Discover how interest rates can affect forex trading

Currency exchange rates are vulnerable to an array of external forces throughout a trading session. Surprise economic announcements, sociopolitical turmoil and trade wars have a tremendous impact on trading volume and liquidity in the market. However, a more predictable and crucial factor to consider is interest rates and the monetary policy of the country’s central bank.

Discover how interest rates can affect forex trading

Interest rates and forex trading go hand in hand. They are one of the most important fundamental indicators that forex traders need to watch out for before deciding the direction of their trades.

It’s commonly understood that a country’s economy is always in a state of flux. Foreign investors prefer strong and expanding economies which means that high interest rates are preferred since they lead to increased foreign investments. However, uncontrolled economic growth may lead to inflation which can hurt an economy just as much as a recession.     

This is why central banks need to constantly monitor the economy and attempt to control inflation through monetary policy in order to keep the economy from growing too rapidly. Lowering or increasing interest rates accordingly is a crucial step in how central banks can achieve economic stability.

In general, central banks are quite transparent about their future decisions regarding interest rate policy which forex traders can take advantage of in order to make accurate predictions in the market.


What are interest rates?

Simply put, interest rates refer to an annual percentage of the amount a borrower needs to pay to the lender for the amount received. If you request a loan from a bank, a high interest rate isn’t ideal as that translates to a higher total over the loan’s repayment period.

The interest rates set by the central banks of each country refer to the percentage the commercial banks need to pay to get access to the central banks’ reserves. Therefore, while investors prefer high interest rates on their deposit for compounding profits – borrowers usually want their repayment rates to be as low as possible.

So, when a central bank increases interest rates, it effectively restricts the public’s access to loans by making them more expensive. Spending decreases, economic activity slows down which in turn keeps the economy stable and out of danger of inflation.  

Therefore, central banks are tasked with increasing interest rates in times of inflation to stagnate growth and cut them down to boost loans when further economic growth is necessary.

Economic Calendar


Interest rate fluctuations and forex

Announcements from central banks regarding their decisions on interest rates are thoroughly anticipated because of how monetary policy affects the overall market sentiment.

Governments and banks prefer stability and the same goes for retail traders. When central banks suddenly change their monetary policy or mess with the money supply, traders will react either by either buying or selling off and closing their positions before the currency appreciates or loses value respectively.

Thankfully, a central bank won’t change its interest rates considerably in one go, but instead make small corrections as needed. This is to prevent dramatic fluctuations in the markets due to rampant speculation.


Trading around interest rates

Traders who conduct thorough fundamental analysis to plan their trades should examine key economic data and how these can translate to future inflation or stagnation of the economy. Simply put, they need to think like a central bank. Turmoil that affects the international markets or a specific industry, the GDP growth and unemployment rates are all important factors to consider as these are the metrics on which the central banks will base their decision regarding future monetary policy.

Central banks also usually announce their targets and which direction they will go to achieve them. Therefore, an economic calendar is particularly important in terms of keeping track of any upcoming developments in monetary policy.

However, since any unexpected announcement will inject volatility in the market, traders would benefit from being able to predict the central bank’s decisions in order to open their positions beforehand and profit from any potential price moves.

This isn’t always the safest route though and most traders would likely prefer to wait for the market to correct itself and decide on the new direction before opening a new trade to limit their exposure to risk.


Final thoughts

Currency pairs and their exchange rate are particularly vulnerable to announcements from central banks and especially those that are coming from the Fed, the central bank of the United States.

Interest rates play a fundamental role in a currency’s performance over time and short-term traders as well as swing traders should keep track of an economic calendar to stay abreast of any new developments.

Even more important, however, is to know the market’s outlook regarding any new updates. Because, if the actual announcement doesn’t match the market’s expectations, the price is likely going to rise or drop dramatically as the buyers and sellers battle it out.

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