Forex Fundamental Analysis | The Effect of Interest Rates

Are you looking to invest or trade the Forex Market? Then you need to keep yourself up to date about Forex Fundamental news or sometimes referred to as Forex News announcements. The number one source for all Forex news or FX news announcements is Forex Factory and its well-organised Forex Factory News calendar. It’s a well-known platform amongst all traders with news announcements/events to take place; for the week ahead and even months ahead. It’s an easy platform to navigate through and is beginner friendly. 

Fundamental Analysis is an essential piece of the trading puzzle, allowing traders to gain a better understanding of current market conditions and predict future trends. Through combining technical analysis with fundamental events – like economic announcements or geopolitical changes – savvy investors can structure more profitable trades; especially when compared to those who solely rely on price sentiment alone. Make sure you are always conscious that Fundamental Analysis requires regular engagement if it forms part of your strategy!

Remember your money is like the seed you sow and the quote “As you sow so shall you reap” best suits you. As an investor or trader, you’re like a farmer. If the farmer does not know the upcoming weather, environmental conditions and which crop is in demand how can he hope to yield the maximum profits? 

Similarly, as a Forex trader you have to be aware of: market sentiment, how you plan to predict possible outcomes (long or short) and be mindful of the impact certain news events/announcements have on the currency pairs (e.g. when Mario Draghi of the European Central Bank speaks it will directly impact EURUSD (Eurodollar) and all other EURO denominated cross currency pairs: EURAUD, EURJPY, EURGBP etc.). 

Impact of Interest rates

If there is one overriding influencing factor in the currency market, it’s forex interest rates. The Central Bank of a country or economic group sets the interest rate on their currency. They adjust these rates to encourage trade and maintain control over inflation. Lower interest rates will encourage economic expansion, as credit becomes cheaper. Higher interest rates will slow down economic expansion as the “cost of money” becomes more expensive. Changes in interest rates can also greatly affect the value of a currency. Ray Dalio, a famous Hedge Fund manager has created a good video explainer of how consumer lending/spending and Interest rates impact our economies today. It’s good to make notes on the video and generally reflects on the macro implications of how interest rates affect our global economy. See the example below, of how an Interest Rate Decision by a country’s central bank affects its own denominated currency. Please always remember that the FX market revolves around Macro Economic/Events.  

A closer look at how Interest Rate Hike impacts affect the Major Currency pairs

According to the BIS (Bank of International Settlements), the top four major currency pairs are GBPUSD, EURUSD, USDJPY and USDCHF. These are the most traded currency. As these four currency pairs are ddollar-denominatedit’s the norm that any news around the dollar will impact the currency price. The FOMC (Federal Reserve’s Open Market Committee) are in governance over The United States Monetary Policy. The interest rate decision made by the FOMC is one of the biggest fundamental news, which sets the overnight Federal Funds Rate and is extremely important when trading the U.S. Dollar. They have in total 8 scheduled meetings every year and the decision is made by the committee and is read out in a statement by the governor (Janet Yellen). They say when Yellen speaks- stop everything and listen. 

The language used during the statements is critical for determining the long-term impact on the currency i.e. they either take a Hawkish (Bullish) or Dovish (Bearish) stance. Oftentimes by the time of the decision announcement, the decision has already been factored into the market; only slight fluctuations are seen if the decision was the decision that was expected. The accompanying statement, on the other hand, is analysed word-for-word for any signs of what the Fed may do at the next meeting. Remember, the interest rate decision itself tends to be less important than the expectations for future interest rate moves.

Bank of England Interest Rate Hike- 2nd November 2017

Below, are snapshot images from Forex Factory and the GBPUSD Daily chart. An example was when Mark Carney (governor and BOE) announced a rate hike of 0.25% in November 2018. It’s important to always note the Forecast column. There was a lot of speculation around this rate hike and if you look closely at the ‘FF notes’ its states the rate decision is usually priced in the market but the overall future fundamental view/picture of the sterling fx would be based on the Monetary Policy Summary. 

Note: Use the forex factory news indicator as a useful tool i.e. flags show the importance of news events. Red Flag signals a high-impact news event. The filter icon allows you to check through historical data and any upcoming news events filtered by country, date, and type of announcements (CPI, GDP, Employment Report, NFP etc.).

As you can see the GBPUSD rose in value (see image below) and if you entered into a long-term trade at 1.303 on 2nd Nov 2018, then you could have potentially banked approx. 1300 pips in just under three months. A $10 risk per percentage point (PIP) would amount to a profit of 1300pips × $10 = $13,000. Don’t get me wrong you would have to check this against your technical analysis for a precise entry point and exit level. We are merely just analysing the long-term impact of Interest Rate hikes on the currency and its bearing on predicting trend direction/bias. Please be aware that the monetary policy summary and the governor’s statement are probably more important than the actual decision.

Why does a currency appreciate when there’s a hike in rates? 

When trading forex, you must realise that a quote includes a base currency against counter currency i.e. GBP/USD would be read out pound against the dollar (the number of pounds equals one unit of USD dollar). Interest Rates are almost like a barometer of that economy’s strength or weakness. As a nation’s economy strengthens over time, prices tend to rise as consumers can spend more of their income. The more we make, the better our vacations can be, and the greater amount of goods and services we can consume/purchase. In other words, more dollars are chasing roughly the same amount of goods and this leads to higher prices for those goods. The rise in prices is called inflation, and Central Banks watch this very closely. If inflation is allowed to run rampant, our money will lose much of its buying power, and ordinary items such as a loaf of bread may one day rise to unbelievably high prices such as a hundred dollars per loaf. 

It sounds like an unlikely far-fetched scenario but this is exactly what occurs in nations with very high inflation rates, such as Zimbabwe. To stop this danger before it emerges the Central Bank steps in and raises interest rates to counter inflationary pressures before they get out of control. Inflation is very difficult to stop once it begins, hence it’s a country’s Central Bank’s constant, almost paranoid vigilance in the fight against it.

However, by increasing interest rates, a nation can also increase the desire of foreign investors to invest in that country. The logic is identical to that behind any investment: The investor seeks the highest returns possible. By increasing interest rates, the returns available to those who invest in that country increase. Consequently, there is an increased demand for that currency as investors invest where the interest rates are higher. Countries that offer the highest return on investment through high-interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital. If a country’s stock market is doing well and offers a high-interest rate, foreign investors are likely to send capital to that country. This increases the demand for the country’s currency and causes the currency’s value to rise.