Fundamental Analysis: Interest Rates

In this article we will look at one of the single most important indicators used in fundamental analysis by Forex Traders: Interest Rates. Interest rates set by the eight major central banks of the world are the single biggest influence on currency rates on the Forex markets. These changes in interest rates are an indirect response to other factor changes in the economy and carry the potential to have significant impacts on the market immediately and with powerful force.

Surprise changes in interest rates is often what causes the biggest change in the market, which is why traders spend much of their time trying to predict what rates the central banks will set in the future. That is what we will look at in this article: How to predict changes in interest rates and what effect they have on the Forex market.

Interest rates are important to forex traders for the simple reason that the higher the interest rates of a nation, the higher the return on an investment in that currency and the higher the profit. Of course there is always a substantial risk with this strategy which is currency fluctuation. A profit made from interest rate payments could be offset by a reverse change in currency rates. So buying a currency with high interest payments by financing it with a currency with low interest rates is not as simple as that. If this was all it took to make arbitrage, there would be millionaires made every second! This isn’t the same as saying that interest rates are to confusing to¬† be properly understood and taken advantage of by the average trader, but it does imply that you spend time educating yourself on the basics of interest rates.

Interest rates are set by central banks all over the world by a board of directors that control the monetary policy of their country or for several countries in the case of the European Union. The basic strategy for the central banks are to raise rates to limit inflation and to lower them to encourage economic growth by lending. This dogma and the trade off between inflation and economic growth has long been considered a balance act where both are not possible to achieve at the same time.

To predict the actions of the central banks and thereby the movements in the forex market it is necessary to look from the viewpoint of the bankers themselves. The central banks will usually examine the most important economic indicators such as:

  • CPI (Consumer Price Index)
  • Consumer Spending
  • Employment Levels
  • Housing Market

With this data the the trader can make an informed decision as to the direction of the interest rates. If the economy is doing well and is growing rates will either stay the same or be raised. On the other hand if the economy is slumping and declining, the central banks may encourage borrowing to stimulate the economy by cutting interest rates.
Outside of doing this analysis yourself the forex trader can watch major economic announcements and listen to economic forecasts from major players in the field.

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