How Interest Rates Affect Forex Trading

However, one aspect that always remains consistent is the currency’s interest rate. Generally, a constant interest rate is a good thing for traders to make money. Investors from all around the world prefer to invest in bonds, money market funds and all other investment instruments that provide interest in exchange for money.

A good benefit of opening a forex account is that it lets you invest funds in foreign currencies which offer interest. This is known as carry trading. Carry trading signifies a practice where the trader picks out a currency pair, one with a high-interest rate and the other with a low-interest rate, and he holds it for a currency that pays more interest. You are paid every day on the difference in interest between both countries. In case you have employed leverage, the traders make an excellent return compared to the capital needed for making the trade. You know the interest rate differential is working out when you are able to identify a country that offers a low-interest rate.

Video Credit – Financial Source

How Do Interest Rates Influence Foreign Currencies?

The most simple answer to this question is that it lets global investors invest money in foreign countries in order to earn more profits on their investment. As the interest rate of a country goes up, so is the interest rate of the currency of that particular country. Additionally, if the interest rate of a country rises over a long period of time, it may cause a conflict with other currencies. Funds keep on piling into these countries until the indication that the party may end soon.

“The four most dangerous words in investing are, it’s different this time.” — Sir John Templeton

The ultimate demerit of this thing is that it is highly risky. Anything that can affect the global economy tends to influence the currency’s interest rate to the maximum. Such a shaky situation is very rare, but if it happens, it can be disastrous, especially when you are unprepared for it. Often, such a situation can leave the forex trading highly volatile for the months to come. Sometimes, there might be a situation of a high-interest rate but falling currency. Such a situation indicates that the interest amount the country is paying is not at all worth the risk. One other thing that it shows is that the interest rate is going to fall soon.

Many people have a perception that interest rates do not move quite often. Although it is a fact that the interest rate of a country does not fluctuate regularly, the expectations on changes in the direction and slope are quite likely to be changing on a weekly basis. The most prevalent market where you can see the changing interest rate expectations is two-year Government Debt, such as the US 2-Year Treasury.

Being a forex trader, it is your responsibility to take into consideration everything and view the picture from a broader perspective. For instance, you need to see how the country is performing economically. Also, you need to check the reasons for changes in interest rates. But above all, you must be aware of the country with whom you are pairing high-interest currency against. Everything in forex trading is about relations. Quite often, it’s one currency in the currency pair that causes movement, and sometimes it can be both. Therefore, it is certainly an excellent idea to have the entire scenario in mind.

Conclusion:

There are various factors that cause a currency to move; however, interest always surpasses the list, followed by risk. Therefore, if you get a grasp of both these factors while making trades, you are going to be fine, provided you don’t overdo it.