Central banks the world over are moving towards easing, with the BOJ being the notable exception. The relative timing and the amounts of interest rate cuts will be pivotal in determining how currency prices vary in the medium to long term in the forex markets.. This process of easing could take well over a year before central banks settle into a holding pattern once again.
During that time, markets will respond to the incentives created by the interest rates. With globalized finances, interest rates more than travel and trade have become the largest driver of currency value. Investors are looking for where to put their money to maximize the amount of return on investment for the minimal amount of risk. Expectations for where interest rates go drive Forex markets as traders and investors try to anticipate interest rate moves to be in position before they happen.
Keeping Profits Real
In an environment in which there are relatively similar inflation trends between the major economies, this is a factor that can often be discounted. However, inflation rates have been unstable for months now. Some central banks have had more success in bringing consumer price growth into line than others.
For investors looking at buying bonds, how much value those bonds lose to inflation can be a significant factor to consider when we are talking about inflation being above target. If, for example, the interest rate is 4%, but the inflation rate is 3%, then the real interest rate is actually only 1%. If another currency has an interest rate of just 3%, but inflation is 1%, then it offers a better real return on investment, and could attract more investors.
It’s All About the Bonds
Forex is driven in large part by what is called “fixed income”. That’s investing in bonds that pay back a set interest rate over a set period of time. They are usually more predictable and safer as an investment. Naturally, bond investors are looking to get the most from their investment, so they will buy bonds in economies that offer the best real rate of return for the duration of the bond. That is, the interest rate considering the inflation rate.
Forex traders are part of this equation with swaps, and the appeal of carry trading. When you enter a trade, you buy one currency and sell the other. Which means you need to borrow one currency in order to sell it, but can loan out the other currency that you’ve bought. This creates a difference in interest rate, or swap. For small retail traders entering and exiting a trade in a short period of time, it isn’t usually a major consideration. But for big institutions that drive markets by moving tens if not hundreds of billions in assets, 1% or 2% interest difference is a huge deal.
How to Apply This with Trading
Central banks might move interest rates, cutting them in the current paradigm. But those cuts can be offset if inflation cools down; or exaggerated if inflation heats up. That’s because if inflation falls faster than rates do, the real interest rate actually increases. And vice versa.
When central banks cut rates, typically inflation picks up as well. But if the economy is slowing down, then inflation can cool down as well. Forex prices, therefore, will not only move just because of the interest rate, but how inflation affects the return on investment as well.rate
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