WHY DO INTEREST RATES MATTER IN FOREX TRADING? A GUIDE FOR 2020
Interest rates keep the forex world turning. One of the first things you learn as you enter the forex market is that interest rates indeed rule the global market. This is because the interest rate of currencies is one of the biggest factors when it comes to determining perceived value.
As a forex trader, it is incredibly important for you to keep close tabs on interest rate policies whenever you trade forex. You will even need to have a keen eye on interest rate policies in countries all over the world, not just on your own. We can not stress enough just how vital it is for forex traders to know the ins and outs of interest rate policies, but of course, we’re here to enlighten you in that very aspect!
Interest rates are pretty much synonymous to forex trading at this point. You need to have a good grasp of one to excel in the other. The key to making any good forex trade is for you to know all the cards you’re dealt with, and this means that you should fully understand what interest rates are and why they are part of forex trading.
Interest rate basics
So, why are interest rates charged in the first place? In a nutshell, this is because when an individual or a business borrows from a certain lender, that lender will then have to sacrifice assets that could have been used for income generating activities or subsidized. In order to make up for that deficit, they then charge an interest rate which will be computed based on the principal of the total amount that one will borrow.
If you are borrowing money from a lender, do not worry about it being inflated or an unexplained amount. The interest rates that they offer are usually based on the level of risk on the part of the person borrowing. This just denotes that if a borrower is deemed to be “high risk” then the interest that the borrower will have to pay for will be noticeably bigger than a “low-risk borrower”.
Interest rates can also be understood as the rate charged by a lender so that they can compensate for the income they could have received if the aforementioned lender had directed those resources to money-making avenues.
Watch this video: How to trade the ECB interest rate decision (21mins 53secs)
Forex and Interest Rates
Now that you have a background on interest rates, it is also essential for you to understand what they have to do with the forex market. In simple terms, the forex market relies on currencies, and currencies rely on interest rates. Interest rates are what dictate the in and out of global capital in a country.
Essentially, interest rates are what investors take note of to help them with decision-making and to gauge whether it is worth investing in a certain country or not.
The higher a country’s interest rate is, the more likely it is for their currency to get stronger. Alternatively, currencies that are plagued by low-interest rates will likely see itself weaken in the long run.
Interest rates and Forex Trading
The way traders manage to make the right calls in forex trading is through several economic indicators. The two best and most important economic indicators are the Consumer Price Index or CPI, along with the Producer Price Index or PPI.
The Consumer Price Index is regarded as the ultimate benchmark for inflation, especially in the economy of the United States. It is published monthly and is carefully monitored by experienced forex traders. These usually consist of transportation, restaurants, electricity, among many others.
Generally, as the prices of goods rise, the purchasing power of a consumer inversely erodes with it. On the other hand, if the consumer’s wages remain the same for a long time, their purchasing power is reduced as well which leads to a lesser quality of living.
In terms of the Producer Price Index or PPI, it is somewhat similar to the CPI in a way that it also tracks inflation. It is also reported on once a month, as it tracks consumer goods and capital equipment. PPI is a direct measure of the wholesale prices from a producer’s perspective, and it gauges the rates of goods or commodities that have undergone transitional processing before reaching their final product.
Interest rates are volatile and always changing, which is why it is a forex trader's duty to keep their finger on the pulse at all times. With the right analysis of interest rates comes good trades!
What are your thoughts on interest rates in forex trading? Lets us know your personal experience or any questions in the comments below.
In short, global interest rates control the forex market, and are crucial to the success of a forex day trader as they help to maximise profits. It is imperative that as day traders, we keep on top of interest rate decisions, and forecast the actions of central banks in order to capitalise on the market's reaction. It's a general rule of thumb that interest in a country's currency goes up as interest rates are increased. To put it simply: Increased interest rates mean increased interest in that currency.
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