if you were to make an investment you would put your money into an asset with a higher rate of return.
- Rising interest rates offer an opportunity to make more money from the investment which increases the demand for the currency. Like all markets Forex is driven by supply and demand, so the increase in demand leads to the currency appreciating in value.
- When interest rates are lowered by a reserve bank, investors are not attracted because this does not offer them an opportunity to make high returns.
As a result, they will not invest and may even pull out some of their money denominated in that currency and reinvest into a higher-yielding currency. Consequently, there is a lack of demand and a high supply (sellers) in that currency. The forces of supply and demand then depreciate the value of that currency.
For Example
If we look at what is happening to the Turkish lira.
- Turkey’s President Recep Tayyip Erdogan renewed calls for lower interest rates, pushing the lira to a fresh low against the dollar and piling pressure on his central bank governor to ease policy despite high inflation.
- As a result, inflation at more than three times the official target of 5%.
- Premature rate cuts in the past resulted in a weaker lira, which eventually pushed consumer prices higher, forcing the monetary authority to undo rate cuts with even bigger hikes.
How does all this affect my trading?
Forex trading involves putting two currencies against each other and measuring their value relative to one another.
A currency with a higher interest rate attached to it should in theory increase in value against a currency with lower interest rates.
This is not always the case as there are too many factors that affect Forex prices. But historically over long timeframes, this relationship usually plays out. – so, this may be something to think about when taking higher timeframe trades.
To what extent will interest rate changes impact my trading?
Forex trading involves putting two currencies against each other and measuring their value relative to one another.
- A currency with a higher interest rate attached to it should in theory increase in value against a currency with lower interest rates.
This is not always the case as there are too many factors that affect Forex prices. But historically over long timeframes, this relationship usually plays out. – so, this may be something to think about when taking higher timeframe trades.
Your trading style will affect this question. If you are more focus on the fundamentals when trading, this will affect your style a lot more then if you are a technical based trader. When trading around interest rate change announcements, you may want to say well clear.
Long term technical traders will also pay more attention to interest rates than short term technical traders because as we discussed over longer periods if one currency has a higher interest rate it will usually increase vs the currency with a lower interest rate.
It will take experience in the market to determine your formula to successful Forex trading and how much you take interest rates into account, all that is required is hard work and patience.
Kamran Wadud | Financial Markets Trader & Mentor
