How Do Interest Rates Affect Forex Trading?

The truth is, forex rates are always fluctuating. This holds true whether you’re exchanging your cash for local currency or simply looking at a chart. 

For beginners, the movements can seem random, but regardless of the pair, interest rates are always a large part of what’s making price move. In fact, interest rates play such a large part that they are the single most important factor that affects a currency’s perceived value. 

In order to have a successful forex trading career, traders must understand the role of interest rates and the effects it has on exchange rates. This understanding will help you develop specific strategies and to understand what’s going on with the currencies you are trading. 

two forex traders analyzing trading platform discussing interest rates

How Do Currency Pairs Work in the Foreign Exchange Market?

Unlike other financial markets, where you trade a single commodity, you’ll always trade currency pairs in forex. 

For any currency pair, such as USD/JPY, the first currency is always the base currency, or the one bought. The second listed currency or quote currency is the one sold. In other words, if you go long on USD/JPY, you’re buying US Dollars and selling Japanese Yen. 

You must also be mindful of the currency you’re trading and if it has a fixed or floating rate. 

A fixed rate, or a rate lock, is when the central bank for the currency or the government ties the exchange rate to another country’s currency or the current price of gold. Some central banks or governments apply a fixed rate to control the currency’s value to remain within a specific range. 

A floating rate is an exact opposite of a fixed rate. A currency with a floating exchange rate is when its price is determined by supply and demand. This is relative to other currencies within the forex market. 

In other words, what you exchange for one US Dollar for one Euro today may differ when you exchange the same amount tomorrow. 

What Causes Interest Rates to Change?

There are many ways that interest rates affect the forex market, but you must first understand why interest rates change in the first place. More often than not, any changes to interest rates are often an attempt to control inflation.

Generally, when inflation increases, interest rates will also increase. This is typically hinted at with hawkish comments from global central banks. This is because increasing rates support reducing high-risk investments funded with borrowed money.

A potential or actual recession is another large factor that affects the direction of interest rates. In the event of a recession, interest rates are generally decreased to encourage people to borrow more and invest. An excellent example is the recent COVID pandemic. 

Of course, as we’ve seen, the act of artificially keeping rates at all-time lows for extended periods can lead to record-high inflation.

A fiscal deficit is another large factor that may cause interest rates to fluctuate. A fiscal deficit is a result of a government spending more than it earns and borrowing to balance out the sheet. 

When countries borrow, they’re not borrowing $10 or even $1,000,000. The large sums that countries borrow to balance their sheets significantly affect the demand for the currency. This, in turn, causes interest rate fluctuation. 

As a general rule of thumb, the higher the country’s fiscal deficit, the more it will borrow, resulting in higher interest rates. 

How Do Interest Rates Affect Your Forex Trading

As mentioned earlier, interest rates have a massive impact on a currency pair’s foreign exchange rate. Big players in the forex game like banks and hedge funds pour money into countries with higher interest rates for a higher realized return. 

The benefit, especially for those with large sums of money, is getting a more favorable annual percentage rate (APR). It makes sense to want to earn money rather than have inflation eat away its value as it sits there. 

Inflation

Until there are signs that a country will start lowering interest rates like a dovish central bank, money will continue to pour into currencies with higher rates. However, there are downsides to consider as well. 

Just because a country offers high-interest rates doesn’t mean it’s a risk-free investment. On the contrary, this type of trading is actually extremely risk-sensitive. 

There are an unlimited number of factors that can affect an economy and bring down the perceived value of a country’s currency. Sometimes there’s a disparity. This is where a currency may have a high-interest rate but have a dramatically falling perceived value. 

A great example of this is the Russian Ruble. Since the country’s invasion of Ukraine, interest rates in Russia reached an all-time high of 20 percent in Feb 2022. However, the country also saw a dramatic fall in the Ruble’s value. 

When there’s such a huge disparity between the two, it’s a sure indication that the interest isn’t worth the risk and a sign that rates will soon lower. This was proven when Russia announced that it would cut interest rates down to 14 percent in April 2022. 

As you can see, inflation plays a significant portion in determining interest and exchange rates. That’s why central banks watch key economic indicators of inflation like CPI and PCE data like a hawk. 

As a part of your forex trading strategy, you want to keep an eye on the inflation data as well. It’s a great way to develop a directional bias. 

Central banks will likely increase interest rates if inflation data is high as a general rule of thumb. This is to promote lower growth and slow down inflation. 

On the other hand, if inflation is stagnant or seemingly low, central banks will likely cut interest rates. This is for the opposite effect: promoting economic growth and increasing inflation. When inflation rates are falling or cut, businesses and consumers are more likely to borrow. This, in turn, boosts spending and promotes economic growth. 

Another example of a global event that affected interest rates and forex trading was Brexit. During this time, a high-interest currency pair GBP/USD saw a maximum daily pip movement that was over ten times the average number of pips on a normal day. 

Expectations, Speculations and Predictions

The financial markets are notoriously sensitive when it comes to risk. Thus, all financial markets are constantly fluctuating in anticipation of events and global occurrences. 

Interest rates are the same but move with less frequency. That’s why in forex trading, you’ll find that at times when interest rate hikes are released, prices will fall, and when rates are cut, prices may rise or be stagnant. 

That’s because forex traders aren’t focused on current rates but instead price the currency into the news release based on expectations. In other words, currencies will move in the direction that interest rates are expected to go. 

For example, a forex trader will keep their eyes and ears open for any hawkish or dovish comments from any of the central banks before they announce whether they will hike rates or cut them. That’s why central banks are so mindful of their words because they can change market expectations in a fraction of a second. 

Many forex traders will also keep their fingers on a currency’s monetary policy. Monetary policies typically follow cycles, and speculators will attempt to determine when changes will occur.

More often than not, if a central bank comes out with a shift in expectations, that typically signals a shift in speculation and will move a currency in a specific direction until the actual change occurs. 

The Dot Plot

If you trade major currency pairs, you’ll want to keep your eye on the United States Federal Reserve’s dot plot in addition to listening to their releases and watching any inflation-related data. 

The Dot Plot is a key tool that the Fed uses to signal its outlook for future interest rates. It’s published after every meeting and shows the projections of the Federal Open Market Committee (FOMC). It’s important to note that each dot on the plot represents the opinion of each member on where they think the Fed funds rate should be by the end of the year. This ultimately helps shape market expectations. 

Differentials

Another way interest rates will affect your forex trading is through the differentials. One way many traders determine if a currency may strengthen or weaken is by comparing the interest rate of one to another. 

This comparison is known as the interest rate differential and is a key point to keep your eyes on. 

For example, an increasing interest rate differential helps fortify a higher-interest currency. On the other hand, a decreasing differential is often good news for the lower-rate currency. 

One of the largest swings you’ll find in the forex market is when the interest rates of the two currencies in a pair move in opposite directions. 

Interest Rates and Forex Trading

As you can see, interest rates play a vital role in any forex trading strategy. You must also keep in mind to always make clear if the interest rate you see is the nominal or real interest rate. Understanding the difference between the two can make or break a trade idea. 

Markets don’t care about nominal rates but rather focus on the real interest rate. This is calculated by subtracting the expected inflation from the nominal interest rate. 

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