Forex Trading Basic

Fundamental Analysis : Interest Rates

Forex Trading Breakout Strategy

Fundamental Analysis of Interest Rates: Central banks make a law for their monetary policy to control the overnight or short term interest rates. They use these rates to give loan to commercial banks to influence mortgage rates and other types of loans. The monetary policy of a central bank will target to control inflation or to promote economic growth. For example, the European Central bank (ECB) aims to keep the inflation under 2% while the U.S. Federal Reserve has a different way to promote economic growth and maintain price stability.

Fundamental Analysis of Interest Rates: Impact on Forex and Economy

Interest rates and the monetary policy which fix them to have a profound effect on a currency’s relative value and on domestic economic activity. Interest rates influence currencies directly in attracting investors to the higher interest bearing currencies and bonds, causing the higher interest currency to go up, or scaring away such investors with lower interest bearing currencies and bonds, causing the low interest currency to go down. Besides, domestic interest rates influence overall economic activity, with the lower rates typically reviving borrowing, investment, and consumption, while higher interest rates disposed to reduce borrowing and increase saving over consumption. As because lower rates push down the currency price, it’ll make exports cheaper for foreign consumers, which will help to be balance in trade.

For traders, the rules of trading are given below:

Interest RateCurrency EffectInflation EffectGrowth Effect
Higher Rate Strengthens CurrencyStablizes InflationSlows Growth
Lower Rate Weakens Currency Increases Inflation Stimulates Growth

The difference in interest rates between one country to another is known as the interest rate differential, and investors will usually be attracted to the currency pair that exhibits a good interest rate differential.

Comparison of Current and Historical Interest Rates:

One should initially try to eyeball the present differences in interest rates within each pair, paying attention to the pairs shows that the greatest positive interest rate differential. For example, below is a ranking of the major country’s interest rates, courtesy of www.tradingeconomics.com :

Fundamental Analysis of Interest Rates

From the graph above one can instantly see that there is a huge gap between the 4% positive interest rate differential between Australia’s 4.25% and United States’s 0.25%, advised that going long the AUD/USD would be the best carry trade.

Next should drill down into the historical interest rates, preferred in overlaid graph format, to see the content of how the two country’s interest rates have changed relative to each other over time. I turned to my trial subscription of tradingeconomics.com to get a peak at the graph overlay of AUD interest rates which was set against USD interest rates with the AUDUSD exchange rate in the background:

7575

One can oversee from the above graph that the two rates fell dramatically in 2008, with USD falling from 5% to near zero and AUD falling from 7.25 to 3. It wasn’t till Oct-2009 that you can look that AUD was climbing back out of its own lower point while the USD remained in the basement, to give signal then to investors that were the time to take the long carry trade on AUDUSD.

Economic Calendar News: Fundamental Analysis of Interest Rates

Interest Rate Decisions

  • Impact on market: High
  • Impact on Countries: All
  • Frequency of Impact: Varies

The most important event about interest rates in the economic calendar is the Central Bank Interest Rate Decisions. Here the central bank policy board makers come to a decision on where to set the rate. Traders look very carefully for a difference in the forecast and actual rate, driving the domestic currency up on a bigger than expected rate and driving it down on a smaller than expected rate.

Difference between forecast and actualCurrency EffectReason
Higher than forecast ratePositive/bullish for currencyForeign investors now want to own a higher interest bearing currency (and bonds)
Lower than forecast rate Negative/bearish for currencyForeign investors are now less inclined to invest in a lower interest bearing currency (and bonds)

Central Banker Speeches

  • Impact on market: High
  • Impact on Countries: All
  • Frequency of Impact: Varies

Time to time, central bank chairman or president may give a public speech to give them hints as to future monetary policy. He may say to concern about raising inflation, provoking speculation that he might higher the interest rates to curb the inflation, or he may say about the state of the economy and raising unemployment, provoking speculation that he might lower interest rates to stimulate borrowing and investment into the economy.  Comments determine a short term positive or negative trend. Be very careful, however, as the volatile result from the interpretation of statements can be dangerous to short term trend traders.

Other Forces in Fundamental Analysis of Interest Rates::

  • Inflation – higher percentage changes can prompt central bankers to increase interest rates to curb inflation
  • Current Account and Balance of Trade – lower numbers can prompt some central bankers to lower interest rates in orderto deflate currency and increase exports
  • Unemployment – higher unemployment numbers can prompt central bankers to lower interest rates to spur investment and employment.

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Please note that: gaining profit from fundamental analysis largely depends on your brokers MT4 platform functions. If your broker is vulnerable to high slippage problem during the time of news release, you are not going to get expected result from trading. So, while Choosing Forex broker, we would like to recommend you to start trading with a broker that has slippage guard. We recommend you to trade with HYCM Broker to get the best possible outcome of forex trading fundamental analysis. Read review of HYCM Broker to learn more on this.

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Chapter 6

Forex Trading Fundamental Analysis

Lesson 1.Forex Trading Fundamental analysis
Lesson 2Forex Trading Fundamental analysis
Lesson 3Fundamental Analysis of Interest Rates
Lesson 4Fundamental Analysis of Inflation Rates
Lesson 5Fundamental Analysis on Balance of Trade
Lesson 6Fundamental Analysis on Government Factors
Lesson 7Fundamental Analysis: Employment / Unemployment
Lesson 8Fundamental Analysis on GDP
Lesson 9Fundamental Analysis on Geopolitical Risks

Go back to Main Page: Forex Trading for Beginners

About the author

Syed Nazim

Syed Nazim is the Marketing Manager of RedMaroon, a Digital Marketing Agency for Financial Institutions. He is also involved with Forexing24.com as a writer and financial Analyst. He is a brilliant marketing geek with vast experience in every sector of Digital Marketing. He likes sharing strategies, tactics and proven methods to help you build a business and live the life of your dreams.

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