How interest rates affect Forex trading strategies

IN a previous article, the topic of fundamental analysis was introduced and we laid the foundation that fundamental analysis involves the use and study of economic factors to forecast future price movements of currencies. 

  Macroeconomic data plays a big role in the price of currencies because it reflects the health of an economy. If a country’s economy is strong and growing it will attract investment which will further boost the currency; whereas if a country is struggling economically investors may be fearful to invest and so there will be less demand, and subsequently a lower valued currency.

  We will now take a more focused look at one of the most important fundamental data indicators, interest rates, and how they impact currency trading strategies.

  Interest rates dictate the flow of global capital into and out of a country, as investors consider the rate of interest when determining if they will invest in a country or go elsewhere. For example if you had to choose between a savings account offering three per cent and another offering 1.5 per cent, you would choose the account offering three per cent interest.

  Interest rates are governed by central banks and they are manipulated in order to dictate the flow of investment into the respective country. By controlling interest rates, central banks also impact currency values. High interest rates help to attract foreign investment and any increased demand generally leads to the country’s currency valuation also rising. The opposite is also the case; if a central bank announces a cut in interest rates this usually results in the respective currency dropping in value. 

  It’s always important to be aware of when a central bank is due to announce its interest rate decision as the market is often very volatile around the time of these announcements.  

  Another way that central banks use interest rates is to manage inflation levels. Inflation is defined as the steady increase in the price of goods and services over time. Put more simply, inflation is the reason why the price of a bottle of Coke 10 years ago was N25 and now we pay N50 for the same bottle. 

  All central banks have inflation targets, with most developed economies aiming for inflation around two per cent and the banks’ monetary policies are put in place with the aim of maintaining this target inflation level.  

  Although it is expected that moderate inflation comes with economic growth, too much inflation can harm an economy as it can inflate prices of ordinary goods to a point where they are out of reach of ordinary citizens. Raising interest rates is one way to halt inflation as higher interest rates generally encourage consumers and businesses to borrow less and save more, putting a damper on economic activity. 

  The opposite is also the case; in times when an economy is struggling – such as what we are witnessing in the Eurozone currently – central banks try to boost the economy by dropping interest rates in the hope that this will lead to increased levels of spending by businesses and consumers. Lower interest rates and a subsequent drop in the value of the currency can also help a country’s export business as importers get more for their money when the currency has a lower value.  

  One of the most widely used indicators of inflation is the Consumer Price Index (CPI) which measures the change in price of items that a majority of the public buys on a regular basis. The forex market can also experience volatility around the CPI announcements because inflation plays a big part in whether central banks decide to manipulate interest rates.

What does this mean for forex traders?

  More than anything, it’s important that forex traders recognize which of the fundamental data announcements have a tendency to create volatility in the market and why. Announcements from the Federal Reserve, the central bank for the United States – also known as “The Fed” – usually have a big influence on the markets, not only because the US is the world’s largest economy but also because the most popular forex pairs to trade are traditionally those partnered with the US dollar.

  Other central banks that have significant influence on the currency markets are the European Central Bank (ECB), the Bank of England, and the Bank of Japan. For those investors who enjoy trading the minor currencies of the Canadian dollar, the Australian dollar and the New Zealand dollar, it is also important to be mindful of the monetary policy executed by the respective central banks for these countries.

•Abiola Akinyele works with ForexTime Nigeria www.forexcircles.com.