Understanding Interest Rate Futures in the FX Market

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Interest Rate Future Help Guide FX Values.

 Talking Points:

Why Interest Rates Matter

Interest Rate Futures

Trading This Information

Before many traders come to the market they make a home in, they often associate news with price. In other words, good news yields higher prices and bad news yield lower prices.  A series of good news announcements or positive economic surprises would result in enough of a price increase to create a bull market whereas a series of bad news announcements can lead to a bear market.

If a market really begins to runaway, the central bank behind that market may end up cutting or hiking interest rates. 

Why Interest Rates Matter

Interest Rates are set by a central bank and are meant as a tool for price stability.  One need not look hard to see that interest rates are low, if not negative in some major economies like the Eurozone, Japan, and the United States right now.  The reason for these low levels is that central banks are trying to stoke inflation or the rise of prices in order to "ensure" a healthy economy. 

As you recently heard about in the Carry Trade note, higher interest rates attract capital from all over the world. Lower interest rates can drive capital away to other higher yielding economies. Because we're focusing on the FX market, we will not spend too much time talking about the domestic effects on interest rates but rather their role in the global economy.

As FX Traders, you can look at Interest Rates as a barometer of the health of an economy and the higher the rates, within reason, the hotter the economy and the lower the rates, the lower performing the economy or the economy can be seen as in need of stimulus. 

Interest Rate Futures

Now that you know what the current interest means, the more important question for FX Traders is what the future path of Interest Rates is believed to be.

To this information, we can look to Interest Rate futures or the Overnight Index Swaps market. the Overnight Index Swaps can help you to see what's being priced in at either the next central bank meeting for a respective economy or the perceived rise or fall over a 12-month period.  While this is not predictive, but rather what is perceived over the recent string of economic news releases mentioned earlier, the change in direction often influences the FX market very heavily. 

Trading This Information

When the data gets bad enough, like it recently has in Australia due to a variety of factors, the Central Bank begins to discuss how they will stimulate the economy.  The method du jour if available to stimulate the economy is to cut interest rates. For example, over the next 12-months, the Reserve Bank of Australia is expected to be cut nearly 50bps. On the other hand the Federal Reserve over the same period of time is expected to rise nearly 50bps. This has kept the focus on AUDUSD to the downside as the path of the two central banks interest rates diverge. 

While Interest Rates ultimately are in the hands of the central banks, the futures market can help you see what's being expected by the market.

Another path to see what the central banks are planning to do is to learn what is important to the central bank and watch the respective news announcements.  For example, even without access to futures market pricing, many traders knew that inflation is the sole mandate for the central bank and when the inflation measurement readings began to underwhelm in the Eurozone, many guessed and rightly so that the ECB would have to cut rates which drove the EUR lower across the board. 

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Summary

Interest rates and their future direction is critical to the attraction of capital.  Rising interest rate expectations often are accompanied by rising currency values. Traders can look to economic news releases that are considered important by central banks like employment and inflation to gauge the trend trend or look to futures market pricing.

 

Happy Trading!