One distinct character of forex market is it's dynamic price changes that could be influenced by many factors. There are big players, macroeconomic indicators, and fundamental factors.
One distinct character of forex market is it's dynamic price changes that could be influenced by many factors. There are big players, macroeconomic indicators, and fundamental factors. One of the many factors is Interest Rates. Once the central bank of a certain country announces its benchmark interest rates, forex market will respond accordingly.
Interest Rates = Demand For Dollar
How interest rates influence forex? Interest rates add values to every country's currency. Higher interest rates in relation of a currency means it offers relatively higher return compared to any other currencies. On the other hand, investors always hope for high return for any of their investment, including forex. This way, interest rates determine the demands of any currencies.
The higher interest rates in a country, the demand for their currency will rise too because investors will want to have them. Higher interest rates will invite foreign capital and cause exchange rate to rise. The opposite may happen with lower interest rates. When a country's central bank lower their benchmark interest rates, their exchange rates will undergo depreciation. In this respect, interest rates influence exchange rates of one currency against the other, especially major currencies.
As an illustration, let's use EUR/JPY. Right now, BOJ (Bank of Japan) interest rates is 0.1%, and ECB (European Central Bank) is about 0.5%. If BOJ increased its interest rates to 0.5%, then their interest rates will be the same with ECB. However, these changes will entice investors to move their assets to Yen, because they want to get some profit from the changes. Such movement will cause the rise of demand on Yen, so that its exchange rates against Euro will rise too. On the contrary, if, say, BOJ lowers their interest rates into 0.05%, investors will sell their Yens and move their investment into another kind of assets, like bonds, property, or another currency with higher interest. If this happens, Yen's exchange rates will be decreased.
On another note, differences in interest rates between two currencies may cause carry trade. Carry trade is a method of forex trading where trader buys a currency with higher interest rates and at the same time sells currency with lower interest rates in order to gain profit from that difference. The higher interest rates of a certain country, the potential of it being carry traded will be higher too.
Interest Rates On Major Currencies
Exchange rates movements that was being illustrated above will happen only when there are changes in interest rates or if there are rumors that changes are being considered. Central banks will consider such policy at times when their country suffers high inflation, large trade deficit, etc. That's why rumors in regard of changes that will be made (usually mentioned by central bank governors) could seriously affect a certain country's exchange rates.
A recent example is AUD. In 2013, Reserve Bank of Australia (RBA) cut their benchmark interest rates twice. Even further, until December that year, the governor repeatedly mentioned the possibility of a third cut. As the result, AUD became one of the worst major in 2013, having entered bearish trend that went on until 2014.
Generally, central banks in Japan, European Union, and other advanced nations are committed to preserve low interest rates. This is because benchmark interest rates is used as standard interest for deposits and loans. If central bank raises interest rates, then loan interest will rise too. As the result, people will find it hard to pay back loans or making new loans, even though they may need it to sustain their business. In order to maintain a continuous economic growth, low interest rates is better than a high one.
The aforementioned circumstances turn interest rates decision by major central bank to be a major event in forex market. Minutes and even hours before the announcement usually marked by sideways where forex traders waiting patiently for the news. Then, just a few minutes after the news, price will move fast up or down. This made for a risky trade. Some traders avoid trading in such times, while others may prefer trade exactly during those times.