How Interest Rates Affect Forex Trading

Forex rates are always on the move. When traders are new, sometimes the moves seem mysterious and random. There are many things that affect the movement of exchange rates between countries. One thing that is always an underlying factor that is constant is the interest rate on a currency. In general it's considered good practice anywhere to gain interest on your money. People all over invest in money market funds, and bonds, and all types of investment instruments that offer paid interest in return for the use of the money.

A huge advantage of having access to a forex trading account is that you can invest your money in foreign currencies that pay interest. This really works out when you find a country that has a low interest rate to pair against. A set up like this is called carry trading. Carry trading is when you pick a currency pair that has a currency with a high interest rate, and a currency with a low interest rate and you hold it in favor of the currency that pays more interest. Using daily rollover, you get paid daily on the difference in interest between the two countries. If you've employed some leverage, you can make a very good return versus the capital required to make the trade.

The question is, how do interest rates affect currencies?

The easy answer is that it makes global investors pour their money into countries so they can get a piece of the return. As interest rates go up, interest in that country's currency goes up. If a country raises interest rates over a long period of time, this can cause an extended trend against other currencies. Money just continues to pile into these currencies until there is any indication that the party might end soon.

The downside of this approach to trading is that it's very risk sensitive. Anything that could affect economies globally can shake an interest rate trade to the core. This type of shake up doesn't come often, but when it does, it leaves disaster in it's wake for anyone that isn't prepared. During the financial crisis of 2008, high interest currency pairs moved sometimes over 1000 pips a day as the world economy became very uncertain. For months after anytime any step of the recovery looked shaky, similar smaller flip outs would happen.

Sometimes a country will have a high interest rate but a falling currency. This is usually an indication that the amount of interest they are paying isn't worth the risk required. The other thing it can indicate is that there are signs that rates will be lowered soon.

As a forex trader, it's good to look at the full picture. How is the country doing economically? Why are they raising or lowering interest rates? Not to mention, you need to know about the country that you're pairing the high interest currency against. This is all a game of relation. Sometimes it's one of the currencies in the pair that is causing movement, and sometimes it's both, so it's always good to take the full picture into account.

There are always multiple factors that move a currency, but interest is one of the number one factors, only followed by risk. If you can understand those two factors when making trades, you'll be just fine as long as you don't over do it.