Interest rates, monetary policies and trading

Interest rates are probably the main factor that contributes to determining the value of a currency, according to macroeconomic theory, as international investors want to own more local currency when the financial assets denominated in this currency increase in yield, just by virtue of the increase in interest rates. This is why forex traders pay so much attention to central bank decisions on monetary policy. One of the major influences on a central bank’s interest rate decision is price stability or inflation, as it is believed that an excessive level of inflation could harm the economy. This is why central banks always keep an eye on the economic indicators that measure inflation, such as the CPI and the EPC. In an attempt to keep inflation under control, central banks raise interest rates, resulting in a economic growth reduction. This occurs because high interest rates normally force consumers and companies to borrow less and save more by reducing consumption. Conversely, when interest rates fall, consumers and companies are more likely to take out loans, increasing retail and capital spending, thus boosting the economic growth.

Forex markets are constantly evolving and anticipate events and situations. Interest rates do the same thing. Most forex traders do not spend time focusing on current interest rates, because the market has already in some way “priced in” them in the currency price. What is important is the expected interest rates. It is also important to know that interest rates tend to move in line with monetary policy, or more specifically, with monetary cycles. This is whe traders always try to forecast when and to what extent a change in interest rates happen.

A shift in interest rate expectations can signal the start of a speculative movement, gaining more momentum as interest rate changes approach. While interest rates change with the gradual shift in monetary policy, market sentiment may also change quite suddenly. This causes interest rates to change more drastically or even in the opposite direction as originally planned. One of the most observed variable by traders to predict interest rates is the Federal Reserve “dot plot”. The US central bank uses this chart to signal its beliefs on the interest rate path. This point chart, which is published after each Federal Reserve meeting, shows the beliefs of each of the 16 members of the Federal Open Market Committee (the Fed’s bigwigs that are actually charged with setting interest rates).

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