How a Central Bank’s Interest Rate Decisions Affect Forex Rates

Federal Reserve Building If there is one paramount factor that affects foreign exchange rates more dramatically than all others, it would most likely be central bank interest rates. Nearly every forex tutorial ever assembled has stressed this fact to newcomers to trading currencies. One must always be aware of central bank interest rates, how they are trending, and what might influence them in the near-term future in, not one, but both countries involved in the forex pair. In other words, a trader must always consider interest rate differentials between currencies and how markets are responding to changes in these rates.

The only problem with this advice is how do you achieve this task? The effort begins with central banks and how they administer policy. A central bank will generally have a benchmark, or discount, rate that it charges member financial institutions for the use of overnight funds. There is also another rate that it pays for excess deposits from its members, but the focus tends to be on the former. This “Fed Funds Rate” can then influence what banks pay for deposit products and savings accounts. It can also dictate changes in the “Prime Rate”, which will impact consumers directly for mortgages, home equity loan products, and credit cards. (Learn more about the interest rate’s effect on the wider economy).

The Global Impacts of Central Bank Interest Rate Changes

The foremost mission for all central banks is to maintain stable prices in their domestic economy, and the value of a nation’s currency has a direct bearing on prices for imported goods and services. When a central bank changes the discount rate, the general rule-of-thumb is that a higher rate will produce a stronger currency.

Investors, on the other hand, are always focused on two things – return and risk. Even though a trader may be more interested in speculation for short-term gains, he must still take into account how a long-term investor thinks.

A higher rate will normally draw more investment capital to a country to invest in its bonds or equities, and the increased demand caused by inflows will naturally put buying pressure on the local currency’s exchange rate. A reduction will have the opposite effect. Capital will leave, and the rate will fall. In the unlikely scenario that the banks for both countries change their rates in tandem, then no change would occur.

Why do central banks change these rates? The discount rate is one tool the central bank has to regulate the local economy. If inflation is rising, the monetary policy committee may move to increase rates to slow down borrowing, a way of contracting the money supply. If inflation is not a problem, but the local economy needs a boost of stimulus, the central bank may reduce the rate, thereby making more liquidity available for lending at a cheaper price.

Consequences for Currency Traders

Trading with regards to central bank interest rate impacts, however, is never as straightforward as the above simplistic discussion. As with any other factor, anticipation, expectation and the facts also influence how the trading community reacts to change. If the rumor mill starts to believe a fall in rates is imminent, the currency may fall well ahead of the official announcement, and even after the announcement, it might actually rise in value. In this case, it would have been “Sell on the rumor, Buy on the fact”. Timing and perception must be given their due.

Let’s take a look at a real life example. The European region is in recession. Inflation is not a problem. The central bank had hinted at wanting to weaken the Euro and stimulate the local economy. Traders expected the ECB to lower its discount rate by 0.25%, and there was some talk about the savings rate being made negative. Here is the chart for that day’s rate announcement:

Central Banks Interest Rate Forex Graph

Well before the actual time of the announcement, the market had already declined in anticipation of the expected move. The Euro fell to a previous support level, and then came the announcement, followed by a press conference. The initial market reaction was textbook, as traders sold, but the removal of uncertainty then caused a sudden upswing in buying activity. This boost, however, was temporary. At the press conference, Mario Draghi, the head of the ECB, hinted heavily that a negative deposit rate might be an eventuality. This “surprise” had not been factored into market thinking.

The lesson is clear. Traders must be ever mindful of interest rate differentials for their chosen currency pairs and what might be expected from either central bank in its home domain. Traders with a short-term trading perspective can react swiftly to changing events, but for those traders that prefer to benefit from a “carry trade” strategy, heeding the warnings about an active central bank takes on a much higher dimension.

The carry trade is the one and only “buy-and-hold” strategy that makes sense in the forex realm. The idea is simple – sell a currency in a low-interest rate country and invest the proceeds in a high-interest rate country. Multinational banks do this all the time. If interest rates remain steady, then the investor profits from the “carry”, the interest rate differential accrued over time. The trade works especially well when the destination currency appreciates, adding another bit of return to the overall equation. Any change in interest rates by either central bank, however, will disrupt this equation, either positively or negatively in a big way.

Concluding Remarks

Following the activities of central bankers and the news related to what they might be considering should be top of mind for all currency traders. Traders must always be mindful of the interest rate differentials of their preferred currency pairs, data that is often posted on various forex websites. As for anticipating the future, it is advisable to follow a number of analysts and then average their expectations. Central bankers will often speak publicly, another place where they might reveal their thought processes. Remember – no one likes surprises in the market!

Further reading:

Fundamental analysis articles.

Read about the CPI data’s impact on forex rates.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.