Interest rates are one of the key fundamentals that many Forex traders pay close attention to. The Foreign exchange markets are particularly influenced by any change interest rates made by the world’s largest central banks. Any change made by the central banks when setting interest rates is an indirect response to other economic indicators, thus rates changes can impact the markets significantly. Often it is unexpected interest rate changes which lead the markets to react with the most volatility, while this volatility can increase risk it also gives traders a chance to make impressive returns.

Introducing Interest Rates

Monitoring Central Bank interest rates is a must for anyone trading the Forex markets. A higher interest rate allows investors holding a particular currency pairing to accrue a higher return on their investment. This of course involves risk, there is always the possibility that exchange rates will fluctuate against the investor offsetting any returns made from the higher rate of interest. This can make buying currencies with a high interest rate using a currency with a lower interest rate a risky proposition. This isn’t to say that the average trader should ignore interest rates, but rather they should advance with a degree of caution.

How Do Central Banks Set Interest Rates

Interest rates are set by a Central Bank’s committee or board who are responsible for controlling the countries monetary policy. Interest rates are one of the most powerful pieces of monetary policy available to central banks, with Central Bank’s increasing interest rates to curb inflation and slow growth while lowering interest rates to encourage spending thus injecting money into the economy.

When making a decision about interest rates central banks take note of a variety of different factors:

  • Inflation: As typically measured by the CPI or RPI.
  • Consumer Spending.
  • Unemployment Levels.
  • Consumer Confidence.
  • And other fundamental data.

It is important to note that central banks operate with slightly different mandates. This means different central banks place a differing amount of importance on the various data points available to them.

Predicting Interest Rates

It is often possible for a trader to predict the action of a Central Bank, as the majority of the indicators taken into consideration are publicly available. Generally as the condition of the economy improves Central Banks will tend to either leave interest rates unchanged or raise rates in order to curb inflation. Conversely if the economy begins to deteriorate interest rates will be lowered in order to encourage consumers and businesses to borrow and ultimately increase spending.

It can also be possible to get an indication of what a central bank will do by paying attention to forecasts. Brokerages and other financial institutions often release forecasts which are a prediction of what the bank will do at the next meeting. These firms release forecasts to help their clients get an idea of what the relevant central bank will do, allowing clients to take the appropriate action. These forecasts tend to be quite accurate, though central banks have a tendency to surprise analysts on occasion.

Unpredicted Rate Changes

No matter how well you have prepared yourself there will be occasions when even the best research couldn’t have predicted the action taken by a central bank. It is on these occasions when the markets will react with the most volatility. This makes it very important that traders have an idea of what action to take when the unexpected happens.

When something unexpected happens, you should ideally have a contingency plan in place. If the Central Bank decides to suddenly and unexpectedly hike interest rates, will the currency appreciate or depreciate?  Planning for all possible outcomes should help you deal with the situations where central banks take unexpected action.

During a news release, it is important:

  • To Act Quickly: The market tends to respond incredibly quickly when the unexpected happens, with huge volumes being placed as traders rush to be the first to react to the breaking news. Being among the first to react can be extremely profitable, provided the trader reacts appropriately.
  • To Watch out For Trend Reversals: While unexpected news may initially send the markets flying in a particular direction, there is always the possibility that the markets may reflect on the data and decide the reaction was unjustified.

Concluding Thoughts

Interest rates as set by Central Banks have the power to move financial markets, and Forex traders should ensure they stay on top of interest rate forecasts and act appropriately. It is also important to plan for unforeseen events, allowing you to have a plan of action should a Central Bank unexpectedly lower or hike interest rates.

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