Interest rates and foreign exchange rates are in a complicated relationship. The understanding of this relationship is hard, but it is also very crucial for successful forex trading. To make money while trading in currency pairs, the traders need to understand the role of interest rates with their effect on foreign exchange. They also need to understand the specifics of the same to build strategies around them.
What is a Foreign Exchange Rate?
The rate at which one currency is exchanged with another currency is called the forex or the foreign exchange rates. These are calculated in currency pairs like the USD/INR. Ted in currency pairs like USD/EUR, INR/JPY, EUR/GBP etc.
It is basically how many units of the vehicle currency can be bought with the base currency. In the case of USD/INR, it is 73.16. Or, 73 Indian rupees are worth one United States Dollar.
The Foreign exchange rate is not just one. It is of two types of market sectors. Either it is fixed or floating.
The fixed rates happen when the fluctuations of a country’s currency do not reflect in the open forex market. This is because the central government is the regulating and governing body of the exchange rates.
Floating rates happen when the demand and supply determine the value of currency pairs.
Why Do Interest Rates Change? What are the Factors that Influence Interest Rates?
Before getting on to the reason behind the change in interest rates, let us understand the factors that influence it. Factors like inflation affect the interest rates the most. In the scenario of inflation, the interest rates are increased. This in turn, reduces the investments that are driven by borrowed money.
Recession is another factor that influences interest rates. In the case of a recession, the interest rates are decreased. This, in turn, encourages people to borrow more from the government and invest in different sectors of the market. In a recession, the interest rates are bound to plummet. A clear example can be seen with the curious case of India and the Covid pandemic. While fighting off the disease, the country is not doing very well economically as well, and the interest rates have fallen from approx 6% to Approx 4%.
Another important factor can be the fiscal deficit. This is the result of the government spending more than it is earning. To balance it out, the government resorts to borrowing. When that happens, borrowing influences the money demand and hence, causes interest rates to fluctuate in return. The traders should keep in mind that the higher the number of deficits, the greater is the borrowing. Hence, higher are the interest rates.
How Interest Rates Affect Forex Trading?
The currency pairs are directly affected by the interest rates. Lao, interest rates are the deciding factor for the out and inflow of cash of the global money inside the country. Imagine two banks, one offering a 7% interest rate and another offering 5% interest rates. You would go with the former, right? Exactly. And that is exactly how currencies work.
The interest rates of that country determine the strength of the currency. The currencies that have a lower interest rate tend to weaken in the long game.
Interest Rates Expectation:
Almost none of the forex traders care about the current interest rate because the market has already included them in the currency’s price. The question is not whether the interest rates are, as of now but what are the expectations in the direction of movement POV.
An increase in the interest rates results in the currency going up as well. Anything that has a global impact can affect currencies and currency pairs a lot. For example, in covid, bull traders were at a high risk of losing money in their trades. Since there are chances that the traders were also trading cfds, their losses in such a situation could be huge. Cfds are a risky trading instrument and should be used only if the trader has seen a good amount of time in the market.
Such instruments include the high risk of loss even to the customers of the retail investor account. Some people like to make fewer trades while taking the risk they can afford to take. In such cases, the traders’ strategies to find out, for example, the price breaks, make all the difference.
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Higher interest rates lead to a higher currency value, and lower interest rates lead to lower currency rates. Increasing interest rates attract investors from all over the world. If you want to start your forex trading journey find some best forex brokers on www.fxreviews.best.