Forex Education: Understanding Interest Rates

By Richard Cox
Richard Cox
Richard Cox
July 17, 2014 Updated: April 23, 2016

When traders are looking to base their positions on fundamental analysis, there is a broad series of data reports that we can draw from when making an assessment on a given currency. Some common examples include the Consumer Price Index (CPI), Retail Sales, of Gross Domestic Product (GDP). But it is not enough to simply assess these reports based on their own merits, as they will not only impact each other but also the level of interest rates that is deemed appropriate by the country’s central bank. 

“All of these economic factors have a direct and very critical impact on the level of interest rates that are put in place by the central bank of a given country,” said Rick Bartlett, currency analyst atCornerTrader . “Many traders would argue that the level of interest rates is the most significant factor in determining appropriate currency exchange values.”

Interest Rate Example: RBA Policy

So, why exactly is this the case? Specifically, interest rates tell traders the amount of yield income that can be gained from holding that currency overnight (and beyond). For example, if the interest rate that is determined by the Reserve Bank of Australia (RBA) is 3% for the Australian Dollar, traders will know that if they buy and hold the currency for one year, a guaranteed gain of 3 percent can be attained as long as there are not changes in the benchmark rate.

Gains or losses can still be seen as the currency itself changes value, but this will have no direct impact on the 3 percent interest rate yield that will be accrued for investors holding on to the Australian Dollar. This return would be guaranteed as long as the RBA does nothing to change interest rates during that time.

Carry Trades: A Common Forex Strategy

There are many traders who implement that are based on interest rates, and nothing else. So, it should be very clear that the interest rate level that is determined by the country’s central bank will be one of the main drivers in how investors view the value of a currency. In most cases, currencies with higher interest rate values rise against those with lower interest rates. This is usually seen during times of relative market stability, as investors are able to buy riskier assets and then hold those positions for long periods of time. During times of heightened market volatility, however, these types of positions tend to see big sell-offs.

So, investors will always watch this aspect of the equation closely before entering into new positions — especially over the long term. In any case, interest rates represent a critical aspect of the market (in fact, for all asset classes). Any suggestion that a central bank is likely to raise or lower their benchmark rate will almost always add to market volatility. For these reasons, it is important to remain aware of these data results before committing to any new position approach.

Richard Cox
Richard Cox