During their November meeting, the Federal Reserve held off on implementing a 12th interest rate hike when officials voted to maintain rates at current levels.
However, Fed Chair Jerome Powell signaled that the fight against inflation is not over. Despite benchmark rates at a 22-year high of 5.25-5.5 percent, Powell stated that the Fed is uncertain whether rate hikes have been sufficient to curb rising prices.
Economic projections from September suggest one more increase is likely before year’s end, which would lift the key borrowing rate to a new 22-year peak of 5.5-5.75 percent. This potential December move could also mark the final rate hike in the current tightening cycle as the Fed assesses the impact of its aggressive policy actions on inflation.
What Are Interest Rates?
The interest rate refers to the cost of borrowing money or the reward for saving money, stated as a percentage of the total loan or deposit amount.
For borrowers, a higher interest rate means you will owe more money overall, as the bank charges you a larger percentage on top of the amount you borrowed. For example, a 5% rate on a $10,000 loan means you pay back $500 in interest. A 10% interest rate on the same loan would double your interest cost to $1,000.
A higher interest rate is beneficial for savers, as it means your deposits earn more interest income. On a deposit of $10,000, a 5% interest rate gets you $500, while a 10% rate would net $1,000 in interest.
Interest rates often change over time. Tracking these percentage movements is important for borrowers, savers, and Forex brokers, as rising rates increase costs for borrowers and boost returns for savers. You can track the correlation between currency prices and interest rate changes on platforms like TradingView.
How Interest Rate Changes Affect Currency Values
When a country’s central bank raises interest rates, it typically causes that country’s currency to appreciate against other currencies. Higher rates make deposits and investments in that currency more attractive, driving up demand and value.
For example, if the Federal Reserve raises U.S. rates, international investors may convert assets to US dollars to earn higher returns. This increased demand for the dollar pushes its value up compared to other currencies. Domestically, higher rates also make saving money more rewarding for U.S. consumers.
However, the impact of interest rates on a currency also depends on the inflation rate. If inflation is higher than interest earned, the currency’s real buying power still declines despite nominal rate hikes.
Conversely, interest rate cuts tend to decrease a currency’s relative value as investors move capital into riskier assets, promising higher returns. Lower rates make saving money less rewarding, so demand for the currency falls.
Rate changes don’t impact currency values in a vacuum. The market reaction depends on whether the rate change was expected or a surprise. For example, if a central bank raises rates less than expected, a currency could still decline due to negative sentiment.
Watch vital economic indicators like inflation, employment, consumer spending, and housing data to predict rate movements. Based on these factors, analyze whether rates will rise, fall, or hold steady. Then, make informed currency trades accordingly, using stops and limits to control potential losses from surprises.
Key Factors That Influence Interest Rates
Understanding the factors that impact rates is essential, as the relationship between interest rates and currency changes is not entirely a straight line. These factors will give you a deeper understanding of the market.
Demand for Money
In a growing economy, demand for credit rises, pushing rates up. When growth slows, borrowing declines, causing rates to fall.
More credit availability reduces rates, while less supply increases them.
Higher inflation typically lifts rates as lenders demand compensation for reduced purchasing power. Investors also shift to fixed-income assets during high inflation.
When government spending exceeds revenues, more significant deficits require more borrowing. This borrowing boosts demand for credit and drives rates higher.
Central banks may adjust rates to influence currency values and trade. Higher rates attract foreign capital inflows, theoretically supporting the local currency.
While interest rates impact currencies, many other factors are also at play, including inflation, debt levels, political stability, trade balances, economic performance, current account deficits, and speculation.
Interest rates both influence and are influenced by broader economic conditions. Analyzing the factors that drive rate changes provides an essential context for understanding exchange rate movements.
Leveraging Interest Rate Differentials for Profitable Currency Trading
Comparing the rates of two currencies can give forex traders an early indication of potential exchange rate movements.
The difference between the interest rates, known as the “interest rate differential,” is a key metric to monitor. A widening differential, where rates move in opposite directions, strengthens the higher-yielding currency. Meanwhile, a narrowing differential boosts the lower-yielding currency.
When interest rates between two countries diverge, with one increasing and the other decreasing, it often leads to major currency swings. These opposing rate changes produce ideal conditions for profitable forex trades.
For example, if the Federal Reserve is hiking US rates while the Bank of England cuts rates, GBP/USD will likely decline as capital flows to capture higher U.S. yields. A trader could profit from this divergence by shorting the pound against the dollar.
Acting quickly allows you to capitalize on interest rate-driven currency moves before major trends become overextended.
Tracking Rates and Identifying Opportunities
Traders should closely track critical economic indicators and central bank policies to forecast interest rate changes. Focus on interest rate differentials between major economies to identify trading opportunities early. Then, leverage widening rate spreads to capitalize on emerging currency trends before they become stretched.
Remember that currencies don’t just move based on rates alone — factor in inflation, political risks, economic growth, and other market forces.