Interest rates are one of the most significant fundamental and macroeconomic factors that affect Forex trading. Let’s look at how interest rates work and how to apply them to Forex trading.
Interest Rate Basics
The term “interest rate” can have several meanings depending on the context. For example, it could mean the interest rate for home mortgages, credit cards or car finance. All these interest rates are linked, but it’s not the type of interest rates we’re referring to when discussing trading. For the financial markets, the interest rates of concern are the rates set by a central bank that determine how banks can lend to each other.
How are a country’s primary interest rates set?
Most nations have a central bank that sets interest rates for the country. In the U.S., this is the Federal Reserve. The U.K. has the Bank of England, Canada has the Bank of Canada, Japan has the Bank of Japan, and so on. Countries in the European Union are unique because the European Central Bank sets the key interest rates for the eurozone.
How do interest rates impact inflation?
For many decades, governments have mandated central banks use interest rates as a primary tool in monetary policy. Interest rates are raised to slow down spending and keep inflation low, stable, and predictable. Understanding inflation is essential to understanding how and why interest rates move.
What is inflation?
Inflation measures how much more expensive a specified set of goods and services has become over a certain period, usually a year. Each country’s government will have a standard formula to decide which goods and services to include when measuring inflation. The measure of inflation is also known as the “Consumer Price Index” or CPI. For example, in the U.S., the Bureau of Labor Statistics calculates CPI. If inflation is 2%, a basket of goods and services measured by the CPI is 2% more expensive than last year.
How Interest Rates Are Determined
Each country will have a different procedure for determining their interest rates, but we’ll use the U.S. as the main example, as many countries operate similarly to the U.S.
How are interest rates set?
In the U.S., the Federal Reserve has a committee known as the Fed Open Market Committee (or FOMC for short) that meets eight times a year. They will look at macroeconomic factors and inflation data to determine where rates should be to keep inflation at a target rate (usually 2%) and help ensure full employment.
How do central banks lower inflation?
Raising interest rates increases borrowing costs in the economy, which, in theory, helps dampen spending. Less spending should mean falling prices.
Can central bank rates be predicted?
Controlling inflation is not an exact science—there can be a time lag between interest rate changes and inflation. Also, the FOMC must consider whether a change in inflation will continue along the same trajectory or whether a change in inflation is more temporary and will return to normal.
Nevertheless, there will be clues to how interest rates could move. Here are a few:
Central bank meeting minutes: Central banks publish meeting minutes that explain their thinking about the economy and whether rate changes are likely. For example, the FOMC generally publishes meeting minutes three weeks after the day of the policy decision. The meeting minutes can push the market in new directions as traders absorb the information.
Published forecast views: Many news sites, such as Bloomberg and Forex Factory, publish forecast rates to help give traders an idea of where interest rate announcements may land.
Futures contracts that show “implied” rates. Various derivative products specialize in interest-rate pricing. Because the derivatives are forward-dated, the pricing reveals how the market thinks interest rates will land. An example is the Chicago Mercantile Exchange’s 30-Day Fed Funds futures. Traders use these futures contracts to hedge short-term interest rate risk. But they are also a direct reflection of collective marketplace insight regarding the future course of the Federal Reserve's monetary policy.
How do interest rates affect Forex and exchange rates?
Higher interest rates are generally bullish for a currency
Higher interest rates offer depositors and lenders a higher return. Therefore, higher interest rates attract foreign capital and should cause the currency's value to rise.
For example, if inflation numbers are unexpectedly high, we might assume that the central bank will want to raise rates. This could have a bullish effect on the currency’s value. Alternatively, if a central bank raises interest rates unexpectedly, this will also cause the currency's value to rise.
Lower interest rates are bearish for a currency
For the same reasons that higher interest rates are bullish for a currency, lower interest rates offer lower returns on capital, which would cause foreign capital to leave. This will lower the price of the currency relative to others.
Forex Interest Rate Trading Strategies
There are lots of ways to incorporate interest rates into Forex strategies. Here are a few:
Carry trades
This is one of the most popular trading strategies based on interest rates. A carry trade means going long a high-interest currency while shorting a low-interest currency to pick up the difference in interest rates. Let's say USD Fed rates are 5% and the Bank of Japan's rates are 1%. By going long USD/JPY, a trader will pick up 5% on their nominal (unleveraged) USD position and only pay 1% interest on the short JPY side, i.e., they will net 4% interest on the trade per year. Of course, the risk is that the spot USD/JPY rate decreases while collecting the interest, making the trade unprofitable. The other danger is that interest rates in either the U.S. or Japan change against the trade. It's worth mentioning that brokers rarely pass on positive interest rate differentials to the trader in full, so in practice, a carry trade is rarely as advantageous as in the example I gave.
Interest rate CFDs
Although this is strictly not a Forex trade, some brokers offer interest-rate CFDs. These are a bet on a country's interest rate without having to trade a Forex pair.
A fundamental view on inflation or interest rates
You may have a strong fundamental view of how a country's inflation or interest rates unfold. During 2020's pandemic, many believed that the U.S. Federal Reserve underestimated inflation and would eventually have to raise rates more than planned. Remember, this is all relative: the same thing could happen in other countries, so the higher rates in the U.S. would be matched by higher rates elsewhere. But certainly, unexpected inflation helped push interest rates higher.
Bottom Line
Interest rates significantly impact a Forex pair. Higher interest rates in one country relative to another will have a bullish effect because this provides a higher return. Central banks use interest rates primarily to control inflation, so inflation data will similarly affect a Forex pair. If a trader feels that a country’s interest rate will rise, they should have a bullish bias. Alternatively, they can directly bet on interest rate movements through interest-rate CFDs. Traders can also trade interest rates by buying a high-interest-rate currency and selling a low-interest-rate currency in a “carry trade.”
FAQs
Do interest rates affect the Forex market?
Yes, interest rates are one of the biggest fundamental pieces of macroeconomic data.
How do higher interest rates affect Forex?
Higher interest rates raise the value of a currency because it means holding it gives a better return.
Does the market drop when interest rates rise?
The stock market usually does not perform well under a high-interest-rate environment.