Interest rates drive the foreign exchange market. Global rates of interest rule the world of forex trading. The expert forex traders closely monitor the interest rates of every country to predict the right time to trade in the forex market. It is of utmost importance to keep an eye on the varied interest rates.
How does the interest rate affect forex trading?
The interest rates of the world
The monetary policy of the central bank is the driving force of the interest rates of the world. Whenever there is a change in the expected interest rate, the currency follows suit as well. The central banks wield a variety of tools of fiscal policy to influence the movement of interest rates.
The central bank generally performs two significant tasks. These tasks include the management of inflation and maintenance of the stability of the exchange rate of a country. The interest rate of a country is an estimation of the country’s economy. The central bank strives to increase the interest rate when the economy of a country grows and thereby induces inflation. On the other hand, the decline of interest rates during economic descent tends to stimulate the economy. Economies are always contracting or expanding. The central banks monitor the rates of inflation and permit the steady growth of the economy.
Economic cycle and interest rates
The consumers in the market begin to earn more when the economies rise, and the GDP witnesses a positive growth. The increase in earnings leads to an increase in the amount of expenditure, which eventually causes growth in inflation. The central bank strives to control the inflation growth and support the level of the target by increasing the interest rates.
When the economies recede, and the GDP witnesses a declination, the deflation in the market tends to be threatening for the forex traders. The central bank then steps in to decrease the currency interest rate for the stimulation of investments and spending. The low rate of interest attracts more and more investors. The forex market experiences a favorable growth in investment, which stimulates further economic growth and employment, leading to inflation. The forex trader needs to keep track of the impact of interest rate on the currency of a country. The higher the interest rate of the country, the greater is the probability of the growth of the currency.
Expectations of interest rate
The expectation of the occurrence of a variety of events constantly continues to change the dynamics of the market. A majority of the foreign exchange traders rarely consider the current interest rates. The forex traders usually try to forecast the overall direction of the interest rate, but it is more prudent to keep an eye on current events and updates for more efficient and profitable forex trading.
The forex trader needs to understand that the interest rate always shifts with changes in the fiscal policies of the central bank. If the interest rate keeps going down, then there will be a shift in the expectation, which will trigger a speculation shift as well. Besides, the gradual shift, there can be sudden shifts in interest rates as well, so it is better to stay alert all the time to make the most of forex trading.
Interest rate differentials
Forex traders often apply the widely popular trading technique of comparison of interest rates between two currencies. The comparison indicates whether the currency will weaken or strengthen while trading. The value of interest rate differential is the difference between the values of two interest rates. It also helps in calculating the probable shifts in currency interest rates. The foreign exchange market witnesses the biggest swings when the interest rates of two currencies move in opposite directions. And when the interest rate of one currency rises, while the other falls, the market experiences erratic fluctuations.
Nominal vs. Real Interest Rates
The nominal interest rate refers to the base rate or the interest rate of the currency before inflation. It is more profitable to focus on the real rate of interest instead of the nominal rate of interest during forex trading.
Keeping tabs on the interest rate is important for successful and efficient trading through forex trading brokers in the foreign exchange market.