from 2009 through 2011. One mini lot trade of 10,000 units of currency would have yielded over $3,000 plus interest.

Interest Rates Conclusion

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