“australian Interest Rates And Forex Profit: Navigating The Relationship”

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“australian Interest Rates And Forex Profit: Navigating The Relationship”

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There is a strong correlation between interest rates and forex trading. Forex is governed by many variables, but the main factor that dominates them all is the interest rate of the currency.

Simply put, money tries to track the currency with the highest interest rate. The real interest rate is the nominal interest rate of inflation.

Forex traders must monitor the interest rates of each country’s central bank and, more importantly, predict the movement of currencies when they are expected to change.

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When traders talk about “interest rates”, they usually mean central bank interest rates. Forward interest rates are very important to Forex traders because if the expected interest rate changes, the currency often follows it. A central bank has several monetary policy tools that it can use to influence interest rates. The most common are:

Central banks have two main functions: managing inflation and promoting stability for the country’s exchange rate. They do this by changing interest rates and managing the country’s money supply. When inflation rises above the central bank’s target, the central bank will raise interest rates (using policy tools) which can restrict the economy and bring inflation back down.

The economy is growing or contracting. Everyone is better off when the economy is growing and worse off when the economy contracts (recession). The central bank aims to control inflation by allowing the economy to grow at a slower rate by managing interest rates.

As economies expand (positive GDP growth), consumers begin to earn more. Earning more leads to spending more, and chasing fewer goods leads to inflation. If inflation gets out of control, it can be disastrous, so the central bank tries to keep inflation at a target level of 2% (for most central banks) by raising interest rates. Rising interest rates make borrowing more expensive and help reduce spending and inflation.

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If the economy is contracting (negative GDP growth), deflation (negative inflation) becomes a problem. The central bank lowers interest rates to encourage spending and investment. Companies start lending at low interest rates to invest in projects that boost employment, growth and ultimately inflation.

The effect of exchange rates on foreign exchange markets is changes in interest rate expectations that lead to changes in the demand for foreign exchange. The following table shows possible scenarios arising from changes in interest rate expectations:

Imagine that you are an investor in the UK and you want to invest a large amount in a risk-free asset such as a government bond. U.S. interest rates are rising, so you start buying U.S. dollars to invest in U.S. government bonds.

You (being a UK investor) are not alone in investing in a country with higher interest rates. Many other investors are tracking rising earnings and increasing demand for the U.S. dollar, which is pushing up the currency. This is the essence of the currency effect of interest rates. Traders can try to predict expected changes in interest rates, which can have a big impact on the currency.

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Here’s an example of what would happen if the market expects the central bank to keep interest rates on hold, but then the central bank lowers interest rates. In this example, the Reserve Bank of Australia is expected to keep interest rates at 2%, instead cutting it to 1.75%. AUD/USD fell as the market fell.

If the trader expects the US to raise interest rates unexpectedly, he expects the value of the US dollar to rise. To increase a trader’s chances of success, a trader can buy the US dollar against a currency with a lower interest rate, as the two currencies move toward their respective interest rates.

Forward rates and their differences greatly affect the appreciation/depreciation of a currency pair. The change in the spread of the exchange rate is due to the appreciation/depreciation of the currency pair. The vision is easier to understand. The chart below compares the AUD/USD currency pair (candlestick) and the spread between two-year AUD government bonds and two-year US government bonds (orange chart). The ratio shows that AUD bond yields are lower than those of US bonds.

Interest rate differentials are widely used in forward trading. In carry trades, money is borrowed from a country with a low interest rate and invested in a country with a higher interest rate. However, there are risks associated with interest rate trading, such as the currency depreciating against the currency used to finance the trade.

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Fed funds futures are contracts traded on the Chicago Mercantile Exchange (CME) that reflect market expectations of where the daily official federal funds rate will be when the contract expires. The market always has its own estimate of where interest rates will be. A trader’s job is to anticipate changes in those expectations.

A trader will need to closely monitor what central bankers are currently monitoring to predict central bank rates. Central bankers try to be as transparent as possible with the public about whether they will raise interest rates and what economic data they are currently monitoring.

Central bankers decide to raise or lower interest rates based on a number of economic data points. You can contact the release of these data points using the economic calendar. Inflation, unemployment and exchange rate are some of the key data points. A trader should be in tune with central bank policymakers and try to anticipate their actions before announcing them to the public. Thus, the trader can take advantage of market fluctuations where they are expected. This method of trading is based on fundamentals, which is different from trading using technical analysis. To understand the different methods of Forex analysis, see our article on Technical vs Fundamental Analysis.

Forex traders can trade the impact of interest rate news by buying or selling a currency the moment the news is released. See our guide to selling newsletters for more information.

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Advanced Forex traders can try to anticipate changes in the central banker’s tone, which could alter market expectations. Traders will do this by monitoring key economic variables such as inflation and trading ahead of the central banker’s speech. Watch our Central Bank’s WeeklyWebinar for expert commentary on recent and upcoming central bank decisions.

Another way is to wait for the currency pair to pull back after the interest rate results. If the central bank unexpectedly raises rates and the currency should appreciate, the trader may wait for the currency to depreciate before executing a long position, expecting the currency to continue to appreciate.

The content on this site is not a solicitation to trade or open an account with any broker or trading firm located in the United States.

By checking the box below, you confirm that you are not a resident of the United States. Journalists on The Australian Advisor’s editorial team base their research and opinions on objective, independent information gathering.

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