What does a Forex trader need to know about the interest rate?
There are many definitions on the internet about what the interest rate is (also called Deposit Rate, Base Rate, Cash Rate, Policy Rate), how it affects the economy, why it is a key parameter for fighting inflation, etc. But all this is a theory, and a trader, as you know, needs the practical use of this knowledge.
First of all, traders should know that the interest rate is the most important parameter that affects the foreign exchange market, in particular, the national exchange rate of a country. Currency interventions are also very important, but they are rarely used by central banks.
The basic rules that a Forex trader should follow regarding interest rates are next:
- If the central bank raises the interest rate, it causes the national exchange rate to rise, government bond yields to rise, and usually stock indices to fall. A rise in interest rates refers to a tightening of monetary policy (Quantitative tightening (QT)).
- Conversely, if the central bank lowers interest rates, it generally causes the national exchange rate to fall, government bond yields to fall, and stock indices to rise. Lowering interest rates refers to the easing of monetary policy (Quantitative easing(QE)).
Thus, if the central bank of one country tightens monetary policy by raising interest rates while the central bank of another country lowers interest rates or keeps interest rates low, close to zero, or negative, it will lead to a medium- or long-term trend in the currency pair of these countries.
Let's look at a concrete example. At the moment, the US Federal Reserve is tightening monetary policy by raising interest rates (Canada and Australia also joined the list of countries that started tightening). At the same time, Japan and China, on the contrary, are on the way to easing monetary policy. As a result, currency pairs like USD/JPY and USD/CNY showed clear upward trends as the dollar index rose and the Japanese yen and Chinese yuan were both declining.
If the central banks of the countries will conduct a similar monetary policy, as a rule, the currency pairs will form broad price corridors without any pronounced trends. For example, once Australia began tightening monetary policy, the medium-term trend on the AUD/USD currency pair ended, as both Australia and the United States are on the way to rising interest rates now.
Is it possible for a Forex trader to make money on this?
Definitely yes. Intraday traders can use this information to look for intraday entry points (on timeframes below H1) in the direction of the main trend because this trend is not caused by technical factors but by fundamental ones, which are more stable. Mid-term traders can take longer-term positions and add on pullbacks in the main trend.
Thus, the tracking of monetary policy of different countries opens up great opportunities for traders to earn money in the Forex market.