Forex rates keep moving all the time. For new traders, this can seem very challenging as these random moves might seldom make any sense to them. There are several factors that can affect the movement of exchange rates around the world. The interest rate of the currency which is typically the underlying factor is something that remains constant. Usually, it is believed to be healthy that you earn interest on your investments. It is hence common for investors to choose money market funds, bonds, and other various types of investment instruments where one can avail paid interest. Check out more about forex trading at Multibankfx.com.
A key plus point of being able to use a forex trading account is that you are able to put your money into foreign currencies which pay interest and hence your funds grow. The interest rate works in your favor when you come across a country where the interest rate is low and hence you can sell. Such a setup is known as carry trading. Carry trading refers to the practice of holding a currency that has a low-interest rate for a currency with better interest rates. With the help of daily rollover, you are able to earn a daily difference in the interest rate of two different nations. If you have used leverage for your trades, your returns could be even better.
Interest Rate Basics
Interest rates play an important role for day traders in the forex market. It is so because the rate of return is much higher which results in more interest and thus more profit.
It goes without saying that fluctuation is a major risk involved which could offset any profits that you may have earned out of your interests. Though you would want to purchase the currencies with higher interest rates and fund them with the ones that have lower interest rates, it may not always be the best decision. Interest rates must be looked at very carefully and you should always pay close attention to any interest rate-related updates from central banks.
How Rates Are Determined
The monetary policy of a country as well as the short-term rate of interest for banks is determined by the board of governors at central banks. The central banks will hike the prices to tackle inflation and bring down the rates when they wish to add more funds to the economy and promote lending.
Prominent economic indicators could give a fair idea of actions that a central bank could possibly take. Here are a few U.S. economic indicators:
- Personal Consumption Expenditures Price Index (PCE)
- Consumer Price Index (CPI)
- Consumer spending
- Employment levels
- Subprime market
- Housing market
How Do Interest Rates Affect Currencies?
The short and simple answer to this is that investors around the world fund different nations to earn a part of the profit. When interest rates are high, the interest in a nation’s currency also increases. If a country increases the interest rates for a longer than expected time frame, it may lead to a larger trend against other currencies. In this case, all the funds would keep adding on to these currencies until there is a sign that it may end soon.
The negative side of this type of trade is the risk. Literally, any aspect that would have an impact on the economies at an international level could affect the interest rate trade. Though rare, a situation like this can be disastrous for the ones who are underprepared and don’t have a proper risk management strategy in place. A nation might have a high-interest rate but a falling currency. A gap like this indicates that the interest isn’t worth risking your funds. It may even be a sign that the rates would come down further.
Do interest rates move that often?
Though it is not wrong that interest rates usually do not show a lot of movement, expectations on the direction and slope of rate changes appear to change weekly. To observe this, it is interesting to watch how the interest rate expectations change for a 2-Year Government Debt.
As a forex trader, it allows you to look at the entire picture. What is the country’s economy like? What is making them increase or lower interest rates? It is important to have proper knowledge about the nation you are aligning the high-interest currency against. In some situations, one currency leads to movement while sometimes they do so together. Having the whole picture in place can be helpful.
There are a number of aspects that lead to movement in a currency but interest and risk are the leading ones. Make sure you understand the two and you’re safe.
When there’s a surprise change in rate
Irrespective of how good your research is or the numerous times you crunched a rate before deciding, a change in the interest rate can take anyone by surprise. Whenever such a scenario occurs, it helps to assess the direction of the market’s move. If the rate is increased, the currency’s value will increase and if the rate falls, maybe you’d want to buy the ones with a lower rate and sell them for the currencies with higher interest.
After you are done determining the direction of the market’s move, do the following:
- Act quick. The market moves in a fraction of time because most traders would want to buy or sell before everyone else. Preparing in advance and acting fast can help you stay profitable.
- Watch for a volatile trend reversal. Traders’ perceptions could be the norm in the market when the data released first. However, then the market would quickly move to its original path.
The Bottom Line
Forex traders should be proactively keeping an eye out for the latest news and updates while also staying up to date with the actions of central banks.
As central banks establish monetary policies of a certain region, currency exchange rates would move which would give traders the opportunity to earn more profits. The profit potential is bolstered not just from the interest that is accumulated but also from market fluctuations.