The Influence Of Interest Rate Differentials On Forex Profit Potential – Global markets are just one big interconnected web. We often see commodity and futures prices affect currency movements and vice versa. The same is true of the relationship between currencies and bonds (the difference between countries’ interest rates): the price of currencies can influence the monetary policy decisions of central banks around the world, but monetary policy decisions and interest rates can also to dictate currency price action.

A stronger currency helps contain inflation while a weaker currency will boost inflation. Central banks exploit this relationship as an indirect means of effectively managing their respective countries’ monetary policies. By understanding and observing these relationships and their patterns, investors have a window into the forex market and therefore a means to predict and capitalize on currency movements.

The Influence Of Interest Rate Differentials On Forex Profit Potential

The Influence Of Interest Rate Differentials On Forex Profit Potential

To see how interest rates have played a role in dictating currency, we can look back to the recent past. After the tech bubble burst in 2000, traders shifted from seeking the highest possible returns to focusing on capital preservation. But because the United States offered interest rates below 2% (and even lower), many hedge funds and those with access to international markets went abroad in search of higher returns.

Usd/jpy Forex Technical Analysis

Australia, with the same risk factor as the United States, offered interest rates above 5%. Thus, it attracted large flows of investment money into the country and, in turn, Australian dollar assets.

These wide interest rate differentials have given rise to the carry trade, an interest rate arbitrage strategy that takes advantage of interest rate differentials between two major economies while aiming to profit from the general direction or trend of the currency pair. This trade involves buying one currency and financing it with another. The most commonly used currencies to finance carry trades are the Japanese yen and the Swiss franc due to their countries’ extremely low interest rates.

The popularity of carry trades is one of the main reasons for the strength seen in pairs such as the Australian Dollar and Japanese Yen (AUD/JPY), the Australian Dollar and the US Dollar (AUD/USD), the New Zealand Dollar and the US dollar (NZD/USD) and the US dollar and the Canadian dollar (USD/CAD).

However, it is difficult for individual investors to send money back and forth between bank accounts around the world. The retail difference in exchange rates can offset any additional returns investors seek. On the other hand, investment banks, hedge funds, institutional investors and large commodity trading advisors (CTAs) generally have access to these global markets and the leverage to have low spreads.

How To Capitalize On The Carry Trade As A Retail Forex Trader

As a result, they move money back and forth in search of the highest returns with the lowest public risk (or default risk). When it comes to the bottom line, exchange rates move based on changes in cash flows.

Individual investors can take advantage of these changes in flows by monitoring yield spreads and expectations of changes in interest rates that may be embedded in these yield spreads. The chart below is just one example of the strong relationship between interest rate differentials and the price of a currency.

Notice how the blips on the graphs are almost perfect mirror images. Our chart shows that the five-year yield spread between the Australian dollar and the US dollar (represented by the blue line) was narrowing between 1989 and 1998. This coincided with a broad sell-off of the Australian dollar against the US dollar.

The Influence Of Interest Rate Differentials On Forex Profit Potential

When the yield spread began to widen once again in the summer of 2000, the Australian dollar responded with a similar rise a few months later. The Australian dollar’s 2.5% margin advantage against the US dollar over the next three years equated to a 37% rise in AUD/USD.

Guide To Managing Foreign Exchange Risk

Those traders who managed to get into this trade not only enjoyed the appreciable capital appreciation but also earned the annual interest rate differential. Therefore, based on the relationship demonstrated above, if the interest rate differential between Australia and the United States continued to narrow (as expected) from the last date shown on the chart, AUD/USD would eventually fall as well.

This connection between interest rate differentials and exchange rates is not unique to AUD/USD. The same kind of pattern can be seen in USD/CAD, NZD/USD and GBP/USD. Take a look at the next example of the New Zealand and US five-year bond yield spread against NZD/USD.

The chart provides an even better example of bond spreads as a leading indicator. The spread bottomed out in the spring of 1999, while NZD/USD did not until the fall of 2000. By the same token, the yield spread began to widen in the summer of 2000, but NZD/USD began to rise in early fall of 2001. The yield gap over the summer of 2002 may be significant going forward beyond the chart.

History shows that the move in the interest rate differential between New Zealand and the US is ultimately reflected in the currency pair. If the yield spread between NZ and the US continued to narrow, then the yield spread for NZD/USD would also be expected to peak.

Pdf) Relationship Between Exchange Rates And Interest Rates: Case Of Albania

Spreads on both 5-year and 10-year bond yields can be used to measure currencies. The general rule is that when the yield spread widens in favor of a particular currency, that currency will appreciate against other currencies. But, remember, currency movements are affected not only by real changes in interest rates but also by the shift in economic assessment or the increase or decrease in interest rates by central banks. The diagram below illustrates this point.

According to what we can observe in the chart, changes in the Federal Reserve’s economic assessment tend to lead to sharp movements in the US dollar. The chart shows that in 1998, when the Fed switched from economic tightening (meaning the Fed intended to raise interest rates) to a neutral outlook, the dollar fell even before the Fed moved on interest rates (note that on July 5 1998, the blue line falls steeply before the red line).

The same kind of movement in the dollar is seen when the Fed moved from a neutral to a tighter bias in late 1999 and again when it switched to an easier monetary policy in 2001. In fact, when the Fed barely considered cutting interest rates, the dollar reacted with sharp sell out. If this relationship were to continue into the future, investors might expect a bit more room for the dollar to rise.

The Influence Of Interest Rate Differentials On Forex Profit Potential

Despite the huge number of scenarios in which this strategy works for predicting currency movements, it is definitely not the Holy Grail of making money in the forex markets. There are several scenarios in which this strategy can fail:

Sterilized And Non Strelized

As indicated in the examples above, these relationships reinforce a long-term strategy. The rise in currencies may not happen until a year after interest rate differentials may have bottomed out. If a marketer cannot commit to a time horizon of at least six to 12 months, the success of this strategy can be greatly reduced. The reason? Currency valuations reflect economic fundamentals over time. There are often temporary imbalances between a currency pair that can cloud the actual underlying fundamentals between those countries.

Traders who use excessive leverage may also not be suitable for the breadth of this strategy. For example, if a trader used 10x leverage with a 2% return difference, he would turn 2% into 20%, and many companies offer up to 100x leverage, tempting traders to take a higher risk and try to turn 2% to 200%. However, leverage comes with risk, and applying too much leverage can prematurely drive an investor out of a long-term trade because they cannot deal with short-term market fluctuations.

Key to the success of yield-seeking trades in the years after the tech bubble burst was the lack of attractive returns from the stock market. There was a period in early 2004 when the Japanese yen soared despite the zero interest rate policy. The reason was that the stock market was on a rally and the promise of higher returns attracted many underweight funds. Most major players had cut exposure to Japan in the previous 10 years because the country faced a long period of stagnation and offered zero interest rates. However, when the economy showed signs of recovery and the stock market began to rally once again, money returned to Japan regardless of the country’s continued zero interest rate policy.

This shows how the role of equities in capital flows could reduce the success of bond returns in predicting currency movements.

How Swap Rates Impact Forex Trading Strategies

Risk aversion is a major driver of forex markets. Trading currencies based on returns tends to be more successful in a risk-seeking environment and less successful in a risk-averse environment. That is, in risk-seeking environments, investors tend to restructure their portfolios and sell low-risk/high-value assets and buy higher-risk/low-value assets.

The riskiest currencies—those with large current account deficits—are forced

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