As a forex trader, you should know that interest rates are an integral part of investment decisions and can drive the currency markets as well as the stock markets either direction. Federal Open Market Committee rate decisions are the second largest currency market moving release behind the unemployment figures.
The impact of interest rate changes not only have short term consequences but also have long term consequences on forex markets. One Central Banks interest rate change decision can affect more than a single currency pair in the interrelated currency markets.
In currency trading, an interest rate differential is the difference between the base currency interest rate and the counter currency interest rate. In the pair, EUR/USD, EUR is the base currency and USD is the counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the US Dollar interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you when you trade forex. In addition to FEDs overnight fund rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.
The reason why it is profitable is that international investors like hedge funds, big banks and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. LIBOR and the 10 year bond yields are usually used as leading indicators of currency movements.
Take an example, suppose the Australian government 10-year bond yield is 5.25%. The US government 10-year bond yield is only 1.75%. The yield spread in this case would be 350 basis points in favor of the AUD.
Suppose the Australian government raised its interest rate by 25 basis points. The 10 year Australian government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of AUD. The AUD will also be expected to appreciate against USD.
The general rule of thumb used is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currency in the currency pair. This is important information for you as a trader in telling you before hand about the change in currency price. Up to date interest rate data is available on Bloomberg. Keep track of the currencies in the pairs that you trade with that data.
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