Interest rates are the most important economic parameters influencing the forex market. Central banks worldwide employ interest rate hikes or reductions in order to regulate the total supply of currencies in the market. An increase or decline in total currency in circulation has a material impact on its value and related exchange rates.
The Federal Reserve hiked the benchmark interest rate, or the federal funds rate, seven times in 2022, causing the greenback to appreciate by more than 12% last year. The reserve currency hit a 20-year high last September. So far this year, the U.S. Dollar Index gained 1.08%, as the U.S. central bank hiked the federal funds rate by 25 basis points last month.
But interest rates and currencies have a complex relationship, as currency exchange rates can fall even if central banks maintain a hawkish trend. The U.S. dollar fell by nearly 7% in three months from November last year to January, despite the Fed’s repeated promises regarding aggressive rate hikes in the near term.
Having a sound understanding of interest rates and their impact on currency exchange rates is crucial for all forex traders. Take a closer look.
What are Interest Rates?
The benchmark interest rates are typically rates at which commercial banks and financial institutions can lend their excess reserves to each other on an overnight basis. Banks are required to maintain a certain percentage of their total deposits as reserves with the Fed (known as the reserve requirement), while the remaining funds can be lent to other institutions.
What Is the Impact of Interest Rates on Currencies?
The interest rates set by central banks have a huge impact on an economy’s functioning, inflation levels, growth and employment. The federal funds rate is the base rate used to determine all other commercial interest rates on all credit products. Banks and other financial institutions typically add spreads to the benchmark rates to set the interest rate charged on auto loans, home loans, business loans and credit cards.
If the Fed hikes the federal funds rates, commercial borrowing between banks becomes more expensive, thereby reducing the demand for the same. In the long term, it increases the total cost of credit, discouraging borrowing and consumer spending. On the other hand, lowering the benchmark interest rate can boost credit demand, leading to increased consumer spending and total gross domestic product (GDP).
Analyzing Forex Interest Rate Differentials
Trading net interest rate differentials is one of the most popular forex trading strategies. Forex traders aim to capitalize on the different benchmark interest rates set by central banks of different economies while trading the respective currency pair, thereby earning interest in addition to capital gains.
The U.S. federal funds rate is higher than Japan’s policy rate. Traders willing to trade the USD/JPY pair can borrow Japanese yen and buy U.S. dollars with the same and invest the same in USD interest-bearing tools such as Treasury bills. Forex traders can generate net interest on the carry trade with this strategy, in addition to potential capital gains if they sell off the currency pair at a profit.
How to Forecast Central Bank Rates
While forecasting a central bank’s next move can be challenging, several economic parameters and data models help traders predict upcoming policy changes somewhat accurately. The federal funds futures contracts, traded on the Chicago Mercantile Exchange (CME), are one of the best indicators of market expectations regarding the interest rate trajectory. These cash-settled futures contract prices reflect the market prediction for the monthly effective federal funds rate and forecast a potential rate hike or cut in the near term.
The Fed dot plot is also another popular tool used by forex traders to forecast the central bank’s next move. The statistical chart tracks the official projections for the short-term interest rates made by regional Federal Reserve governors and other officials, including the Fed chair. This allows investors to ascertain the trajectory of interest rates in the economy.
Forex Interest Rate Trading Strategies
Several profitable interest-rate trading strategies are out there. While experienced traders often opt for interest rate differential currency trades, trading news releases is also a profitable forex strategy.
Based on their prediction regarding the central bank’s monetary policy actions in the near term, traders can buy and sell currency pairs immediately after any interest rate news releases become public, at a time when exchange rates are most volatile. Tracking other economic parameters such as inflation and unemployment levels can also help traders forecast the Fed’s next move more accurately.
Economic Backdrop and Interest Rates
Interest rates are one of the most important economic parameters influencing currency exchange rates. Keeping track of the current economic scenario and the Fed’s outlook on economic growth prospects can help traders forecast the interest rate trajectory better.
With inflation being one of the biggest concerns since mid-2021, the Fed has been focused on raising rates to control the price levels since last year. The central bank aims to maintain its aggressive hawkish stance, as stated by Fed officials and Chairman Jerome Powell several times in the past few months.
But with recession warnings in place, traders should keep an eye on the official projections made by the Fed as well as the market expectations in order to determine the interest rate trajectory and its impact on the currency exchange rates.
Frequently Asked Questions
How does real interest rate affect forex?
Real interest rate is the rate of return on an investment after adjusting for inflation. This rate can have a significant effect on foreign exchange (Forex) rates. When a country’s real interest rate is higher than other countries, investors will be more likely to invest in that country’s currency, causing it to appreciate in value relative to other currencies.
What is the most important thing in forex trading?
The most important thing in forex trading is understanding how real interest rates affect currency exchange rates. The real interest rate is the interest rate that a borrower pays on a loan after adjusting for inflation. It is important to understand how this rate affects currencies because it can significantly influence the demand for and supply of that currency, which in turn will have an impact on its value against other currencies.