Simply put, interest rates dominate the foreign exchange market.
The interest rate of a currency is likely to be the biggest determinant of the currency value of the currency. Therefore, understanding the monetary policy of a country’s central bank, such as interest rate decisions, is essential for fundamental analysis.
The factor that has the greatest impact on the central bank’s interest rate resolution is price stability, which we call “inflation”.
Inflation measures the increase in the price of goods or services.
Inflation can explain to us why your parents or your parents’ parents spent 5 cents in the 1920s to buy a bottle of soda, but now people pay more than 20 times the price to buy the same product.
A widely accepted view is that moderate inflation and economic growth have kept pace.
However, excessive inflation will harm the economy, which is why the central bank has always closely watched economic indicators related to inflation, such as CPI or PCE indicators. In order to control inflation at an appropriate level, the central bank is most likely to take interest rate hike measures, which will slow down the economy and inflation growth.
The reason for this is that setting the interest rate at a high level will usually force consumers and businesses to reduce borrowing and increase deposits, as well as inhibit economic activity. Loan costs have become more expensive, while holding cash has become more attractive.
On the other hand, when interest rates fall, consumers and businesses will be more inclined to borrow, because banks relax the terms of loans. This will drive the growth of retail sales and capital expenditures, and therefore help to stimulate the economy.
So, what does this have to do with the foreign exchange market?
Simply put, currency and interest rates are closely related, because interest rates determine whether global capital enters or leaves a country. The interest rate determines whether the investor invests in a certain country or elsewhere.
For example, of the two banks that offer a 1% deposit rate and a 0.25% deposit rate, which one would you choose?
You might say that I wouldn’t deposit the money in the bank. Isn’t it good to put the money under my bed? However, that is not our choice.
You would choose the 1% deposit rate, right?
We hope so, because 1 is greater than 0.25, and the currency interest rate is also divided into high and low.
The higher the interest rate of a country, the greater the probability that the country’s currency will strengthen. Low interest rate currencies are more likely to weaken in the long run.
It’s simple, isn’t it?
The focus of our study here is that domestic interest rates directly affect the views of global market participants on the currency of the country compared to other currencies.
Interest rate expectations
The market will continue to change as people expect different events or scenarios. The same is true for interest rates-interest rates also change-but it does not change frequently.
Most traders will not focus on the current interest rate level, because the market has “priced” the current price of the currency. They are more concerned about the future trend of interest rates.
We also need to know that interest rates will move with changes in the central bank’s monetary policy, and more specifically, will change with changes in the currency cycle.
If interest rates continue to fall, or have continued to fall for a long time, then interest rates will likely move in the opposite direction.
Interest rates will rise at some point in the future.
You can watch speculators predict when the central bank will raise interest rates and how many basis points will be raised.
The market will tell them that it is the nature of speculators to pay attention to the future trend of interest rates. The expected change means that its speculation strategy will start to change, and as interest rate changes are approaching, speculators will be more willing to adjust their strategies.
Although interest rates will adjust with gradual changes in monetary policy, market confidence may change suddenly, and this change is only due to a currency statement report.
This statement may herald a change in interest rates that will become more significant, even in the opposite direction as originally expected.
Some foreign exchange traders will use the spreads of different currencies to determine whether a currency will be stronger or weaker.
The spread is a factor that foreign exchange traders need to pay close attention to. Changes in interest rate spreads can help us judge the trend of currency pairs.
The expansion of currency spreads favors high-yield currency trends, while the narrowing of spreads favors low-yield currency trends.
The reverse movement of interest rates in the two countries usually leads to huge fluctuations in some markets. If one country raises interest rates and another cuts interest rates, it is likely that market volatility will be inevitable.
Nominal interest rate vs real interest rate
When people talk about interest rates, they are buying real interest rates or nominal interest rates.
Is there any difference between nominal interest rate and real interest rate?
The nominal interest rate does not always tell us the whole story. The nominal interest rate does not take inflation into account.
Real interest rate = nominal interest rate-expected rate
The nominal interest rate is usually the benchmark interest rate (such as the yield of bonds).
On the other hand, the market does not focus on nominal interest rates, but on real interest rates.
If you hold a bond with a nominal yield of 6%, but an inflation rate of 5%, then the actual yield of this bond is only 1%.
This is a big difference, so we must always remember the difference between the nominal interest rate and the real interest rate.