Interest rates are an important driver for forex markets so it’s important that traders understand the effects of hikes and cuts on currencies. Let’s look at how interest rates affect currencies and a popular forex interest rate trading strategy.
How do interest rates affect forex?
Interest rates affect forex in that they shape how a currency’s value is perceived. So, changes in a country’s interest rate will impact the exchange rate between the domestic currency and other global currencies.
Effect of interest rate rises on currencies
Interest rate rises generally cause a country’s currency to appreciate against foreign currencies, because there is an increased demand for domestic money.
When a central bank raises rates, commercial banks hand off the higher rates to consumers and businesses too. This means that borrowers are charged more, but there are better returns on savings. Investors – both domestic and international – seek to take advantage of the higher rates by changing their higher-risk assets into the domestic currency and keeping it in savings accounts. This causes demand for the currency to rise and its value relative to other currencies to increase.
However, when interest rates are high it’s also important to look at the rate of inflation. Inflation causes a currency to lose its purchasing power. For example, if an interest rate is 2.5%, but the inflation rate is 5% too, the real interest rate is -2.5% because the currency is devaluing faster than interest is being paid on it.
Learn more about inflation and financial markets.
Effect of interest rate cuts on currencies
Interest rate cuts tend to cause a decline in the value of a currency, as it becomes less attractive to foreign investors.
When central banks cut rates, it becomes less appealing to keep money in savings and investors tend to move their capital into higher-risk assets. This leads to capital moving out of the domestic money market, and into assets denominated in other currencies. The value of the national currency declines relative to others.
But the relationship between interest rates and forex rates isn’t always straightforward. While a rate change will have a particular impact on the long-term outlook of a currency, short-term price movements are driven by whether the central bank’s decision was expected or comes as a surprise to markets.
For example, if analysts expect the Bank of England to raise rates by 0.50%, and they only vote to raise rates by 0.25%, then the price of the pound might fall – even though rate rises are typically positive for a currency’s outlook.
So, it’s important to be aware of when central bank interest rate announcements occur and what the likely outcome will be: a rate hike, a rate cut or a holding of the rate. Economic indicators that can give clues as to the direction of interest rates include the Consumer Price Index, the condition of the housing market, employment statistics, and consumer spending, so these are all worth keeping an eye on.
Once you know which way rates are expected to go, you can take your position. But remember, a surprise could send markets the other way, so it’s important to attach stops and limits to your position to protect yourself from adverse price movements.
To ensure you’re on top of the latest announcements, check out our economic calendar.
Forex interest rate carry trade strategy
The most popular forex strategy around interest rates is known as a carry trade. This is where a trader borrows or sells a low-interest-rate currency in order to purchase another currency with a higher interest rate.
Carry trades aim to make a profit on the difference between the interest rates. For example, Australia has a higher interest rate than Japan, so going long on a pair like AUD/JPY – buying the Aussie dollar and selling the yen – would allow your capital to appreciate faster than if it was denoted in the lower-yield currency.
Learn more about currency carry trades
How to trade forex with City Index
You can speculate on how interest rate decisions impact forex markets with City Index in just four easy steps:
- Open a City Index account, or log in if you’re already a customer
- Search for a currency pair in our award-winning platform
- Choose your position and size, and your stop and limit levels
- Place the trade
Or you can trade forex risk free by signing up for our demo trading account.