What to know about forex interest rate trading

Interest rates are crucial to follow for forex traders. Here, discover more about how rates impact currency markets and how they can be incorporated into a strategy.

FOREX 4

Interest rates are an important driver for forex markets and are therefore consequential for traders looking at fundamental and technical analysis alike. Read on for more on how interest rates affect forex – and discover a simple forex interest rate carry trade strategy for a relevant currency pair.

How do interest rates affect forex?

Interest rates affect forex in that they shape how a currency’s value is perceived. Higher rates mean increased demand for that currency, causing people to buy more of it. Therefore, any change in the interest rate will impact forex, meaning forex traders should always be aware of when central bank interest rate announcements occur. To ensure you’re on top of the latest announcements, check out our economic calendar.

Forex traders who are prepared will understand where rates are expected to go, and factor this likelihood into their decisionmaking. For example, if rates are likely to shift at the end of a monetary cycle within, say, a month’s time, a longer-term position trader will need to consider if a trade opened immediately will be affected by this fundamental event down the line. 

How interest rates are calculated

Interest rates are calculated via central banks’ board of directors. Rates can be hiked to curb inflation and cut to encourage lending in the economy. Economic indicators that can give clues as to the direction of interest rates include the Consumer Price Index, the condition of the housing market, employment statistics, and consumer spending, so these are all worth keeping an eye on for those trading forex.

Dot plot interest rates

Dot plot interest rates can help traders understand the Fed’s interest rate forecast at certain FOMC meetings. This method of data visualisation shows the projections by FOMC members for interest rates in future years, plotted as dots on a graph. When the median of the dots on the dot plot is calculated, this may give an overall FOMC outlook for rates.

In the below example, each dot represents each FOMC member’s view on where interest rates should be at the end of the year.

FOMC dot plot

Forex interest rate carry trades

A forex interest rate carry trade is where a trader borrows or sells a low interest rate currency in order to purchase another currency with a higher interest rate. Carry trades may be popular where the interest rate spreads between the two currencies are high. This is because paying a low rate on the borrowed currency potentially allows for a return on the higher rate of the purchased currency.

In simple terms, if you go long on a pair like AUD/JPY, where the Australian Dollar has a higher interest rate than the Japanese Yen, you are making a carry trade. In effect, the broker will be paying the interest rate differential between the two currencies, minus the spread.

Forex interest rate trading strategy

When putting together an interest rate trading strategy, consider that every currency pair will be beholden to interest rate decisions that affect the relevant country. Therefore, traders should be aware of when the next central bank meetings pertinent to their forex trading will take place. 

Being cognizant of central bank policy in this way will mean you aren’t caught out by unexpected market movements, for example when making a purely technical trade based on Fibonacci retracement levels.

Next, you need to check out the charts and can use multi timeframe analysis to assess trends. For example, looking at a chart with a timeframe 4-6x higher than the chart you plan to trade on can give a helpful idea of conditions, whether an uptrend, downtrend or ranging market. When making a long-term carry trade for instance, it may be worth assessing the durability of an uptrend on a daily chart but actually trade on a 4-hour chart.

Notice in the below chart how the carry trade for AUD/JPY is filtered in the direction of the trend. The confirmation of the uptrend is made as higher highs and higher lows are made on the daily chart as price moves higher above the 200-day exponential moving average. Then, an entry can be made on a shorter timeframe chart (such as 4-hour) in the direction of the carry trade, using technical indicators where necessary to judge potential entry and exit points.

Carry trade with AUD/JPY

When making this trade, effective risk management processes are essential. If the trend changes or the interest rate differential narrows, heightened losses can arise. This means that traders may want to consider tighter stops to lessen the impact of a reversal, so they can reassess the market conditions without maintaining a losing trade.

Interest rate trading takeaways

  • Be aware of when interest rate decisions are released by central banks
  • Refer to dot plots for an idea of future rates
  • Trade the FX pairs with significant interest rate spreads
  • Use multi-timeframe analysis to assess broader trends
  • Employ technical analysis to assist with entries and exits
  • Ensure your risk management is on point as a reversal could be damaging for your balance

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