Interest rates are one of the key drivers of currency markets and include both a speculative and current affect on all currency pairs. The base interest rate is the amount that lenders of a currency can expect to receive as payment for their loan. These rates are set and manipulated by the largest banks that oversee and attempt to maintain the health of the economy through the adjustment of these rates, known as monetary policy. Whilst governments can change tax rates and other fiscal means to direct the economy, the central banks control the supply and demand of the national currency in order to achieve its economic goals. They may, for example, attempt to stimulate economic growth by decreasing the demand and thus devaluing the value of the currency in order to increase international sales of exports.
The real reason why base rates affect forex markets
Interest rates directly influence the demand for currencies in two ways. Firstly, they provide an actual demand for the currency in the knowledge that the worlds largest investors, such as countries and banks, will look for the highest rate of return on their investment with the lowest risk. Interest rates therefore determine how attractive a currency appears to these investors and by increasing or decreasing the base rate of interest this can be achieved. In the same way as holding money in a regular bank account these investors need to purchase the currency in order to gain the preferential interest rate. Therefore, raising the base rate even only very fractionally results in an increase in demand for that currency which is instantly reflected in the value between forex pairs.
The speculative influence of base rate changes
The second way in which interest rates operate is that they provide a speculative basis for many forex traders. Examples of how interest base rate speculation can influence the value of currency pairs are evident through the markets interest in key economic indicators. Events and news releases such as the non-farm payroll data, CPI levels and GDP figures all provide fundamental traders with a basis to speculate on future interest rate decisions by the central banks. This is due to the relationship between interest rates and inflation in every economy throughout the world. High inflation, created through strong employment and consumption figures, is often controlled directly by adjusting the cost of borrowing within an economy. High costs of borrowing, through increased interest rates, have the effect of “cooling” an economy by slowing consumption and at the same time making exports appear expensive to international buyers (the effect of increasing the strength of the currency).
Trading the announcement
Interest base rates are therefore one of the most important drivers of currency values. Fundamental traders will use this information to look for long-term trends in forex pairs whilst technical traders may trade the decision days themselves. Announcements by major central banks, such as the Federal Reserve or European Central Bank, on base rate changes have a similarly volatile effect on currencies as that of key indicators such as unemployment figures. One of the key differences in the release of interest rate decisions, however, is the fact that it is generally only interpreted as positive or negative rather than incorporating several different perspectives. Furthermore, the rationale for the change, as explained in the minutes of central bank meetings can be equally, if not more influential, than the event itself. This can also provide great opportunities for forex traders to interpret these correctly and take long or short positions on currencies.
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Risk Disclosure Notice: CFD’s can put your capital at risk if used in a speculative manner.