The exchange rate between two currencies is determined by the interaction of several variables. Some variables have more influence on the determination of currency rates than the others. One such variable is the interest rate.

In general, changes in the interest rate create huge fluctuations in the value of all currencies. In fact all major currency crises have invariably been preceded by a major change in the interest rates. Simply put, money attempts to follow the currency with the highest real interest rate. The real interest rate is the nominal interest rate less inflation. Forex traders must keep an eye on each country’s central bank interest rate and more importantly, when it is expected to change, to forecast moves in currencies.

In this article, we will look why interest rate changes influence the Forex market to such an extent and we touching upon:

• Definition of Interest Rates and Interest Rates Calculation
• Forex interest rate differentials.
• How traders can forecast central bank rates and the impact on the FX market.
• Key forex interest rate trading strategies.

What are Interest Rates?

Interest rates are the cost of borrowing money. They represent what creditors earn for lending you money. These rates are constantly changing, and differ based on the lender, as well as your creditworthiness. Interest rates not only keep the economy functioning, but they also keep people borrowing, spending, and lending. But most of us don’t really stop to think about how they are implemented or who determines them.

Interest Rates determination

1. Short-Term Interest Rates: Central Banks

In countries using a centralized banking model, short-term interest rates are determined by central banks. A government’s economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so the supply of money within the economy is neither too large, which causes prices to increase, nor too small, which can lead to a drop in prices.

In the U.S., interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates. The actions of central banks like the Fed affect short-term and variable interest rates.

If the monetary policymakers wish to decrease the money supply, they will raise the interest rate, making it more attractive to deposit funds and reduce borrowing from the central bank. Conversely, if the central bank wishes to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money.

The Fed funds rate affects the prime rate—the rate banks charge their best customers, many of whom have the highest credit rating possible. It’s also the rate banks charge each other for overnight loans.

2. Long-Term Interest Rates: Demand for Treasury Notes

Many of these rates are independent of the Fed funds rate, and, instead, follow 10- or 30-year Treasury note yields. These yields depend on demand after the U.S. Treasury Department auctions them off on the market. Lower demand tends to result in high interest rates. But when there is a high demand for these notes, it can push rates down lower.

If you have a long-term fixed-rate mortgage, car loan, student loan, or any similar non-revolving consumer credit product, this is where it falls. Some credit card annual percentage rates are also affected by these notes. These rates are generally lower than most revolving credit products but are higher than the prime rate.

Many savings account rates are also determined by long-term Treasury notes.

3. Deposit & Loan Rates: Retail Banks

Retail banks are also partly responsible for controlling interest rates. Loans and mortgages they offer may have rates that change based on several factors including their needs, the market, and the individual consumer.

For example, someone with a lower credit score may be at a higher risk of default, so they pay a higher interest rate. The same applies to credit cards. Banks will offer different rates to different customers, and will also increase the rate if there is a missed payment, bounced payment, or for other services like balance transfers and foreign exchange.

4. Individual Factors

For any individual loan, whether it be a personal loan or mortgage or corporate bond issue, interest rates may deviate from the baseline rates set by the processes above. For instance, a high-risk borrower with a low credit score will pay higher rates on a loan with the same terms as a low-risk borrower with a high credit score. In addition:

• Longer maturity loans will also have higher interest rates than short term loans.
• Loans secured by collateral will have lower interest rates than unsecured debts.
• Bonds with embedded options will have higher interest rates than those are non-callable.

Interest Rates Calculation

Each central bank’s board of directors controls the monetary policy of its country and the short-term rate of interest at which banks can borrow from one another. The central banks will hike rates in order to curb inflation and cut rates to encourage lending and inject money into the economy.

Typically, you can have a strong inkling of what a bank will decide by examining the most relevant economic indicators; namely:

• The Consumer Price Index (CPI)
• Consumer spending
• Employment levels
• Subprime market
• Housing market
  

Predicting Central Bank Rates

Armed with data from these indicators, a trader can put together an estimate for a rate change. Typically, as these indicators improve, the economy will be performing well and rates will either need to be raised or if the improvement is small, kept the same. On the same note, significant drops in these indicators can portend a rate cut to encourage borrowing.

Outside of economic indicators, it is possible to predict a rate decision by:

1. Watching for major announcements
2. Analyzing forecasts

Major Announcements

Major announcements from central bank leaders tend to play a vital role in interest rate moves. However, they are often overlooked in response to economic indicators. Whenever a board of directors from any of the eight central banks is scheduled to talk publicly, it will typically provide insights into how the bank views inflation.

Analyzing Forecasts

The second way to predict interest rate decisions is by analyzing predictions. Because interest rates moves are typically anticipated, brokerages, banks, and professional traders will already have a consensus estimate as to what the rate will be.

Traders can take four or five of these forecasts (which should be very close numerically) and average them for a more accurate prediction.

Why interest rates are important

• Interest rates determine the number of resources needed for related credit expenses, such as paying minimum loan payments towards outstanding debts.
• The Fed Funds Rate is the main mechanism to implement monetary policy between the government authorities and the market.
• In modern economies, have a well-controlled monetary policy that is public and transparent provides the flexibility of a free market without overly restricting commerce and trade.

Conclusion

Following the news and analyzing the activities of the central banks should be a high priority for forex traders. As banks determine the monetary policy of their region, currency exchange rates move. As currency exchange rates move, traders have the potential to increase profits not only by earning interest from car carry trades, but also from real fluctuations in the market. A thorough research analysis will help a trader avoid surprise rate moves and deal with them correctly when they inevitably occur.