How Interest Rates Affect Forex Trading
They Affect Everything, Especially FX
Forex rates are always on the move. When traders are new, sometimes the moves seem mysterious and random. Many things affect the movement of exchange rates between countries. One thing that is always an underlying factor that is constant is the interest rate of a currency. In general, it's considered good practice anywhere to gain interest on your money. Investors everywhere tend to prefer money market funds, and bonds, and all types of investment instruments that offer paid interest in return for the use of the money.
An enormous advantage of having access to a forex trading account is that you can invest your money in foreign currencies that pay interest. The interest rate differential works out when you find a country that has a low-interest rate to sell. A set up like this is called carry trading. Carry trading is when you pick a currency pair that has a currency with a high-interest rate and a currency with a low-interest rate, and you hold it for the currency that pays more interest. Using daily rollover, you get paid daily on the difference in interest between the two countries. If you've employed some leverage, you can make a very good return versus the capital required to make the trade.
How Do Interest Rates Affect Currencies?
The easy answer is that it makes global investors pour their money into countries so they can get a piece of the return. As interest rates go up, interest in that country's currency goes up. If a country raises interest rates over an extended period of time, this can cause a broad trend against other currencies. Money just continues to pile into these currencies until there is any indication that the party might end soon.
The downside of this approach to trading is that it's very risk-sensitive. Anything that could affect economies globally can shake an interest rate trade to the core. This type of shakeup doesn't come often, but when it does, it leaves disaster in its wake for anyone that isn't prepared. During the financial crisis of 2008, high-interest currency pairs sometimes moved over 1000 pips a day as the world economy became very uncertain. For months after, anytime any step of the recovery looked shaky, similar smaller flip outs would happen.
Sometimes a country will have a high-interest rate but a falling currency. Such a disparity is usually an indication that the amount of interest they are paying isn't worth the risk required. The other thing it can indicate is that there are signs that rates will be lowered soon.
But I Thought Interest Rates Did Not Move Very Often?
While it is true that rates do not move much, expectations on the direction and slope of rate changes seem to change on a week-to-week basis. One of the most popular markets for watching changing interest rate expectations are 2-Year Government Debt like the US 2-Yr Treasury.
As a forex trader, it's good to look at the full picture. How is the country doing economically? Why are they raising or lowering interest rates? Not to mention, you need to know about the country that you're pairing the high-interest currency against. It is all a game of relation. Sometimes it's one of the currencies in the pair that is causing movement, and sometimes it's both, so it's always good to take the full picture into account.
There are always multiple factors that move a currency, but interest is one of the number one factors, only followed by risk. If you can understand those two factors when making trades, you'll be just fine as long as you don't overdo it.