There are many factors that move the forex market, the key of which is interest rates. With central banks around the world hiking interest rates following a decade of persistently low global interest rates, it has become more relevant for investors and traders alike to keep watch for any interest rate changes.
As the interest rate is the overall lending rate of the country, it affects the value of the exchange rate by causing it to appreciate and depreciate based on changes and expectations. Understanding why and how these changes affect the currencies would help traders forecast future moves in the currency pairs.
What Happens To The Value Of The Currency When Interest Rates Change?
When the interest rate of a currency increases, the demand for the currency by investors increases because of its higher returns relative to other currencies. With increased demand, the value of the currency also appreciates. This flow of funds is known in economics as “hot money flows”.
On the other hand, when the interest rate of a currency falls, demand weakens as investors sell the currency in favour of other higher-interest-bearing currencies. The lower investor demand would cause the value of the currency to depreciate.
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Nominal Vs Real Interest Rates
Typically, when the interest rate of a country is discussed, it is referring to the nominal interest rate, which is the rate before adjusting for inflation. However, traders in the forex market focus more on the real interest rate, which is the nominal interest rate minus the expected inflation rate.
Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate
Therefore, it is important to distinguish between the two rates when analysing the fundamentals of a currency.
Why Do Interest Rates Fluctuate?
Changes to the interest rate of currencies are carried out by the respective global central banks as a form of monetary policy to control inflation and promote the stability of the country’s exchange rate.
When the economy is expanding fast or faces runaway inflation, the central bank may step in to increase the interest rate to moderate the pace of inflation while allowing the economy to grow at a moderate pace. By increasing interest rates, it would make the cost of borrowing high for both consumers and businesses, which helps reduce spending and inflation.
Similarly, the central bank may step in to lower interest rates when the economy is contracting or facing a deflationary environment to spur economic growth. With lower interest rates, businesses would be willing to borrow for their expansion, which increases employment and boosts economic growth.
The 8 major central banks, which heavily influence the forex market set their key domestic interest rates 8 eights a year, or every 6 weeks. The interest rate changes are usually dependent on other economic indicators such as Consumer Price Index (CPI), Consumer Spending, Employment Levels, and Personal Consumption Expenditures Price Index (PCE) that are announced throughout the month and are seen as indicative of the strength of the economy.
| Country | Central Bank | Interest Rates* |
| Australia | Reserve Bank of Australia (RBA) | 4.10% |
| Canada | Bank of Canada (BOC) | 5.00% |
| European Union | European Central Bank (ECB) | 4.25% |
| Japan | Bank of Japan (BOJ) | -0.10% |
| New Zealand | Reserve Bank of New Zealand (RBNZ) | 5.50% |
| Switzerland | Swiss National Bank (SNB) | 1.75% |
| United Kingdom | Bank of England (BOE) | 5.25% |
| United States | Federal Reserve System (Fed) | 5.50% |
*Accurate as of 14 September 2023
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Why Forex Traders Should Take Note Of Interest Rate Changes
Interest rate changes affect not only the exchange rate of the currency but also the direction of the trend. Understanding the factors including the expectations that affect currency values in the forex market allows traders to trade with the trend for higher success probabilities.
Moreover, understanding interest rate differentials, which simply mean the differences in interest rates between two countries, allows traders to profit by executing carry trades. It is a popular forex trading strategy where a trader borrows or sells a lower interest rate bearing currency to purchase another high interest rate bearing currency. For example, the US Dollar has a higher interest rate than the Japanese Yen, and going long on USD/JPY—buying the US Dollar and selling the Yen— would allow the trader to hold onto a positive carry trade.
Other Factors To Consider
It’s important to note that the effects of interest rate changes on forex are neither isolated nor guaranteed. Rather, several factors, including the expectation of the country’s future economic strength and stability, affect the overall demand and supply of the currency. This, in turn, would affect the exchange rate and volatility of the currency.
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