How the interest rate affects the exchange rate
Good day, comrades traders!
The topic of interest rates often arises on the agenda of various media outlets and many are already aware that this is closely connected with the global economy and finances and somehow influences the processes taking place in the foreign exchange markets.
But what do interest rates really mean and why do they affect Forex trends?
Below is a small analysis of the forces that drive monetary policy and trends in markets, including Forex.
The official interest rate of the central bank (discount rate, refinancing rate)
This is the percentage at which the central bank grants loans to commercial banks. Those, in turn, issue loans to commercial companies, focusing on this official rate. If the rates are high, then loans are more expensive, goods in the markets are also less competitive. Demand for loans falls, inflation slows down and, consequently, the currency rises in price.
And vice versa, if rates are low, then commercial banks and then companies take loans at lower interest rates (sometimes negative), which allows them to sell goods cheaper, the Central Bank prints more money and inflation accelerates - the currency becomes cheaper.
Monetary policy: why and how are rates regulated
Rates are high and low. However, these values are always relative, and therefore it is important to take into account rather the historical dynamics and growth / decrease in relation to their historical values.
Photo from the March meeting of officials of the Federal Committee on monetary policy of the United States (FOMC)
The central bank raises interest rates to prevent the economy from overheating. This happens when there is no room for growth in the economy and prices begin to rise outside the real increase in the production of goods and services, which leads to accelerated inflation and a decrease in the currency exchange rate.
Rising rates hinder inflation and make the currency more attractive in the eyes of investors, and commercial banks place investor funds on deposits at a higher percentage.
The rate cut, on the contrary, is stimulating in nature and serves to accelerate economic processes, cheap loans for businesses, low taxes, reduce unemployment and increase business activity. This accelerates inflation and reduces the exchange rate.
When and how often bids are adjusted
Central banks independently determine the timing of the revision of the interest rate. For example, the US rate is regulated by the Federal Open Market Committee (FOMC). And is it worth saying that the whole world is watching their meetings. And usually the special committees of national central banks adopt a particular monetary rate at the beginning of the financial year, but in which case they can change it later.
In the EU, the refinancing rate is regulated by the European Central Bank. In the UK, by the Bank of England. In Japan - by the Bank of Japan and so on. The markets also take into account the rates of Switzerland, Canada, RBA, Norway, China, India, Korea and individual European countries such as France, Italy, Germany, Spain and others.
Learn more about the current interest rates of various banks here.
What is going on in the forex market
If you open the economic calendar and find that officials of a national central bank are gathering to decide on interest rates, then the rates can change and modify the trend, depending on whether they are reduced or raised.
Or the rates may remain at the same level, and then the trend will be determined on the basis of the current dynamics: if the previous time the rates were reduced, then the trend will be bearish, and if raised, it will be bullish.
As a rule, prospects for rising or lowering rates are announced repeatedly over long periods of time before they are changed. This is used by long-term investors and positional traders to make a profit or vice versa - to avoid risks.
- It is important to monitor interest rates in order to understand the global currency trend;
- Lower rates stimulate the economy, and higher growth cools economic growth;
- Interest rates go up - the currency strengthens, and if it goes down, it weakens;
- You can track the dynamics of changes in interest rates of leading Central Banks here.