How the interest rates affect forex markets

We know that central bank’s decisions influence the forex market. This happens through interest rates and money supply. Economic textbook teaches that the lower the rate, the less willing the banks are to keep deposits at the central bank, therefore, and the more domestic currency in circulation.

For example, the Eurozone economy has been in a stagnation for a long time, after the 2008 Great Recession. The European Central Bank decided to cut the interest rate to zero and to a negative level on deposit facility, in order to force banks not to pay a kind of tax on deposits so they would rather withdraw the Euro kept at the ECB. This move helped the Eurozone economy to recover, but weakened the euro because there was much more euros in circulation.

When central banks take expansionary monetary policy decisions, we can observe a price reaction before the cut, according to market expectations by traders, in the first few minutes after the cut and over the weeks after the cut. The magnitude of the reaction depends, as we said, on if and how much the move was priced in by investors. If the move had been anticipated by the market, perhaps thanks to a keen forward guidance undertaken by the central bank, then it is very likely there are no surprises. Otherwise, an unexpected move could lead to emotional reactions soon after the decision, and this may worth hundreds of pips in the first few minutes, depending on how ‘strong’ is the central bank’s decision.

Usually, the price of the related currency goes in the same direction as the interest rate decision, meaning that when the rates are cut the currency falls, and when the rates are hiked that currency rises. But sometimes the price and the rate decision move in opposite directions, although this is an exception rather than the norm. Therefore, some experience is needed to be able to carry out profitable trades close to the decisions of the central banks, also to understand exactly how to manage the “anticipatory signals” coming from the markets.

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