Interest Rates and Forex

Forex prices are determined by a lot of variables, and in fact the importance or weighting of each variable itself changes in time. In other words, a fundamental value that is crucial to analyzing currency trends today may be of much less significance at another time. But in all this uncertainty, if there is one value that is always in the mind of the trader, it is the interest rate determined by the Central Bank of a currency.

At the basic level, interest rates decide the carry of a currency pair. That is, when you a buy a pair like the EURUSD, you receive interest on the Euros, and pay interest on the USD (since you sell it.) This difference, if positive, can bring great profits to the trader, especially if the returns are multiplied by leverage. But interest rates determine a lot more than just the attractiveness of a currency to carry traders. Crucially, they decide the cost of the cheapest money available to borrowers in a nation. If the central bank decides to raise rates, borrowing will be harder, and economic activity may slow down, which might lead to the depreciation of the currency in the long term, all else being equal. The lowering of rates may boost economic activity, as more corporations and consumers can borrow at cheaper rates and invest in the buoyant economic atmosphere that emerges. Interest rates also have an important role in initiating the different phases of the credit cycle. Higher interest rates may cause many borrowers to default which can cause banks to contract credit to protect their balance sheets, and all that can lead to recessions, or an economic slowdown. All of that, of course, has important consequences for forex trends. Finally, apart from their direct consequences on trade and economic activity, interest rates provide a valuable gauge for determining the economic health of a nation. While they are not exceptionally useful when used alone, interest rates are always an important component of the calculations that help determine the fundamental health of any economy.

Many central banks have a legal obligation to keep inflation low which ties their interest rate decisions to the inflation statistics of the nation. Often there are other, unstated concerns depending on how independent the institution is, and understanding and learning about them requires experience and practice, aside from the study of textbooks and forex courses. But in all cases, comprehending the relationship between interest rates and forex is the first step for any trader who wants to gain even a rudimentary skill in fundamental analysis, and no serious trader, technical, or fundamental, can afford to ignore the this important variable in the profit equation.

Author Box:
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