Using Interest Rate Differentials as Fundamental Trading Strategy
As a forex trader, you should know that interest rates are an integral part of investment decisions and can drive the currency markets as well as the stock markets either direction. Federal Open Market Committee rate decisions are the second largest currency market moving release behind the unemployment figures.
The impact of interest rate changes is not only short term but also long term on the currency markets. One Central Banks interest rate decision can affect more than a single currency pair in the interconnected forex markets.
In forex trading, an interest rate differential is the difference between the base currency interest rate and the quoted currency interest rate. In the currency pair, EUR/USD, EUR is the base currency and USD is the quoted or counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the USD interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you when you trade forex. In addition to FEDs overnight fund rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.
The reason why it is profitable is that international investors like hedge funds, big banks and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. London Inter Bank Offer Rate and the 10 year government bond yields are usually used as leading indicators of currency movements.
Lets take an example, suppose the Australian 10-year government bond yield is 5.25%. The US 10-year government bond yield is 1.75%. The yield spread in this case would be 350 basis points in favor of the Australian Dollar.
Suppose the Australian government raised its interest rate by 25 basis points. The 10 year Australian government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of AUD. The AUD will also be expected to appreciate against USD.
The general rule of thumb used is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currency in the currency pair. This is important information for you as a trader in telling you before hand about the change in currency price. Up to date interest rate data is available on Bloomberg. Keep track of the currencies in the pairs that you trade with that data. - 23218
The impact of interest rate changes is not only short term but also long term on the currency markets. One Central Banks interest rate decision can affect more than a single currency pair in the interconnected forex markets.
In forex trading, an interest rate differential is the difference between the base currency interest rate and the quoted currency interest rate. In the currency pair, EUR/USD, EUR is the base currency and USD is the quoted or counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the USD interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you when you trade forex. In addition to FEDs overnight fund rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.
The reason why it is profitable is that international investors like hedge funds, big banks and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currency prices. London Inter Bank Offer Rate and the 10 year government bond yields are usually used as leading indicators of currency movements.
Lets take an example, suppose the Australian 10-year government bond yield is 5.25%. The US 10-year government bond yield is 1.75%. The yield spread in this case would be 350 basis points in favor of the Australian Dollar.
Suppose the Australian government raised its interest rate by 25 basis points. The 10 year Australian government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of AUD. The AUD will also be expected to appreciate against USD.
The general rule of thumb used is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currency in the currency pair. This is important information for you as a trader in telling you before hand about the change in currency price. Up to date interest rate data is available on Bloomberg. Keep track of the currencies in the pairs that you trade with that data. - 23218
About the Author:
Mr. Ahmad Hassam is a Harvard University Graduate. He is interested in day trading and swing trading stocks and currencies. Learn Forex Nitty Gritty. Read about Trend Forex System. Try Netpicks Forex Signal Service.
posted by X - Men @ 1:11 AM
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