Interest rates have changed rapidly in the past year, where central banks attempt to tackle an inflationary economy and control spending. These changes affect consumer prices, borrowing costs, investment returns and the foreign exchange market.
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Adjusting the base rate is a tried and tested response to inflation and can make a substantial difference to forex traders and the broader market because variances between national interest rates directly influence movements in exchange rates.
Traders use economic modelling and technical and fundamental analysis to try and predict how currencies may shift and anticipate economic or political factors that will tie into the outcomes of their trades. However, unexpected central bank announcements can cause uncertainty and volatility.
The results are not always negative, and experienced forex traders can use surprise interest rate changes to their benefit and maximise profit if they move quickly enough.
The Link Between Interest Rates And Forex
Interest rates are particularly relevant to forex day traders, who enter and exit positions within one trading day and aim to accumulate small profits through multiple trades.
If return rates are higher and invested currency accrues more interest, the more profit they make – but this can work the opposite way.
The risk is that any forex investment strategy based on expected interest rate changes relies on exchange rates following forecast trends, which does not necessarily happen. Rates can be affected by multiple other influences, such as political news or speculation about scheduled central bank announcements.
Forex is also volatile, and the theory that currencies with high-interest rates will provide greater returns when funded with a lower-interest denomination does not always play out.
How Interest Rates Are Decided And Adjusted
Central banks, like the Bank of England (BoE) in the UK and the Federal Reserve (the ‘Fed’) in the US, control national monetary policy. They set base rates that financial institutions use for interest rates charged on borrowing or paid on savings.
Governors of each central bank also decide on short-term interest rates that banks pay to borrow from either other.
When a central bank raises the base rate, the objective is to mitigate inflation. Reducing rates means more capital is injected into the economy and encourages greater lending.
Traders can monitor economic indicators to get an idea about the potential actions the relevant central bank might take, but surprise announcements are far from unheard of.
Indicators that determine how a central bank responds include consumer spending, the property market, the Consumer Price Index (CPI), and the US Personal Consumption Expenditures Price Index (PCE).
How To Anticipate Changes To Central Bank Interest Rates
There are no guarantees that any indicator will give a specific guide to how base rates will change. Still, forex traders use data to prepare for potential adjustments.
When economies are stable, the chance of a rate change is minimal because there isn’t any impetus for a central bank to make adjustments.
If economies are weak, it is normal for the central bank to intervene and reduce or boost rates to incentivise or restrict borrowing.
Knowing when they choose to intervene is never an exact science.
The best option is to keep a close eye on economic forecasts, particularly from government bodies or monetary institutions.
Central bank announcements
Central banks meet according to a known schedule, so it isn’t so much a case of knowing when an announcement will be made – but what it will include.
Any major announcement is important for forex traders because governors often indicate potential future changes to prepare the markets and avoid shockwaves.
Traders can follow announcements, review the language used, and predict possible changes – a what-if scenario is useful to model potential trades depending on how interest rates evolve.
These announcements can impact forex markets even if the central bank doesn’t make any adjustments there and then.
For example, the Chair of the Federal Reserve gave a monetary policy report on July 16, 2008, one of two annual presentations.
The Chair reports on the value of USD and invites committee members to ask questions. In this particular session, he spoke strongly about the condition of the national currency and was clear that central bank actions would provide stability amid talk of recession.
Forex traders perceived these statements as a signal that the Federal Reserve was about to increase the base rate, which caused a short-term rally.
Those who responded quickly made a profit of $440 per dollar, with a drop in EUR/USD of 44 points within 60 minutes.
Interest rate forecasts
Another helpful metric is to analyse economic forecasts because interest rate changes can be predicted by understanding how the economy is performing and how the central bank will interpret those underlying indicators.
Professional forex brokers, traders and investors often have a consensus about what interest rates might do and discuss their estimates for future market conditions.
A trader might use several forecasts to arrive at an average to base their planning around.
Responding To A Surprise Interest Rate Change In Forex
Even with diligent monitoring, sometimes a central bank will make a rate change without warning and potentially against speculation and forecasting from the market.
The first task is understanding what that unexpected announcement means for the market. Increases in rates normally mean a currency appreciates, and traders will buy. Rate cuts usually signify the opposite, as traders sell in favour of higher-interest currencies.
Forex markets move fast, and traders will immediately flood the market with a mass sell-off or snap up the currency to get ahead of the competition. Those who get there first will inevitably make greater profits.
Another point is that trend reversals are normal in such a volatile market. While surprise interest rate changes can prompt a sudden shift, it is equally likely that trends will course-correct back to the original trajectory.
Case study
New Zealand’s central bank, the Reserve Bank of New Zealand (RBNZ), made such an announcement in 2008.
In July, the base rate was 8.25 per cent, which was one of the highest of any central bank. This rate had been stable for four months, and NZD was an attractive forex currency due to the higher-than-average returns.
At the monthly meeting, the governors decided to reduce the rate to eight per cent. The forex market responded by interpreting this as a concern about inflation.
Traders began to sell the currency or withdraw funds, replacing NZD with lower-interest alternatives amid uncertainty.
The New Zealand currency fell by 83 points in less than ten minutes, with the NZD/USD rate dropping from 0.7497 to 0.7414; traders that sold one lot straight away made a net $833 profit.
However, the trend reversal corrected this drop quickly because NZD remained a higher interest currency than most others with an eight per cent base rate.
This example illustrates why it is important to review detailed central bank statements to try and gauge how the bank views potential rate changes and what it considers when making decisions.
Keeping An Eye On Interest Rates FAQ
Why do forex traders need to follow interest rates?
Interest rates impact the forex market in several ways. Some currencies are subject to interest, directly affecting the trading value and the costs of buying, selling or exchanging a currency pair.
Another factor is that when interest rates change, so too do exchange rates, which means traders need to consider this when selecting currencies or taking a position.
Who decides when interest rates go up or down?
Central banks are responsible for managing national economics, setting monetary policy and overseeing the financial system. They decide to increase or decrease inflation rates to control the value of their currency or address stagnant growth or inflation.
Which banks set interest rates for the UK and USA?
The UK central bank is the Bank of England, and the Federal Reserve is its counterpart in the US. Both are influential central banks because GBP and USD are primary currencies used in forex and international markets – although USD is wider used and, therefore, can have a more dramatic effect on global economics.
Why have UK interest rates become so high?
Usually, central banks set higher base rates to control rising inflation. The Consumer Price Index reported a price rise of 9.4 per cent in June 2022.
This inflation level is the highest since 1982 and beyond the target inflation rate of two per cent, prompting the central bank to increase borrowing costs.
There are multiple reasons behind inflation, including shortages and price rises in fuel, electricity and gas, and increased food import prices partially due to the war in Ukraine.
How have interest rates changed in 2022?
In September 2022, the Bank of England announced a base rate increase from 1.75 per cent to 2.25 per cent, the seventh consecutive rise since December 2021.
The next announcement is scheduled for November 3, 2022, when the Monetary Policy Committee will review the latest inflation figures and decide whether to make any further changes.
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