Do you know that the interest rate decision can make a forex pair go wild?
The interest rate on a currency is arguably the most important element in influencing its actual worth.
So understanding how a country’s central bank makes monetary policy decisions, such as interest rate, is important.
Well, let’s dig a bit deeper into how interest rate decisions affect forex. In this guide, we will break down how interest rate decisions can affect the forex market.
Central banks would most likely raise interest rates to control inflation at a manageable level, resulting in weaker overall growth and slower inflation. This happens when high-interest rates compel people and companies to borrow less and conserve more, stifling economic growth. Loans are becoming more costly, while cash is becoming more appealing.
However, when interest rates fall, individuals and companies are more likely to borrow (as banks loosen lending restrictions), boosting retail and capital expenditure and helps the economy develop.
Interest rates determine global money movement into and out of a country; thus, currencies rely on them.
Interest rate adjustments by any of the eight global central banks impact the foreign currency market.
These shifts are an indirect reaction to other economic indicators monitored during the month, and they can affect the market quickly and dramatically.
Major pronouncements often influence interest rate movements by central bank officials. However, in reaction to economic indicators, they are frequently overlooked.
Whenever a board of directors from one of the eight central banks speaks publicly, it usually gives insight into the bank’s inflation outlook.
Federal Reserve Chair Ben Bernanke spoke before the House Committee on Monetary Policy on July 16, 2008. Bernanke read a prepared statement on the value of the US currency and answered questions from committee members at a typical meeting.
Although worries of a recession were affecting all other markets, Bernanke was certain that the US dollar was in good health and that the government would stabilize it in his statement and replies.
They closely followed the statement session. Because it was favorable, traders expected the Federal Reserve to raise interest rates, resulting in a short-term gain in the dollar ahead of the next rate decision.
Over the space of an hour, the EUR/USD fell 44 points in favor of the US dollar, resulting in a $440 profit for traders who responded to the news.
As you can see, EUR/USD went downwards after the statement and stayed down till October.
Recently, following its July 27-28, 2021 meeting, the Federal Reserve stated that interest rates would remain unchanged, with the federal funds rate set at 0 to 0.25 percent.
As you can see on the chart above, the price of EUR/USD skyrocketed after the decision.
Markets are always shifting in response to various events and conditions. Interest rates do the same thing — they fluctuate – but not nearly as frequently.
Because the market has already “priced” current interest rates into the currency price, most forex traders do not spend much time thinking about them. What matters more is where interest rates are anticipated to go in the future.
It’s also worth noting that interest rates tend to fluctuate in response to monetary policy, or more precisely, after monetary cycles.
If rates have been steadily declining for a long time, the reverse is almost certain to occur.
Many forex traders utilize a method of comparing one currency’s interest rate to the interest rate of another currency as a starting point for determining whether a currency will weaken or strengthen. The “interest rate differential,” or the difference between the two interest rates, is the crucial figure to keep an eye on.
This spread might help you see currency movements that are not always evident.
At some time, rates will have to rise. And you can bet that speculators will try to predict when and by how much this will happen.
An increasing interest rate disparity strengthens the higher-yielding currency, whilst a decreasing divergence benefits the lower-yielding currency.
When the interest rates of two nations move in opposing directions, some of the market’s most dramatic swings occur.
The optimal equation for sharp swings is an increase in one currency’s interest rate paired with a reduction in the other currency’s interest rate!
As a side point, reading a central bank press statement is critical for determining how the bank perceives future rate decisions. Following the short-term impacts, the data in the release will frequently trigger a new trend in the currency.
It’s important to consider the big picture as a forex trader. What is the state of the economy in the country? Why are interest rates being raised or lowered? Not to mention that you must be familiar with the country with whom you are matching the high-interest currency.
Consider that every currency pair will be influenced by interest rate choices that affect the relevant country while devising an interest rate trading strategy. As a result, traders should be informed of the dates of the next central bank meetings relevant to their forex trading.
After that, you should study the charts and analyze patterns using multi-timeframe analysis.
Looking at a chart with a period 4-6 times higher than the chart you want to trade on, for example, can give you a good sense of whether the market is in an uptrend, downtrend, or ranging market.
For example, while considering a long-term carry trade, it may be worthwhile to analyze the sustainability of an uptrend on a daily chart but trade on a 4-hour chart.
Below you can see two charts, daily and 4-hour. You can notice that on the daily chart, there is a clear uptrend. However, we won’t trade on it. Instead, we took our positions on the 4H chart for the long-term carry strategy.
Many variables influence the value of a currency, but interest is one of the most important, second only to risk.
You will be fine as long as you do not overdo it if you can grasp those two aspects while making trades.
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